Rationing of China ETFs Hits U.S. Market as Demand Soars

By Boris Korby

The fund managers running the X-trackers Harvest CSI 300 China A-Shares ETF at Deutsche Asset & Wealth Management are facing a problem their rivals would love to have. They’re luring too much money.
In the span of five days last month, the U.S.-based exchange-traded fund pulled in $130 million, sending assets surging by 33 percent to $515 million and nearly exhausting its Chinese government-imposed A-share purchasing quota. Managers were forced to get creative. They limited new creations and borrowed quota from another fund to avoid closing the year-old ETF to inflows and keep a potentially disruptive premium to underlying assets from developing.
Their dilemma highlights what’s likely to become an increasingly common predicament as fund providers from BlackRock Inc. to CSOP Asset Management Ltd. look to follow suit and open up China’s more than $4 trillion A-shares market to
U.S. ETF investors. How should they handle growing demand for exposure to mainland companies from Industrial Bank Co. to Gree Electric Appliances Inc. (000651) even as Beijing continues to ration out the quota foreign ETF providers need?
“The A-shares market has gotten a lot of attention,” Dodd Kittsley, the New York-based global head of ETF national accounts and strategy at Deutsche Bank AG’s Deutsche Asset & Wealth Management unit, said in an Oct. 8 telephone interview. “We’ve been proactive in trying to create capacity without quota.”

Attractive Market

Surging demand has been fueled in part by the biggest quarterly gain for mainland stocks since 2009. The Shanghai Composite gauge rallied 15 percent in the three months through Sept. 30, even as the MSCI Emerging Markets Index fell 4.3 percent. The Shanghai gauge slid 0.4 percent today.
To deal with the influx of new money, Frankfurt-based Deutsche Asset & Wealth Management said Sept. 11 that the ETF would accept just one creation unit per day. A unit represents 50,000 shares or about $1.3 million at current valuation. The fund provider is increasing the cap to 10 creation units per day, according to a statement today.
“We wanted to maintain a valve of liquidity, increasing the fund size but doing so in a measured way, in anticipation of getting a higher quota,” Kittsley said.
A Qualified Foreign Institutional Investor license, known as a QFII, or Renminbi Qualified Foreign Institutional Investor license, known as an RQFII, is needed for foreign asset managers to buy A-shares. Once the license is obtained, the investor also needs to submit an application to China’s State Administration of Foreign Exchange for a specific dollar amount of investment quota that they can use to buy mainland stocks.

Securing Quota

U.S.-based asset managers currently aren’t eligible to apply for a license directly, and therefore use sub-advisers to secure quota.
Deutsche Bank has also taken advantage of excess quota from its sister product, the Deutsche X-trackers Harvest CSI 500 China A-Shares Small Cap Fund, and is investing on a limited basis in futures contracts to meet investor demand.
That’s helped keep the ETF’s premium over its net asset value from spiking. The fund has actually traded at an average discount of 0.29 percentage point to its underlying securities over the past month, Bloomberg data show.
Now BlackRock, the world’s largest money manager, is looking to roll out a competing U.S.-based product, the iShares MSCI China A ETF, that would similarly invest directly in Chinese equities trading on the Shanghai and Shenzhen stock exchanges, according to a Sept. 15 U.S. regulatory filing.

‘Be Involved’

Since 2004, the fund provider has managed the $9.4 billion Hong Kong-domiciled iShares FTSE A50 China Index ETF, which uses derivatives known as China A-Share access products to replicate mainland stock performance.
CSOP Asset Management, which runs the $6 billion CSOP FTSE China A50 ETF, the world’s second-largest exchange-traded fund investing in mainland Chinese stocks, filed to create a U.S. version of the Hong Kong-registered ETF three days after BlackRock’s filing.
“This ETF product offering, the A-shares suite, is one of many steps in the right direction to get global investors exposure to mainland China,” Chris Hempstead, the head of ETF sales at KCG Holdings Inc. in Jersey City, New Jersey, said in an Oct. 10 telephone interview. “It’s natural people want to own the companies that will win the most from an expanding and growing Chinese economy. People are tired of watching on the sidelines, they want to be involved.”
While there are at least four other U.S.-registered exchange traded funds investing in Chinese A-shares, including products from Van Eck Securities Corp.’s Market Vectors, Invesco Ltd.’s PowerShares and Krane Funds Advisors LLC, none have taken off like the Deutsche Bank ETF. The largest, the Market Vectors ChinaAMC A-Share fund, has about $30 million in assets, Bloomberg data show.

Exchange Link

Deutsche Bank and its sub-adviser, Harvest Global Investments Ltd., continue to work with Chinese authorities and other sources to increase the fund’s RQFII quota, according to Kittsley. They’re also exploring other means to access the market, including taking advantage of a bourse link set to start this month between Hong Kong and Shanghai that will allow a net 23.5 billion yuan ($3.8 billion) of daily cross-border equity purchases.
“We view the Hong Kong-Shanghai connect as another avenue to open up the A-shares market to non-Chinese investors,” Kittsley said. “Down the road it may be an avenue that would allow the fund to access specific securities, but it isn’t something we’d do right now.”