Here's How to Invest in China -- Or Around It -- With Four ETFs

In this era of what I'll call "conscious investing," one of the hottest of hot-button topics is allocating to China.

Some of you may read that line and say, "What's the issue with China? Its economy has been growing at 8.70% on average since 2000." Others may look at that growth and counter, "Impressive -- but at what cost?"

And there are issues, including how dissidents are punished and religious groups persecuted; how industrial intellectual property is appropriated; how capital markets are intervened upon; and how high-profile people occasionally disappear and then reappear. 

In this article, I'm going to look at two funds that focus on China and two that have zero exposure.

China? Yes, Please.

The first two funds are the 70 basis point KraneShares CSI China Internet exchange traded fund  (KWEB) and the 86 basis point Emerging Markets Internet & Ecommerce ETF (EMQQ) .

KWEB

KWEB is 100% allocated to China, as the names suggests and tracks the CSI Overseas China Internet Index. Qualifying constituents are required to be incorporated in mainland China, have operations based on the mainland, as well, and generate at least half of revenue from mainland China. Companies must have a market cap of at least $2 billion and daily average traded value of at least $3 million.

For initial public offerings, there are two sets of rules. For Hong Kong listings, the methodology states that IPOs should be seasoned for three months, "unless the market value of the IPO exceeds 3 billion USD." For IPOs on overseas markets, if the IPO valuation "is more than 10 billion USD, the IPO company will be added into the index at its 11th trading day."

The index is market-cap weighted and positions are capped at 10% at rebalance (June/December). Based on diversification rules there are a series of caps that may be triggered if the sum of positions greater than 5%, in aggregate, is greater than 40%.

EMQQ

EMQQ is a broader emerging markets product focusing on companies that generate at least half of revenue from internet and ecommerce activities in emerging market countries. It tracks the EMQQ The Emerging Markets Internet & Ecommerce Index. Constituents must have at least a $300 million market capitalization and have at least $1 million a day in average value traded over the trailing 3-months prior to rebalance (June/December). Per the issuer, the fund shows a 61% allocation to China. The index utilizes a modified market cap weighting scheme and positions are capped at 8%. There are no "Fast Track" rules for IPOs.

What Ever Happened to the ANT IPO, Anyway?

A couple of things about these funds, one of which will tie into some comments I'll make later and the other is something that I see a lot of targeted products do, which requires a minimum 50% exposure to the strategy. In building a thematic, or targeted index, I like to see at least 75% revenue exposure. 

Also, if you bought either of these funds on April 22, 2020, and sold this past Friday, here's what would have played out: You would have seen your position grow 108% in KWEB and 129% in EMQQ by Feb. 19 of this year. But then by Friday, when you sold, you would have seen KWEB give back those gains and EMQQ take a 37% haircut.

This round trip speaks to a bigger picture issue about investing in China, which is, if the Chinese government feels like it is losing control, or may in the position to lose control of just about any situation, the authorities will take quick, decisive action to "correct" course.

We have seen this recently with the abrupt cancellation of the ANT IPO and subsequent, let's say, "reclusiveness" of CEO Jack Ma; the clampdowns and ultimate banning of crypto activity; and the clear signaling from Beijing that the experiment the country has been conducting regarding capitalism seems to have run its course. These are monumental shifts in policy and appeared to have materialized overnight. This all confirms what my father told me after concluding some negotiations with China in the 1980s when he worked at the Gulf Investment Corporation. He said, "Mark, China does whatever the hell they want."

Given the statements and actions of the PRC over the past six months, investors that are looking for lower levels of volatility and steady state growth should not be considering China in their overall mix.

KWEB and EMQQ returns mirrored each other for the period shown.

Some China-Free Solutions: Looking for FRDM

Assuming investors are looking to reduce or even eliminate their exposure to China within their emerging markets allocation, there are products that can provide that experience. Two that I will talk about here are the 34 basis point (25 after a 9bps waiver) iShares MSCI Emerging Markets ex China ETF (EMXC) and the 49 basis point Freedom 100 Emerging Markets ETF (FRDM) .

EMXC

EMXC tracks the MSCI Emerging Markets ex China Index. Reading though the (189 page!) methodology the index looks to capture names with market cap at least $1.48 billion. Honestly, the document is such a labyrinth of references and cross-references that I could not find a clear description of just how country or constituent weights are determined. (I also think that while in there, I ran into a minotaur.)

I was able, however, to learn from the website that the fund has allocations to 23 of the group of 27 countries identified as "emerging" markets that accounts for the 678 equity positions in the index. Major country allocations (based on last Friday's holdings file from the iShares website) include Taiwan at 22.17%, South Korea at 19.16%, and India at 18.64%.

FRDM

FRDM invests following the Life and Liberty Freedom 100 Emerging Markets Index, which incorporates data from the Fraser Institute, the Cato Institute and the Friedrich Naumann Foundation for Freedom to develop a composite score of "Freedom," which captures civil, political and economic freedoms. The index then uses these scores to select and weigh the top ten ranked countries. State-owned companies are screened out and the 10 largest securities are market capitalization weighted within each country allocation. Top countries represented in the fund (per the latest factsheet) are Taiwan at 20.84%, Chile at 16.08%, Poland at 15.92% and South Korea at 15.59%.

Slow and Steady Wins the Race?

The round trip that KWEB and EMQQ took between April 22, 2020 and last Friday spelled out a 62.23% gain for EMXC and a 61.51% for FRDM. Tying back to my opening comment about conscious investing, there is something I find interesting. Not only did FRDM produce these returns with allocations to only 10 countries (vs. EMXC's 23) and 100 holdings (vs. EMXC's 678) but it did so while excluding countries like Russia, Saudi Arabia, Turkey and a number of other EM countries that scored poorly on Life & Liberty's freedom scale.

The takeaways here are twofold: First, understand that investing in China is and always has been a very risky proposition if only for the "unknown unknown" of what direction the Chinese government will decide to take with regards to supporting or suppressing pockets of its own economy and how it will allow the outside world to participate. Second, while avoiding China may make sense to investors, why not use that same rationale and apply it to the rest of your emerging markets allocation to do both well and good? I would offer that FRDM provides a strong solution for investors to do both.

At the time of publication, Abssy had a position in FRDM.