Xtrackers CSI300 Swap ETF 1C (LSE:XCHA) - ETF price


ETF Report

Xtrackers CSI300 Swap UCITS ETF 1C XCHA

AnalystReport

PortfolioConstruction

The CSI 300 Index is provided by the China Securities Index Company Limited, a joint venture between the Shanghai Stock Exchange and the Shenzhen Stock Exchange. It is one of the most widely quoted indexes inside and outside Mainland China. The CSI 300 Index is a free-float-adjusted market-capitalisation-weighted portfolio composed of the A shares of 300 largest Chinese companies trading on the Shanghai Stock Exchange or the Shenzhen Stock Exchange. An advisory committee has certain subjective leeway in selecting the constituents. For inclusion in the index, stocks must have been listed for more than three months, must be in the most-liquid 50% of all A shares (60% for existing constituents), must not have had financial problems or legal/regulatory infractions, must not have exhibited large price volatility that shows evidence of manipulation, and must be considered appropriate by the committee. Once those screens are run, the 300 largest stocks are included. The underlying stocks are reviewed on a semiannual basis and changes are made as needed. To control portfolio turnover, there are buffer zones around the index’s inclusion criteria, so that a constituent is not automatically removed if it fails to meet all the initial standards. Financials make up the largest sector of the index, representing around 36%, followed by consumer staples (12%) and industrials (12%).

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Fees

The ongoing charge for this ETF is 0.50%. Although this lies at the low end of the ETFs focused on onshore Chinese equities, when investing ETFs, investors should take a holistic approach to assessing the total cost of ownership, including, but not limited to, swap fees, brokerage commissions, and bid-offer spreads. The ETF is also subject to an “Index Replication Cost” which is embedded in the valuation of the swap, which is not a predictable item and changes along with market conditions. As a comparison, the category median is 1.25%. The calendar year tracking difference was negative 2.26%, +0.06%, and +2.50% in 2016, 2017, and 2018, respectively. The recent positive tracking difference was helped by the positive index replication cost in two past years. It is also worth noting that the premium/discount levels of the ETF’s Hong Kong listing has been fairly volatile in the past two years, for example, traded at an average premium of 1.5% in first-quarter 2019. Market dynamics as well as changes in rules on QFII/RQFII might affect the discount levels. An uncertain discount/premium level will become a cost for investors.

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FundConstruction

This ETF employs synthetic replication to track the underlying index by entering into an unfunded swap with counterparty Deutsche Bank AG. The ETF uses investors’ cash to buy a substitute basket of securities and exchanges the return on that basket (net of a swap fee) for the net total return of the CSI 300 Index. The substitute basket, which can change daily, is made up of liquid stocks that belong to eligible indexes and are traded on recognised exchanges. There are three share classes to this ETF--share class 1C (listed in various exchanges in Europe) capitalises dividends while share class 1D (KT4 listed in Singapore) and 2D (03049 listed in Hong Kong) pay out dividends annually. Xtrackers ensures that the ETF is either fully collateralised or overcollateralised at the end of each day. As of 13 Aug 2019, the substitute basket was primarily made up of US and Japanese stocks. The use of swaps to access the A-Shares market also incurred an "index replication cost." The magnitude of the “index replication cost” is not a predictable item and changes along with market conditions, which varied largely from 1.80% three years ago in September 2016 to negative 4.80% (income) as of August 2019. The swap counterparty has its own QFII quota limit. Once the quota is reached, the swap counterparty may not be able to hedge its position, causing a disruption to the creation and redemption process. These quota-related considerations together with other factors such as market supply/demand dynamics and trading limits which apply to the underlying stocks, could lead the ETF’s market price to stray from its net asset value. Investors should be aware that this premium can change upon the change of regulation on QFII quotas and rules. In November 2014, the Ministry of Finance and the China Securities Regulatory Commission put forth Notice 79, which asserted that QFIIs and RQFIIs without an establishment or place in China will be temporarily exempt from corporate income tax on gains derived from the trading of equity investments (that is, capital gains tax) effective from 17 Nov 2014. The notice also stipulated that CGT will be imposed prior to 17 Nov 2014. Subsequent to the notice, the ETF’s provisioning policy was adjusted to only provide for CGT on realised gains prior to 17 Nov 2014. Further on 22 Dec 2015, the manager of the ETF determined with the swap counterparty on the shortfall/excess regarding the tax liability and made an adjustment to the ETF’s NAV (on share class 2D) which amounted to +1.85% of the ETF’s NAV as of 18 Dec 2015.

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Suitability

This exchange-traded fund tracks the CSI 300 Index, which is a well-known benchmark capturing the 300 largest and most-liquid stocks in the onshore Chinese equity space, covering around 55% of the universe (proxied by the MSCI China A IMI Index).

Given the structure of the onshore Chinese equity market, the ETF’s sector exposure is skewed to the Financials sector at around 37%, but portfolio concentration is minimal with individual stock weightings at below 7% each. By selecting the 300 largest stocks in the market, the portfolio is skewed towards large-caps. This ETF's risk-adjusted returns have been below average (in the third quartile) during the trailing three- and five-year periods, largely owing to the ability of its active peers move between large-, mid-, and small- cap stocks. 

All in all, investors seeking onshore Chinese equity exposure may find this ETF suitable given its fairly broad exposure. However, as of now, we do not have conviction that the fund can deliver returns in excess of the Morningstar Category average on a risk-adjusted basis over a full market cycle. We are also wary of the fund’s synthetic replication, which results in uncertainties pertaining to its “index replication cost” (embedded in the valuation of the spread) and premium/discount levels. As a result we have maintained a Morningstar Analyst Rating of Neutral for this ETF.

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Fundamental View

China’s 2018 gross domestic product growth landed at 6.6%, which is in line with the government’s target of “around 6.5%” but slightly lower than 2017’s figure of 6.8%. GDP growth for the first half of 2019 was recorded at 6.3%, roughly in line with the government’s 2019 GDP growth target of “6.0% to 6.5%.” In the long run, the further opening up of the capital markets, as acknowledged by the inclusion of Chinese onshore equity (MSCI have included China A-Shares, at increasing weights, into its emerging markets indexes) and renminbi-denominated bonds (Bloomberg Barclays to include China onshore government bonds into its Global Aggregate Index) into international indexes, and the ongoing liberalisation of the renminbi, should benefit the country as a whole. This will also increase China’s representation in international indexes, closer to its true economic footprint. However, in the near to medium term, risks from trade-related tensions with the U.S. are factors that investors should monitor. Policies and fundamentals (that is, risk/return) could be in flux as talks of trade wars linger. Also, the supply and demand dynamics of the Chinese onshore equity markets could change along with the treatment of Chinese stocks within international indexes. In the meantime, the fluctuation of the renminbi can also affect the profitability of companies with international businesses and, on a wider scale, the Chinese economy. The renminbi has been fairly volatile in the past two years, especially in response to the U.S.-China trade war situation of late. The renminbi depreciated more than 5% against the greenback in 2018 and depreciated further by around 3% for the year to 12 Aug 2019. All of this ETF’s portfolio is composed of Chinese companies traded in renminbi.

By selecting the largest 300 stocks in the market, the portfolio is skewed towards the large-caps. As a result, this ETF is likely to underperform when the market favours the mid-/small- caps and vice versa. 

The financial sector accounts for around 37% of the portfolio, the largest sector exposure for the ETF, consisting mainly of Chinese banks (around 17%) and securities companies (around 7%). Investors should be aware of any changes to the Chinese banking regulations and the effects it could have on incumbents’ market share. Ping An Insurance (7%), the largest component of this ETF. The performance of shares of Chinese insurance companies is also inherently linked to the China A-Share market itself as insurance companies invest their surplus in local equity markets.

The second-largest sector exposure for this ETF is consumer staples, accounting for 12% of the portfolio, followed by industrials (12%), consumer discretionary (9%), and information technology (8%). The industrials, consumer discretionary, and consumer staples sectors are subject to export demand (for example, for machinery and other exported consumer goods) and domestic growth.

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Alternatives

This ETF is domiciled in Luxembourg and is listed in Hong Kong (03049), Singapore (KT4), and various exchanges in Europe. There are a number of ETFs tracking the CSI 300 Index and other onshore Chinese equity exposures. When choosing among ETFs tracking the onshore Chinese equity market, investors can watch out for their replication methodology and assess the total cost of owning the ETFs holistically. 

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