New vehicles for passive investors

If you had invested in the Hang Seng China Enterprises Index at the end of 2003, 10 years later your total return would have been 207 per cent, compared with just 124 per cent in the MSCI World index.

More recently, the story has not been so compelling; a 9 per cent return compared with 25 per cent over the three years to the middle of June. But while the slowdown in China’s economy has caused its stockmarket to stall, its economic growth rate is still putting the developed world to shame.

While the IMF predicts growth to cool further over the coming years, a pertinent question is whether after three years of lukewarm returns, this period of slightly slower economic growth has been priced into Chinese equity markets. In many ways, Chinese equities look as if they may offer good value; for instance, price-to-earnings ratios are down at 9x compared with 19x for the US. For the three years to the end of 2013, the Chinese economy had grown by a cumulative 27 per cent while the MSCI China Index had added only 4 per cent.

There are still reasons for caution, including fears for the Chinese financial sector and ongoing political reforms. But if you believe that China will avoid its own version of a banking crisis – and well over $3trn (£1.8trn) of foreign currency reserves puts it in a good position to do so – now might be a good time to have another look at the region.

The good news is there are now many ways to invest in China, particularly for passive investors, with new developments that are opening up the market.

There are two main markets for equity investors: Hong Kong ‘H’ shares and Chinese ‘A’ shares. The H-share market is a US dollar market for international investors and consists of Hong Kong listings of large companies based and largely operating in China.

The A-share market is based in Shanghai, denominated in renminbi and is much larger, consisting of the full spectrum of Chinese listed companies. Restrictions imposed on the A-shares market, which make it difficult for overseas investors to access, has meant domestic Chinese investors dominate the trading flows, giving the market a unique flavour.

But until recently, the only way for passive investors to access this market was via synthetic exchange-traded funds (ETFs) using a swap.

More recently, the Chinese authorities have increased the quota of renminbi available for foreign investors to invest in renminbi-denominated A-shares. As a result, physical ETFs have been launched offering overseas investors access to the local Chinese market through a plain vanilla product.

While there has never been any suggestion that the synthetic China ETFs were not completely safe, local counterparties were involved in the process, making due diligence much harder. Having the option to access the market through a plain vanilla, synthetic ETF will appeal to a wider universe of investors.

This is a positive development as the H market tends to be more correlated with the rest of the world’s stock exchanges. By definition, the H-shares tend to be owned by overseas investors and will reflect their trading views.

There are two complications that A-shares investors need to consider, however: tax and currency. There is a chance the Chinese tax authorities will apply retrospective withholding taxes on dividends and capital gains on A-shares, but this is not yet clear. Just in case a tax is levied, providers offering physical A-shares ETFs plan to hold back part of the dividend and capital gain on the ETF. If no tax is levied, they will eventually release the provision back to investors.

When it comes to currency, it is only recently that exposure to the renminbi has been anything other than a positive experience for international investors. That one-way bet unravelled in April when it devalued by 0.7 per cent against the US dollar. The renminbi is a ‘non-deliverable’ currency, which means it cannot be hedged, so do not expect currency hedged ETFs to be launched as they have been for sterling investors into euro, US dollar and yen markets.

After this brief reminder that there is no such thing as a free lunch, the renminbi has reverted to its more sedate existence. Currency risk does remain but the renminbi has been strong for some years, so exposure might even be a help rather than a hindrance.

Christopher Aldous is managing director at Charles Stanley Pan Asset