Tech crackdown creates sizeable gap in Chinese ETF performance

The recent divergence in performance shows how different some China indices are from one another. 

China has the world’s largest population, second-largest economy and a plethora of world-leading companies. All of this, combined with its still brisk economic growth rates, makes it an attractive place for investors. However, it is also a complicated and at times confusing place when it comes to gaining exposure, particularly when it comes to using exchange-traded funds (ETFs).

One of the main issues is the various share classes. Historically, China has been reluctant to allow foreigners to invest in domestic stocks denominated in its local currency. As a result, Chinese companies have often listed on stock exchanges outside of mainland China, notably New York or Hong Kong.

This has given rise to various “classes” of Chinese shares. For example, there are the Chinese A-shares, which are listed on mainland China exchanges and denominated in the local currency. Meanwhile, shares on the Hong Kong exchange are labelled H-shares and those that have listed in New York are called N-shares.

Until 2003, foreigners were banned from investing in A-shares. Restrictions have since gradually been relaxed. As a result, in 2018 many A-shares were added to the main MSCI China Index. However, the distinction between the different share classes persists and still shows up in indices and the ETFs tracking the China market. So, for example, while the MSCI China Index now includes A-shares (alongside N-shares and H-shares, among others), there is still the MSCI China A Index. As the ‘A’ indicates, it only includes domestic local currency stocks – A-shares.

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This understandably can create some confusion among investors, especially those who just want quick and easy passive exposure to China. But the distinction between the two indices is important. Despite the inclusion of A-shares in the main index, the two indices still have a very different composition. As a result, the performance of the two can diverge widely.

This has particularly been the case in recent months. Towards the end of 2020, Ant Financial, a spin-off from e-commerce giant Alibaba (NYSE:BABA), was due to list publicly. However, the plan was abruptly shelved by Chinese authorities, supposedly after critical comments from Alibaba founder Jack Ma about China’s regulatory authorities.

Eventually, this spread into fears of wider a backlash against big tech companies in China. Alongside Alibaba, several other large tech companies become the subject of anti-monopoly probes by the Chinese government. This, combined with the global market shift away from growth and tech stocks, has taken a toll on the performance of China’s large tech companies in recent months.

These tech companies, however, are mostly listed on exchanges outside of mainland China, mainly New York. Alongside the historic regulations listed above, this was also to gain access to more international capital, with the US investment market being the largest in the world. As a result, these names are found in the MSCI China Index, which includes off-shore listings, but not in the domestic A-shares focused MSCI China A Index.

As a result, the difference in performance between the two indices has widened. Over the past three months (as of 15 June), the HSBC MSCI China ETF GBP (LSE:HMCH), which tracks the main index which includes foreign-listed shares, has lost 4.6%. In contrast, the A-shares-only iShares MSCI China A ETF USD Acc (LSE:CNYA) has gained 5.8%. A large part of this can be attributed to the poor performance of N-share (New York listed) and H-shares (Hong Kong listed) Chinese tech companies over this period, which make up huge weighting in the main MSCI China Index.

As noted, the worse performance is partly the result of the specific perceived risks surrounding these stocks due to the supposed government crackdown on tech companies. However, it is also the result of the switch from growth stocks, which include tech, to more cyclical and value stocks – a global market trend. This can be seen in the sector composition of the two indices.

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The main MSCI China Index has a weighting to consumer discretionary of 32% and almost 20% to communication services, meaning together these sectors account for over 50%. Those two sectors are often where e-commerce and other tech platform companies are placed. In contrast, about 50% of the MSCI China A-shares Index is split between the financials, consumer staples and industrials.

Either way, the two ETFs tracking indices with seemingly similar names, have very different compositions and therefore have provided investors with very different types of exposure and therefore different performance.

None of this is to say that the MSCI China A-shares Index is the ‘better’ option due to the recent performance. Many of the tech stocks that have  negatively impacted the performance of the MSCI China Index are still companies that many investors are very bullish on. But what this recent divergence in performance underlines is the difference between these two indices and the potential divergence of performance between the two. Therefore, it is essential that investors looking to gain access to this market are familiar with these different indices so they know exactly what they are gaining exposure to.