FXI’s Not The Best China ETF

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Matt Hougan, our president of ETF Analytics, was on CNBC's Fast Money recently and talked about the pitfalls of the iShares FTSE China 25 Index Fund (NYSEArca:FXI) and why other funds like the SPDR S&P China ETF (NYSEArca:GXC) might be a better choice for those looking for broad China exposure.

I'll pick up where Matt left off to examine in detail the various China ETFs, and why some funds make more sense than others, as there are big differences between them.

When I consider a China ETF, the first thing I check for is what type of shares the ETF is eligible to hold.

As most of us are aware, foreign investment in China is still restricted, and with the exception of a select few qualified foreign institutional investors (QFII), investing in 'A-shares' is for the most part off the table.

Therefore, the current ETFs access the Chinese market through a combination of H-shares, Red Chips, P-chips, B-shares or N-shares. Let's call all these shares 'investable' Chinese shares.

Let's look at the table below, because there are many different share classes, and grasping their differences is crucial.

Share Type Description
A-shares Chinese companies incorporated in the mainland and traded in Shanghai or Shenzhen in RMB
H-shares Chinese companies incorporated in the mainland and traded in Hong Kong
Red Chips State-owned Chinese companies incorporated outside the mainland and traded in Hong Kong
P-chips Nonstate-owned Chinese companies incorporated in certain foreign jurisdictions (Cayman Islands, Bermuda,
etc.) and traded in Hong Kong
N-shares Chinese companies traded in the U.S. (sometimes ADRs of H-shares and Red Chips are also
referred to as N-shares)
B-shares Chinese companies incorporated in mainland traded in Shanghai in USD or Shenzhen in HKD (open to foreign ownership)
Note:Some companies float different share classes on different exchanges.

Interestingly, many popular China ETFs aren't eligible to hold all investable shares, making their China exposure limited in scope.

If you want the broadest, most inclusive exposure to China, wouldn't you want an ETF that's eligible to hold all these investable shares?

FXI is by far the most popular China ETF. As I said at the outset, it has $4.8 billion in assets, and it trades over $600 million a day at pennywide spreads. For an institution whose primary concern is liquidity, FXI is a no-brainer.

But for most of us looking to invest in total China, FXI has some serious shortcomings.

Apart from only holding 25 of the largest Chinese companies traded in Hong Kong, I can't help but notice that mega-cap Tencent Holdings is missing from its portfolio.

Tencent Holdings is China's largest Internet company, with a market capitalization of $53.7 billion. Its instant-messenger site, QQ.com, has over 700 million users and, according to Alexa.com, it's the second-most-visited site in China.

Still, it's missing from FXI's holdings. Why?

FXI is only eligible to hold H-shares and Red Chips. Tencent is incorporated in the Cayman Islands, so even if it's Hong Kong-listed, it's classified as a P-chip, so it's not eligible for inclusion.

I should note here that while FXI's underlying index provider, FTSE, currently assigns P-chips to Hong Kong, only a few weeks ago it announced the reclassification of P-chips from Hong Kong to mainland China. That change is set to become effective in March 2013. That could mean the holdings of FXI may change sometime next year.

In the meantime, FXI is basically a mega-cap play on China's state-owned telecoms, energy and financial companies. China's 'big four' state-owned banks-China Construction Bank, ICBC, Bank of China and Agricultural Bank of China-make up over a quarter of the fund's weighting. No thanks.

As Matt suggested on CNBC, GXC is a broader fund that not only holds 180 positions, it's also eligible to hold all investable Chinese shares. Another fund with a similar scope is the Guggenheim China All-Cap Fund (NYSEArca:YAO).

While both GXC and YAO are still top-heavy in many of the same mega-cap names as FXI, investors will also find P-chip names like Tencent and Want Want China, as well as N-shares like Baidu, Sina and NetEase among their holdings.

Baidu is China's largest search engine-basically the Google of China. Sina, on the other hand, not only operates the largest Web portal in China, it runs the micro-blogging site Weibo, which is China's equivalent to Twitter, which now has over 300 million users.

If you were to buy the broadest U.S. fund, wouldn't you want Google, Yahoo-and Twitter, if it were public-and other big tech names included?

There's a relatively new China ETF that's now gaining in popularity, the iShares MSCI China Index Fund (NYSEArca:MCHI). It's already amassed over $400 million in 15 short months. I hate to pour cold water on such a blistering run, but if you look closely, MCHI doesn't hold any N-shares.

That's because it tracks an MSCI index, and MSCI considers a stock's primary listing and country of incorporation as a large component in assigning stocks to countries. Since many of these Chinese tech names are incorporated in tax havens such as the Cayman Islands and exclusively list in the U.S., MCHI isn't eligible to hold them.

The iShares FTSE China Index Fund (NYSEArca:FCHI) is even more limited in scope. It's not eligible to hold P-chips, and only holds H-shares and Red Chips, making FCHI a broader, total market version of FXI.

For those looking to completely get away from China's state-owned mega-caps, two of my favorites are the Guggenheim China Small Cap ETF (NYSEArca:HAO) and the Global X China Consumer ETF (NYSEArca:CHIQ).

HAO is a small-cap fund with roughly half its weighting in industrials and consumer goods, while CHIQ focuses specifically on the China consumer space. But most importantly, both are eligible to hold all investable Chinese shares.

The takeaway here isn't so much a bullish call on China; it's that if you're going to invest in China for the long haul, wouldn't you prefer to have exposure to all investable share classes?

By being all-inclusive, it opens the fund up to more exposure to the consumer and entrepreneurial side of China. That, to me, is where the true growth potential lies, rather than the old state-owned behemoths that you see in FXI.

Disclosure:I am currently long CHIQ.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , ETFs
Referenced Symbols: CHIQ , FXI , HAO , YAO

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