This report is first written on FSMOne.com, you can read the original article here.

  • The vast number of Chinese equities listed around the world has given birth to multiple share classes, whose exposure cannot be completely captured using single share class ETFs.
  • The use of a total China ETF such as the Vanguard Total China Index ETF provides investors with exposure to all Chinese equities, regardless of where they are listed.
  • With low correlations to other equity markets, Chinese equities are a critical component of every globally diversified portfolio.

China has come a long way since the 1980s, growing by leaps and bounds to become a global economic powerhouse. Today, it is the second-largest economy in the world, with an approximate 15% share of global GDP. With continuing economic reforms and a shift towards a more sustainable growth model, China is fast catching up to the US, and it is just a matter of time before it topples US to become the number one economy in the world.

Mirroring the remarkable economic growth is its stock market, which has reached a total market capitalisation of USD 6.5 trillion in 2018, making China home to the second most valuable stock market in the entire world. With such a sizeable economy and stock market, China is simply too big to ignore for investors who wish to construct a globally-diversified portfolio.

Navigating China’s different share classes can be a challenge

China’s thousands of publicly-listed companies are categorised into various share classes, each with distinct characteristics (Table 1). While the majority of them are listed on mainland exchanges such as the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE), there are also a handful of companies that have chosen to list on other exchanges, like the Hong Kong Stock Exchange (HKEX) and the New York Stock Exchange (NYSE).

Table 1: Chinese equities are listed on a wide variety of exchanges

Share ClassDescriptionCurrencyNumber of stocks
A-sharesChinese companies incorporated in mainland China and listed on the Shanghai and Shenzhen stock exchanges.RMB3622
B-sharesChinese companies incorporated in mainland China and listed on the Shanghai and Shenzhen stock exchanges.USD100
H-sharesChinese companies incorporated in mainland China and listed in Hong Kong.HKD272
Red ChipsState-owned Chinese companies incorporated outside mainland China and listed in Hong Kong.HKD174
P ChipsChinese companies incorporated outside mainland China and listed in Hong Kong.HKD737
N-sharesChinese companies incorporated outside mainland China and listed in US.USD172
S ChipsChinese companies incorporated outside of mainland China and listed in Singapore.SGD98
Source: Various Exchanges, iFAST Compilations 
Data as of May 2019

With so many different share classes available, investors often face the tough question of which ones they should invest in. As a result, many often resort to predicting the next best performing share class, which sounds like a good idea in theory, but like most things, is easier said than done.

If we analyse the returns of various share classes over the past 10 years, two important observations stand out. First, none of the share classes were consistent outperformers during this period. Second, there was no discernible pattern that would have allowed investors to successfully predict the next best performer (Figure 1).

Figure 1: The top performing share class is difficult to predict

Coupled with the fact that most China-centric ETFs in the market only provide exposure to a single share class, navigating China’s equity market can be a huge challenge, especially for investors who are seeking complete exposure to all classes of Chinese equities.

For example, if you had bought into an A-share ETF, you will not have exposure to HKEX-listed Tencent (HKEX.700), one of the largest tech companies in China. Similarly, a H-share ETF will not give you exposure to certain prominent mainland Chinese companies, such as Kweichow Moutai, the world’s most valuable liquor company. Even if you own both an A-share ETF and a H-share ETF, you will still lack exposure to China’s home grown search engine giant Baidu (NASDAQ.BIDU), which is listed in the US.

In light of this, investors who wish to obtain complete exposure to all Chinese equities will have to own multiple ETFs. The idea of buying multiple ETFs for exposure to a single country may not appeal to some investors, as this adds to transaction costs and the amount of effort required to monitor multiple ETFs.

One ETF to trade them all

Fortunately, there is a solution for all the above-mentioned problems. Investors who wish to capture the entire growth potential of China with only a single instrument can consider the Vanguard Total China Index ETF (HKEX.3169).

Comprised of over 900 holdings across various share classes (Figure 2), this ETF provides diversified exposure to the entire Chinese equity market, while sparing investors the stress of accurately predicting the next winning share class and the pain of monitoring multiple ETFs in their portfolios. The mix of share classes within this ETF also helps to mitigate the volatility of the retail-dominated A-share market, which has a reputation for being the most volatile market among the lot.

Figure 2: The Vanguard Total China Index ETF provides exposure to all share classes of Chinese equities

Besides diversifying across multiple share classes, the Vanguard Total China Index ETF also offers balanced exposure across various Chinese equity sectors, unlike most A-share and H-share ETFs, which can be heavily weighted towards the financial sector (Figure 3). With lower concentration risk, the probability of large losses during periods of heightened volatility is reduced.

Figure 3: The FTSE Total China Connect index provides a more balanced sector exposure compared to the CSI 300 index and the HSCEI index

Using only this ETF, investors can obtain complete and diversified exposure to all Chinese companies regardless of where they are listed. What’s more, this ETF has an expense ratio of only 0.4%, which is fairly low considering the amount of convenience and exposure it delivers.

Another plus point about this ETF is that the majority of its top 10 holdings contains several companies which we are hugely positive on, such as TencentPing An Insurance GroupAlibaba and the Big Four Chinese Banks (Table 2), making it the perfect instrument for investors who are looking to buy only one ETF for their China exposure.

Table 2: Top 10 holdings of the Vanguard Total China Index ETF

HoldingShare ClassSectorWeightage (%)
TencentP ChipCommunication Services9.6
AlibabaN-shareConsumer Discretionary7.6
Ping An InsuranceH-shareFinancials3.5
China Construction BankH-shareFinancials2.8
Industrial and Commercial Bank of ChinaH-shareFinancials2.6
Kweichow MoutaiA-shareConsumer Staples1.9
China Merchants BankH-shareFinancials1.7
BaiduN-shareCommunication Services1.6
Total34.7
Source: Vanguard, iFAST Compilations 
Data as of 30 Apr 2019

An essential component of every globally diversified portfolio

Given the size of China’s economy and the rate at which its stock market is growing, it is hard to deny that China is playing an increasingly important role in global equity markets. MSCI’s move to include China A-shares in several of its key indices also underscores the importance of Chinese equities.

(Related Article: MSCI’s Inclusion Of Chinese A Shares – What’s Next?)

Presently, Chinese equities constitutes roughly 30% of the MSCI Emerging Markets Index. At full inclusion, the proportion of Chinese equities will exceed 40% of the index, making China an essential component of every globally diversified portfolio. From a portfolio perspective, an allocation to Chinese equities can yield significant diversification benefits, as they have historically low correlations with other global equity markets (Figure 4).

Figure 4: Chinese equities can serve as a diversification tool for your portfolio

Source: Bloomberg, iFAST Compilations
Matrix constructed using 5 year weekly correlations 

Lately, the lack of progress on the trade front, coupled with the developments surrounding Huawei and US chipmakers, has led to a pull-back in Chinese equities, creating another opportunity for investors who missed the sell-off last year to enter the market.

(Related Article: What you need to know about the latest developments surrounding US chipmakers and Huawei)

Although the FTSE Total China Connect Index has bounced back from its December 2018 lows, current valuations are still considered attractive as two of its largest components (A-shares and H-shares) which makes up more than 60% of the index are still trading well below their estimated fair PE ratios of 13x and 12x respectively (as measured by the CSI 300 and HSML 100 indices).

On the whole, a look at the estimated earnings growth also supports our bullish case for Chinese equities, as earnings for the FTSE Total China Connect index are projected to grow by 15.8% and 13.5% in 2020 and 2021 respectively. With such strong earnings growth, we should see an upward revision in share prices over the next few quarters as prices are predominantly driven by earnings.

(Related Article: Here’s what investors should know amidst the Trade War)

Investing does not have to be complicated or difficult. For those who are interested in adding Chinese equities to their portfolio but are not confident in their stock picking skills, they can consider doing so through an ETF such as the Vanguard Total China Index ETF (HKEX.3169).

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.

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