how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.

 

2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.

 

 

 

 

 

MSCI and China’s A shares

A few days ago, MSCI, the premiere authority on the structuring of stock market indices around the world, declared that it had been carefully considering adding Chinese A shares to its Emerging Market indices–and concluded that it would not yet do so.

What is this all about?

MSCI

MSCI (Morgan Stanley Capital International) creates indices that investment management companies use to construct their products–both index and actively managed– and to benchmark their performance.

Having a certain stock, or a set of stocks, in an index is a big deal.   For passive investors, it means that they must hold either the stocks themselves or an appropriate derivative.  Either way, client money flows into the issues.

For active investors, they’re forced to at least research the names and keep them on their radar.  If they don’t hold a certain stock or group, they’re at least tacitly betting that the names in question will underperform.

 

If we measure economic size using Purchasing Power Parity, China is the largest in the world.  It seems odd that the country not be fully represented in at least Emerging Markets indices.

 

China

Beijing, in the final analysis, would like to have international investors studying A shares deeply and buying and selling them freely.

How so?

In many ways, the story of the growth of the Chinese economy over the past three decades has been one of slow replacement of the central planning attitude of large, stodgy state-owned enterprises with the dynamism of more market based rivals.  The heavy lifting has been done by constant political struggle against powerful entrenched, backward-facing, political interests that even today control some state-owned enterprises.  It would be nice for a change to have the market do some of the work–by bidding up the stocks of firms that increase profits and punishing those that simply waste national resources.

 

In addition, Beijing now seems to believe that freer flow of investment capital in and out of China can act as a safety valve to counteract the extreme boom/bust tendency that the country’s domestic stock markets have exhibited in the past.

 

the burning issue?

Foreign access to the A share market is still too limited.

Fir some years, China has had a cumbersome apparatus that allows large foreign institutions to deposit specified (large) sums of money inside China and use the funds to buy and sell stocks.  But becoming a so-called qualified foreign institutional investor and operating within government-set constraints is a pain in the neck.  It’s never been a popular route.

Recently, Beijing has begun to allow investment money to flow more freely between Hong Kong and Shanghai.  A HK-Shenzen link is apparently also in the offing.

In MSCI’s view, this isn’t enough free flow yet.  I think that’s the right conclusion.  Nevertheless, weaving A shares into MSCI indices is only a question of time.

my thoughts

As professional securities analysts from the US and elsewhere turn their minds to A shares, there stand to be both big winning stocks and equally large losers.  The big stumbling block will be getting reliable information to use in sorting the market out.

cooling the Chinese stock market fever

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.

 

We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.

Specifically,

–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.

 

 

Current Market Tactics, March 12, 2014

I’ve just updated Current Market Tactics.

Maybe a correction isn’t in the offing.  Too bad.  On the other hand, upside momentum seem to me to be waning.

junk bond ETFs underperforming in a down market: it’s the nature of the beast

ETFs

ETFs are a great innovation, in my view.  Legally, they’re set up as investment corporations, like mutual funds (read my posts on ETFs vs. mutual funds for more details).  But, unlike mutual funds, which process buys and sells in-house (and charge a recurring fee to holders for doing so), ETFs outsource this market-making function to Wall Street brokerage firms.

This difference has several consequences:

–no recurring fee, so lower overall fund expenses,

–you can buy and sell all through the trading day, instead of selling at closing net asset value,

–unlike a mutual fund, an ETF holder has no guarantee he can transact at NAV, and

–you pay the broker a commission and a bid-asked spread when you transact (the second is an “invisible” cost that may offset the advantage of lower fund fees).

If you’re a buy-and-hold investor (the wisest course for you and me, in my opinion), ETFs have it all over index funds, especially for very liquid products like an S&P 500 index.

what about junk bond ETFs?

Why, then, have junk bond index ETFs been seriously underperforming their benchmarks during the current period of rising interest rates?

Several obvious factors:

–junk bonds aren’t particularly liquid.  Many don’t trade every day.  In fact, junk bond fund and ETF managers employ independent pricing services, which estimate the value of bonds that haven’t traded that day, in order to calculate daily NAV.

This means that if redemptions come, a junk bond index fund/ETF has to go hunting for buyers and won’t get the best prices for the bonds it’s selling.  The sharper-than-benchmark falls in ETF NAVs suggests they’re taking big haircuts on the positions they’re liquidating.

–ETFs attract short-term traders, who are more prone to redeem

–ETFs can be sold short, adding to downward  pressure

–ETFs don’t accept dribs and drabs of redeemed shares from the investment banks it uses as middlemen.  Brokers hold until they have minimum exchangeable quantities.  While they’re waiting, they may hedge their positions–meaning they may short the ETF, too.

Ouch!

One not-so-obvious one:

Unlike a mutual fund, the broker you’re buying and selling through has no obligation to transact for you in an ETF at NAV.  Quite the opposite.  Your expectation should be that the broker will make a profit through his bid-asked spread.

The broker typically has a very good idea what NAV is on a minute-to-minute basis.  Individuals like us usually don’t.  NOt a great bargaining position to be in.

In addition, in contrast with an S&P 500 index fund, where the broker gets an up-to-date NAV every 15 seconds, no one knows precisely what a junk bond fund NAV is at any given time (certainly the broker has a better idea than you and me, but that’s another issue).  This uncertainty makes the broker widen his spread.

On top of that, when a broker is taking on more inventory of shares than he feels comfortable with, he’ll widen his spread further, to discourage potential sellers from transacting.

Brokers know how much money they make through these spreads.  No one else does.  We do know, though, that in past times of stress the last trade of the day in a less-liquid ETFs has often been substantially below NAV.  My guess is that recent junk bond ETF sellers have paid a hefty price through the bid-asked spread to get their transactions done.  If you’re one, compare your selling price with that’s day’s NAV and see.