Hong Kong Safer Than US Exchanges?

Nick is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Prior to joining Global X Funds, Alex Ashby lived and traveled extensively throughout Asia.  He currently manages a group of six ETFs covering the consumer, energy, financial, industrial, material, and technology sectors of the Chinese economy.

[continued from “Taking Stocks of China (The Upside of 25 Million Single Drunks)]

Nick Slepko:  The SEC recently charged the major accounting firms (DeloitteErnst & YoungKPMGPricewaterhouseCoopers, and little BDO) with securities violations in collaboration with nine Chinese companies that are listed/quoted on US exchanges.  Though not yet publicly disclosed, the Gang of Nine probably include the usual suspects like Longtop Financial and China MediaExpress [neither of which are currently part of the Global X China ETFs].  Your China ETFs only include stocks listed on the Hong Kong Stock Exchange, or depository receipts (DRs/ADRs) linked to the SEHK, whereas it is likely that the Nine are those structured in a way that they only appear publicly on US exchanges (or are quoted OTC).  Do you feel securities listed on the Hong Kong exchange are as good, or possibly better, in terms of the information and the reliability of the data you get with a NYSE (NYSE: NYX) or NASDAQ (NASDAQ: NDAQ) listing?

Alex Ashby:  At the end of the day I view [the recent SEC move] as a positive development in the long run, clearly there needs to be more cooperation/standardization among regulators in the two countries.  While no regulator can guarantee complete prevention of fraudulent activity – which we have seen many times here in the US as well – we believe that the SEC and its counterpart in Hong Kong are both moving in the right direction and taking action against companies while also creating deterrents for future misconduct.  This also demonstrates another area where ETFs and mutual funds can benefit investors: by providing built-in diversification through a wide range of holdings, investors can reduce company-specific risk and dampen the impact of these types of events. 

Foreign investment in China is highly restricted, but most Chinese companies have listings across a number of share classes available to foreign investors.  These share classes are B-shares in China, which are open to foreign investors, H-shares of companies incorporated in China and listed in Hong-Kong, red chips of state-owned Chinese companies also listed in Hong Kong, P-chips of nonstate-owned Chinese companies incorporated outside the mainland and traded in Hong Kong, and N-shares or ADRs of Chinese companies listed in the NYSE or NASDAQ. Not all ETFs focused in China provide access to all these share classes, but all the Global X China ETFs do provide comprehensive access to all these investable share classes.

Slepko:  Some places like South Africa and Japan have far more intense listing requirements, and many assume that because of Sarbanes-Oxley and other regulations that the US is the most complicated and secure.  But I think it depends on what you are comparing. China has a reputation, but on the other, there is Hong Kong – two systems and all.  Is the SEHK better, or has it just not gotten caught yet?

Ashby:  From a listing requirement standpoint, we view the Hong Kong exchange to be equally as diligent as its US counterparts.   The penalties for violating requirements in Hong Kong are severe, so there is a strong incentive there to play by the rules and make sure everything is in order.  However, I wouldn’t say their requirements were any more stringent than the US exchanges. The other important consideration from an investor protection standpoint is the Hong Kong Securities and Futures Commission (SFC), which is equivalent to the SEC in the US.  We also view the standards of the SFC as strong, with a renewed focus on financial accounting and oversight.  This is partly why the reverse merger process is important to understand – it allowed companies based in China to list on US exchanges without being subject to local regulations (because they weren’t listing in Hong Kong) and bypassing many domestic regulations because the reverse merger allowed them to avoid the typical IPO regulatory process.

Slepko:  While I’m not a China bull, if I were inclined to invest in Chinese public companies, I would start by considering the two hundred included in your six China ETFs.  Along with the other criteria Global X and its indexers use, they seem like the safest risks in terms of having reliable reporting and confirmed solvency.  However, I’m curious about Baidu (NASDAQ: BIDU) and Chinese companies that use VIE-structures.  Often, these companies are traded (as ADRs) on US exchanges with their underlying securities being untradeable,Cayman Islands ordinary shares.  Does Baidu (and companies with similar structures) require special homework for Global X, its indexers, or the average individual investor – especially since this is a popular arrangement with Chinese companies? 

Ashby:  The VIE structure has become a popular arrangement for Chinese companies in large part because China imposes significant restrictions for foreign investment on Chinese companies that operate in particular sectors (such as the Internet and media).  What the VIE structure has done is to allow some Chinese companies like Baidu to access funding from multinationals and venture capitalists abroad.  The VIE structure itself isn’t inherently problematic, but it is more opaque and there are some unique characteristics that investors should be aware of – we recommend that investors take a closer look at SEC filings for these companies so that they can identify firms that have VIE agreements that offer significant shareholder protection (Baidu is an example of such a firm).  Interestingly, this structure is not just a Chinese phenomenon – US companies such as Amazon (NASDAQ: AMZN) and Expedia (NASDAQ: EXPE) have also used the structure for their operations in China.

Nick Slepko (hukgon) has no position in any company mentioned here at the time of publication. The Motley Fool owns shares of Amazon.com and Baidu. Motley Fool newsletter services recommend Amazon.com, Baidu, and NYSE Euronext. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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