By Steven C. Johnson and Nishant Kumar
NEW YORK/HONG KONG (Reuters) - Where there's an investing niche, there's probably an exchange-traded fund that exploits it. Mainland China is an exception.
Chinese plans to increase foreign access to its $3 trillion onshore stock market may pave the way for ETFs that can own these shares and be sold to foreigners. But getting there is likely to be a long, difficult process, and investing in such securities will likely carry big risks.
China's onshore market is one of the few major markets that has not been overrun by exchange-traded funds. There are 1,450 U.S.-listed ETFs, holding about $1.4 trillion in assets. Some track major stock indexes, while other are more targeted, focusing on specific industries, currencies and countries.
Almost all U.S.-listed ETFs focusing on Chinese stocks are confined to the Hong Kong-listed H-shares represented in global equity indexes or companies such as technology giants Baidu <BIDU.O> and Sina Corp <SINA.O> that trade on U.S. exchanges.
That is because Beijing has long restricted foreign access to so-called A-shares, which are priced in yuan and traded on the giant stock markets in Shanghai and Shenzhen.
To prevent a flood of overseas money from sloshing in and out of the country at the click of a computer mouse, Chinese regulators require foreigners to apply for status as qualified investors. If approved, Beijing decides how much they can invest by issuing them so-called QFII or RQFII quotas.
Now, regulators in Beijing are expanding the exclusive list of more than 200 foreign investors allowed to buy A-shares, part of an attempt to attract more stable, long-term investment that would help the stock market and economy develop.
While the quotas to buy A-shares will mainly go to banks, large asset managers and sovereign wealth funds, money managers say it could be enough to open a spigot of ETFs, securities that track an index or group of assets but trade like a stock.
That would give smaller U.S. retail and institutional investors a new way to invest in the world's No. 2 economy.
It won't happen overnight, though.
New China ETFs are "definitely a possibility down the road," said Jennifer Hsui, a portfolio manager at BlackRock's iShares, the world's biggest provider of global ETFs. "That said, there are still some unique challenges to overcome, which makes the barrier to entry relatively high."
VERY GRADUAL PROCESS
For one thing, regulators have been stingy with their quotas. BlackRock, which manages $3.8 trillion, was awarded a quota worth $100 million late last year. State Street Global Advisors, a prominent ETF provider, manages $2.2 trillion, but its Asian unit has a quota worth just $50 million.
While greater foreign access should allow A-shares to be represented in global indices run by FTSE and MSCI, making ETF inclusion easier, there are still currency, liquidity and other hurdles to tackle.
"It will be a very gradual process. It's still a ways away because I think the quota is probably not big enough yet for index inclusion," said Patricia Oey, senior analyst at Morningstar Research. "The index companies will have to review things and see how feasible it is to include those shares."
Donald Keith, deputy chief executive of FTSE indices, told Reuters recently he expected Chinese A-shares to be in global indices within five years.
China has so far handed out about $42 billion in investment quotas. But that's still just a drop in the bucket of China's massive onshore market. At the end of 2011, U.S. investors overall held only about two percent of the value of China's equity market, less than the typical 9 percent for countries that attract the most U.S. investment, according to U.S. Treasury data.
As quotas increase, analysts expect more asset managers to try to create ETFs that offer access to the onshore market. It is particularly appealing because many retail firms have mainland listings, which would give U.S. investors access to a growing subset of middle class Chinese consumers.
BlackRock's Hsui would not comment on whether iShares has plans for ETFs that track A-shares. The asset manager has a Hong Kong-listed ETF, the FTSE A50 China Index, that invests in A-shares via derivatives, but its U.S.-listed ETFs, including the $6.3 billion iShares FTSE China 25 Index Fund <FXI.P>, invest in China via Hong Kong-listed H-shares.
ACTIVE VS PASSIVE
A-shares alone do not encompass all of China's markets. Dennis Hudachek, an ETF analyst at IndexUniverse in San Francisco, said some Chinese companies, including giant state-owned energy firm CNOOC Ltd <0883.HK> and China Mobile <0941.HK>, the world's largest mobile carrier by subscribers, list in Hong Kong but not Shanghai or Shenzhen.
"There is really no perfect China fund right now that encompasses all the different kind of share classes," said Hudachek. "Whether you go the H-share route or the A-share route, you are still missing out on names one way or another."
The quotas also make buying difficult. Asset managers receive quotas for a certain amount of investment. Once that is used, a manager would have to apply for a new quota. For an ETF, which has to buy more assets as investor money comes in, that's a problem.
If demand keeps rising and ETFs can't increase their quotas, "the premium of these ETFs in the secondary market will increase," said Marco Montanari, head of passive asset management in Asia Pacific for Deutsche Bank.
Also, unlike H-shares, denominated in the U.S. dollar-pegged Hong Kong dollar, A-shares are priced in more tightly-controlled yuan, and foreigners must comply with lock-up periods before they can repatriate principal balances.
Chinese regulators also have not yet published a standard capital gains tax rate for repatriating investment quota funds. All of this can create headaches for ETF managers every time sentiment toward China sours and investors rush to pull their money out.
Managers say closed-end mutual funds that raise a fixed amount of capital in an initial public offering and are then actively managed may be a better vehicle for a coveted quota than a passively-managed, open-ended ETF.
Paul So, head of beta products at Hong Kong-based Enhanced Investment Products Ltd, said Hong Kong-listed ETFs targeting A-shares tend to use derivatives rather than buy shares directly.
That is the strategy employed by the Market Vectors China ETF <PEK.P>, the only U.S.-listed China-focused ETF that offers access to mainland shares. Asset manager Van Eck Associates Corp which runs the ETF, declined comment on future China-focused ETF plans.
An active approach also avoids the pitfalls of investing in companies with weak corporate governance and poor records on minority shareholder rights, said Donald Amstad, director of business management at Aberdeen Asset Management in Asia, which oversees $322 billion and has a $200 million quota.
Many investors consider it less risky to invest in China through Hong Kong or the United States because legal and regulatory systems are more advanced.
"Access is a good thing, but the real test will be whether you are getting access to companies that treat shareholders fairly," he said. "It's one thing to be passive in your S&P 500 exposure, but in Asia, an active approach is essential."
(Additional reporting by Gabriel Wildau in Shanghai; Editing by David Gaffen and Tim Dobbyn)