China ETF: Meaning, Pros and Cons, Example

What Is a China ETF?

The term China ETF refers to an exchange-traded fund (ETF) that invests in Chinese securities. Like other ETFs, shares are listed and traded on stock exchanges. They tend to be passively managed, which means they mirror the holdings of an underlying index such as the MSCI China Index or the FTSE China Indexes. As a result, they come with low initial investments and low costs. Investors who choose to purchase shares in these ETFs are able to diversify their portfolios in more than 50 China ETFs that trade on U.S. exchanges.

Understanding China ETFs

China's economic growth has attracted a lot of interest from the investing community. But accessing its financial markets has been challenging for foreign investors. Not only are some of the country's largest companies state-owned, but there are also a lot of intricacies involved. There are a variety of share classes that trade on Chinese exchanges, not to mention the complications of how funds are structured.

Adding Chinese stocks to an investment portfolio provides exposure to a fast-growing economy, as well as a cushion against losses when the economy takes a turn for the worse in other parts of the world. This is where exchange-traded funds come into play.

ETFs use capital from multiple investors with similar goals. They are listed on exchanges and are traded throughout the day just like ordinary corporate shares. Their goal is to track the performance of an equity market, specific sector or industry, or trend by replicating an index's holdings. As such, this makes ETFs hypothetical portfolios of securities that represent a particular segment or entire market.

Investors have many choices when it comes to China ETFs. As of December 2023, there were 55 China ETFs that trade on U.S. stock exchanges with combined assets of more than $24 billion. The largest of these is the iShares MSCI China ETF (MCHI). Many of these funds track one of 13 Chinese stock market indexes. Others track the performance of the country's biggest companies while others hone in on specific sectors and themes such as the internet, formerly state-owned enterprises, consumer discretionary, financials, and small-caps.

Special Considerations

China's financial markets were fairly closed off to investors in the past. But things have opened up for eager investors, giving them four options from which to choose when it comes to investing in China. These include:

• Investing directly in companies listed on the Shanghai or Shenzhen stock exchanges (investors must be Qualified Foreign Institutional Investors to do so)
• Opening a brokerage account in Hong Kong, which would give investors access to mainland Chinese companies listed in the city
• Buying the global depositary receipts or ADRs of Chinese companies
• Targeting U.S. companies that grow their businesses in China

Stock picking in this country isn't a strategy suited to most investors. That's because the Chinese market can still be very volatile. The opacity of financial information, not to mention a lack of veracity, makes it difficult to evaluate individual companies. Investors hoping to tap into China are usually better off spreading their bets.

And there are still two very pressing issues that are weighing on the Chinese markets, including related ETFs. These are the trade war that began under President Donald Trump and the subsequent delisting of Chinese ADRs in the U.S. market.

U.S.-China Trade War

The fallout from the U.S.-China trade war was troublesome for the majority of ETFs. The world's two leading economies imposed tit-for-tat tariffs on hundreds of billions of dollars of each other's goods. In January 2020, a truce was reached and a preliminary deal signed, much to the relief of investors. But there are some trickier, delicate issues that still remain unresolved.

Delisting of Chinese ADRs

On Dec. 18, 2020, the Holding Foreign Companies Accountable Act was signed into law. The bill bars Chinese companies from listing shares on U.S. exchanges unless they allow the Public Company Accounting Oversight Board (PCAOB) to audit their financial records. Chinese companies have three years to comply before their shares are delisted.

On Nov. 12, 2020, President Trump signed an executive order that prohibited U.S. investors from holding shares of companies that are owned or controlled by the Chinese military. The order prohibited the purchase of companies with Chinese military links beginning on Jan. 11, 2021. Investors had until Nov. 11, 2021, to divest any existing holdings.

In response, FTSE Russell removed multiple Chinese companies from its indices. S&P Dow Jones Indices said it would remove 10 companies from its indices, including shares of contract chipmaker Semiconductor Manufacturing International. Shares of China Mobile, China Telecom, and China Unicorn were delisted from the New York Stock Exchange (NYSE) in May 2021.

Advantages and Disadvantages of China ETFs

As with any other investment, there are benefits and drawbacks that come with investing in China ETFs. We've listed some of the major ones below.

Advantages

China represents an ideal investment opportunity that few want to pass up. The country's economy is one of the fastest-growing in the world, coming in second after the United States. China's gross domestic product (GDP) for 2020 was $17.96 trillion.China's economy is projected to grow by 5.0% in 2023 and another 4.2% in 2024—much faster than the United States, which is poised to grow by 2.1% and 1.5%, respectively.

There are several other key benefits to investing in China ETFs. Here are a few of them:

• ETFs offer perhaps the easiest way to tap into this growth engine without worrying about legal and tax implications and individual company setbacks
• ETFs are bought and sold on a national exchange and trade just like stocks
• Management fees are typically lower than mutual funds
• ETFs can also provide diversification in markets fraught with risk and unknowns to the average investor

Disadvantages

Investing in China also comes with certain drawbacks. The country is led by a single political party that gooses GDP figures by spending on questionable infrastructure projects. Obtaining solid and accurate information about Chinese public companies is also difficult.

Volatility or price swings can be an issue so it's not unusual to see benchmark indices swing as much as 10% within a day. Experts blame this on retail investors who have few outlets for their savings and account for a significant portion of domestic turnover. Domestic fund managers are also fairly impatient and prone to emphasizing short-term performance.

Another major issue is the level of diversification China ETFs offer. Investors should research the holdings and sector weightings of individual ETFs to see if they align with their goals as certain funds may be heavily weighted toward financial, construction, and telecommunications companies.

Example of China ETF

As noted above, the iShares MSCI China ETF is the largest of its kind. MCHI launched in March 2011 and has more than $6.5 billion in assets as of December 2023. Shares trade on the Nasdaq. The fund's management fee was 0.58%.

The three main sectors are consumer discretionary (30%), communication (19%), and, financials (15.6%). The basket is comprised of 617 holdings, notably Tencent Holdings, Alibaba Group, and Meituan. The fund, which tracks the performance of the MSCI China Index, returned -34.13% over a one-year period and 3.8% for 10 years. This is compared to the performance of the underlying index, which returned -31.70% and 5.69% for those same periods.