What’s the most intelligent way for advisors to help their clients invest in the Chinese stock market? According to Michelle Gibley of Charles Schwab, until last year there was no way to invest directly into Mainland Chinese stocks or “A” shares, whose market value has reached approximately $4 trillion.
Today, instead, advisors have four distinctive ways to invest in Chinese Stocks: 1) Buying directly “A” shares through the new “stock link” 2) Purchasing Open Ended Mutual Funds focused on China 3) Buying China ETF’s or 4) Purchasing discounted Closed End China Funds.
Buying China A shares directly: The good news is that investors now have access to China “A” share equities, due to new market reforms. This allows financial advisors to purchase a limited amount of “A” shares exchange companies for their clients through a stock “connect” between Hong Kong and Shanghai. The “connect” is comprised of a “Northbound link,” which offers stocks of 568 companies, and a “Southbound link,” which features stocks of 266 companies. However, it is a bit more complex than that, as the “A” share exchange index trades at a 27% premium to the “H” share index. This premium makes an analysis to determine which shares to purchase more complicated. In addition, the new “stock connect link” may provide a way for “arbitrageurs” to trade away the premium, which will result in a more efficient pricing between the “A” and “H” shares. If that happens, advisors want to own the shares trading on the exchanges at 27% discount. The bad news is that it is still very difficult and complex to find research on the available stocks, calculate their premiums and then figure out what’s available to trade.
Purchasing Open Ended Mutual Funds: For most investors, the most suitable course of action remains to hire professional managers. Currently, most advisors and investors select their funds from the Morningstar’s listed 19 “China region” funds, which collectively manage approximately $5.6 billion. Unquestionably, relying on Morningstar or on experienced financial advisors to select the most appropriate funds remains the most viable strategy.
Buying China ETFs: Another choice is to select ETF contracts that focus on China, Hong Kong and Taiwan. Currently, there are 25 ETFs with a 5- year history and managing over $24 billion, which give advisors a wide range of choices to select from. ETFs have the advantage of lower fees, good liquidity and tracked benchmarks, which prevent advisors from getting unwanted portfolio holdings.
Purchasing Discounted Closed End China Funds: This last choice is typically the most misunderstood, but one that can be most rewarding if properly analyzed. Buying mutual funds at discounts to their Net Asset Value has many advantages. There are currently 7 offering of “closed end funds” that focus on the China region. Our current favorite strategy is to purchase shares in the MS China “A” Share Closed-end Fund, [NYSE: CAF], a 4 Star Morningstar rated fund with a market capitalization of $933 million. It’s current 20% discount to its Net Asset Value (NAV) is well below the funds average discount of -9.52% over the last 52 weeks. If the fund’s discount moves back to that average, investors will benefit by earning an extra 10% over similarly managed open-ended funds or ETFs. Managed by Morgan Stanley, this fund has a very good track record. For more sophisticated investors, financial advisors might even consider buying CAF and selling calls against the “A” Shares exchange through the ETF ASHR that tracks the CSI 300 index (the largest 300 “A” shares listed in Shanghai and Shenzhen). This is not a perfect hedge, but the correlation is very high and should mitigate some risk if the index were to decline from today’s level.
Our research indicates that consistently buying deeply discounted Closed End Funds results in superior returns and alpha generation. Our firm has generated a 20+-year study that highlights the excess returns that can be generated by buying discounts in any types of funds, including emerging market funds like CAF.
Since the People’s Bank of China announced the rate cut on December 8th, the China “A” share market is up more than 50%. If advisors are considering making an allocation to China, we think buying CAF at a 20% discount to its NAV is a much more astute way than any other alternative.
Bryn Torkelson is Chief Investment Officer at Portland, OR-based Matisse Funds, (www.matissefunds.com), a mutual fund company that invests solely in Discounted Closed-end Funds (DCEFs).
