In the “old days” of exchange traded funds (we're still in the early innings to be sure), investors had somewhat limited options for accessing China despite the country's status as the world's second-largest economy. Those opting to access China via single-country ETFs rather than diversified emerging markets funds encountered large, if not excessive exposure to Chinese banks and other state-owned enterprises (SOEs).
Thing is large banks, integrated oil companies and state-controlled utilities aren't growth companies. That's true in plenty of markets around the world and it's particularly true in China. Fortunately, the ETF industry has evolved to include offerings more reflective of the Chinese economy beyond lumbering SOEs.
Today, there are more than 570 ETFs with some exposure to China, including dedicated single-country funds. Included in that group is the WisdomTree China ex-State-Owned Enterprises Fund (CXSE). CXSE, which tracks the WisdomTree China ex-State-Owned Enterprises Index, was born as an exclusionary fund.
The ETF debuted in 2012 as a China dedicated to excluding bank stocks, a novel concept at the time. In 2015, WisdomTree (WETF) went all in on dumping SOEs from the fund, reconfiguring it to the ETF investors can access today.
When Different Is Better
CXSE features a strict requirement in that it excludes companies in which 20% or more of the shares outstanding are controlled by Beijing. In other words, a company need not be majority owned by the Chinese government to be kept from CXSE's roster.
That may seem too stringent, but investors reap the rewards of CXSE's exclusivity. Year-to-date, the WisdomTree fund is up 25.32% and is beating the SOE-heavy FTSE China 50 Index by a margin of better than 4-to-1.
“It’s true that state-owned enterprises are less efficient than private firms in China,” according to research from Seafarer Funds. “For example, across the industrial sector, state firms have a return on assets (ROA) less than half that of private firms and the gap between the two appears to be growing.”
Efficiency, or lack thereof, often begets performance, or in the case of SOEs, slack performance relative to private companies.
“The performance gap between state-owned and private enterprises persists for publicly listed companies,” notes Seafarer Funds. “By one estimate, listed private enterprises outperform state-owned enterprises by a factor of 2:1.”
Trading Up For Growth
As noted above, some of the obvious benefits of trading out of an SOE-heavy China ETF for CXSE include exposure to more efficient companies, firms with better ROA and the potential for superior performance. Related to the last point, and not surprisingly, CXSE member firms offer improved avenues for growth.
Indeed, the fund has a growth feel to it, allocating nearly 55% of its combined weight to the consumer discretionary and communication services sectors. A contrarian might be apt to think that if CXSE is a growth fund, then Chinese state-controlled companies may be value plays. Maybe, maybe not.
For the four years ending 2018, earnings growth for the MSCI China Index was mostly stagnant while CXSE's underlying benchmark posted earnings growth of 40% over that period. So while old school, SOE-laden China benchmarks may look inexpensive compared to CXSE, the fund justifies the higher multiples with corresponding earnings growth.
Of course, “rich” valuations are in the eye of the beholder. CXSE's underlying index trades at 18.66x earnings. That's less expensive than the multiple on the S&P 500 Consumer Discretionary and the S&P 500 Communication Services indexes.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.