New Banking Rules Shake up Major Chinese ETFs

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

When it comes to Chinese ETFs, the first name that pops up in an investor’s mind is the FTSE China 25 Index Fund ETF (NYSEMKT: FXI). With an enormous market cap of $7 billion, this ETF represents the blue chips of the Chinese economy, particularly its financial services sector. FXI is now changing its structure and becoming more diverse. But currently, investors looking for exposure towards large cap Chinese financial institutions have better alternatives to FXI.

The world’s largest bank, Industrial and Commercial Bank of China (ICBC), as well as China Construction Bank, Bank of China and Agricultural Bank of China, make up 30% of FXI. However, investors looking for an even greater focus on China’s financial services sector should look towards Global X China Financials ETF (NYSEMKT: CHIX). The four big banks constitute more than one third of CHIX.

<table> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>FXI</strong></p> </th><th> <p><strong>CHIX</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>ICBC</strong></p> </td> <td> <p>8.2%</p> </td> <td> <p>9.9%</p> </td> </tr> <tr> <td> <p><strong>China Construction Bank</strong></p> </td> <td> <p>10.5%</p> </td> <td> <p>9.9%</p> </td> </tr> <tr> <td> <p><strong> Bank of China</strong></p> </td> <td> <p>7.2%</p> </td> <td> <p>10.6%</p> </td> </tr> <tr> <td> <p><strong>Agricultural Bank of China</strong></p> </td> <td> <p>3.9%</p> </td> <td> <p>5.0%</p> </td> </tr> <tr> <td> <p><strong>Total, 4 Big Banks</strong></p> </td> <td> <p>29.7%</p> </td> <td> <p>35.4%</p> </td> </tr> <tr> <td> <p><strong>Total Financial Services</strong></p> </td> <td> <p>59.4%</p> </td> <td> <p>76.4%</p> </td> </tr> </tbody> </table>

A few weeks ago, the Chinese regulators, China Banking Regulatory Commission (CBRC), moved to curb the increasingly popular yet highly controversial short-term investment products, often called the wealth-management products. The move will give greater confidence to foreign investors, especially those looking to invest through CHIX. This will both harm the banks' short-term profitability on that front while slowly improving their capital quality and funding structure. Ultimately this is good news for foreign investors looking for an entry through the Chinese banking services ETFs.

For the first time, the banks mentioned above revealed that by the end of 2012, they had $467 billion of such outstanding products. Banks usually sell these to their customers as an alternative to the relatively less attractive bank deposits -- due to extraordinarily low mandated interest rates.

According to Fitch, the amount of money held in such products rose by 53% in just one year to $2.1 trillion (¥13 trillion) by the end of 2012. These are then invested into a variety of high- to low-risk securities and virtually all other forms of “assets.” Although it is generally understood that this capital is invested in low-risk money market instruments, little oversight and almost no disclosure is a recipe for a perfect disaster. Some regulators have also highlighted that some of the money is being diverted to high-risk individuals who otherwise are not allowed to take loans from banks. All of this is going to change with CBRC’s intervention.

The regulator has asked the banks to clarify asset classes linked to the wealth management products, which will then be audited. Moreover, the banks are being required to provide information as to where the funds are going and who is going to ultimately benefit from it.

Meanwhile, FXI, has certainly not lived up to its name. In the last 52-weeks, CHIX has easily outperformed FXI. It has been criticized in the past for focusing on just 25 companies and narrowing it down further to just Hong Kong listed red-chips and H-shares. H-shares are those companies that are incorporated in mainland China and trade on the Hong-Kong Stock Exchange (HKG) while red-chips are strictly state-owned enterprises that are incorporated outside of the mainland (e.g. Hong Kong) and trade in Hong Kong.

However now, like the MSCI China Index Fund ETF (NYSEMKT: MCHI), FXI will also consider P-chip stocks -- companies owned not by the government but independent Chinese entrepreneurs listed outside of mainland China, including foreign territories such as the Cayman Islands, and traded in Hong Kong .

The fund will however, continue to focus on just 25 firms – which in no way represents the country’s vibrant economy – but it will open its doors towards new sectors with financials dropping in weighting but still dominating. Tencent Holdings (NASDAQOTH:TCEHY) is now a part of FXI along with China’s largest shoe retailer Belle International. With these two firms, FXI finally has exposure to some of China’s emerging consumer-driven sectors, reflecting both its rising middle class and governmental focus on a more consumer-oriented economy.

As of April 4, the combined weighting of the two new firms in the index is 8.8%. Moreover, Tencent, a company of which I am already very fond due to a number of excellent assets in its portfolio like Riot Games, publisher of the hugely popular League of Legends, is the fifth biggest holding in FXI. This is a significant change for an ETF generally considered to ignore the technology sector.

FTSE’s reclassification will also affect its sister fund, the iShares FTSE China Index Fund.  FXI has dropped by ~4% in the last 52-weeks whereas CHIX has been up by 6.5% in the same period. However, FXI is still relatively expensive and less lucrative than CHIX, which is evident through its higher P/E and lower yield. FXI has seen a drop in AUM of more than 65%, down below $700 million US since the beginning of the year. With huge rallies in both the S&P 500 and the Nikkei 225 versus the languishing of the Shanghai Index clearly investors are looking for yield and still believe the story of liquidity-driven growth. For value investors, the time to begin looking seriously at China’s equity market is rapidly approaching. China may be cheap for a reason, but the S&P 500 is expensive for a less fundamentally sound one.

<table> <thead> <tr><th> </th><th> <p>FXI</p> </th><th> <p>CHIX</p> </th></tr> </thead> <tbody> <tr> <td> <p>Stock 52-weeks</p> </td> <td> <p>-3.7%</p> </td> <td> <p>6.5%</p> </td> </tr> <tr> <td> <p>P/E</p> </td> <td> <p>9</p> </td> <td> <p>8</p> </td> </tr> <tr> <td> <p>Yield</p> </td> <td> <p>2.6%</p> </td> <td> <p>3.1%</p> </td> </tr> <tr> <td> <p>Exp Ratio</p> </td> <td> <p>0.72%</p> </td> <td> <p>0.65%</p> </td> </tr> <tr> <td> <p>Fund Flows (52w)</p> </td> <td> <p>$702Mn</p> </td> <td> <p>-$6.3Mn</p> </td> </tr> <tr> <td> <p>Fund Flows (YTD)</p> </td> <td> <p>-$1.3Bn</p> </td> <td> <p>$1.6Mn</p> </td> </tr> </tbody> </table>


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