Two ETFs that buy mainland-traded Chinese equities and have assets of less than $45 million have outperformed almost 1,500 U.S.-listed funds this year. The Market Vectors China AMC SME- ChiNext ETF, which focuses on technology and software companies, has surged 49 percent. The Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF has gained 37 percent.

Chinese small-cap companies are trading at record highs after climbing more than three times faster than the broader market this year. The stocks have rallied as the government pledged to support developing industries like technology and health care to diversify the economy, which is heavily dependent on manufacturing and property development for expansion.

“Part of the rally is the government’s focus on wanting these ‘new economy’ sectors––technology and software, consumer discretionary––to succeed,” Eric Balchunas, a Bloomberg Intelligence analyst, said by phone Wednesday. “If you look at the stocks that make up these small-cap ETFs, technology and consumer-oriented stocks, you virtually have a new economy coverage there.”

Demand for the stocks also has been bolstered by a planned exchange link between Shenzhen and Hong Kong, which will expand foreign investors’ access to smaller companies.

State Support

Technology, consumer and health-care companies comprise almost half the Shenzhen gauge, while state-backed banks and industrial conglomerates dominate Shanghai’s bourse. Technology stocks that make up almost a third of the Market Vectors China AMC SME-ChiNext ETF and about 15 percent of Deutsche’s small-cap A-shares fund have been the main drivers of those funds’ growth this year, data compiled by Bloomberg show.

Equities on the Shanghai Composite Index rallied 13 percent in March, the most among the world’s biggest benchmarks, amid speculation policy makers will enact further measures to prevent economic growth from falling below their 7 percent target. The small-cap ChiNext Index and CSI Smallcap 500 Index each surged 21 percent last month.

The ChiNext rose 1.1 percent at 10:41 a.m. local time, while the Shanghai Composite added 0.2 percent.

China’s central bank said in January it supports the development of technology companies and will allow the formation of smaller lenders to support them. Premier Li Keqiang signaled at a press conference a year ago that he will tolerate slower growth to shift the economy away from the state-led stimulus to a more sustainable model based on services and consumer demand.

Swelling Assets

The ChiNext ETF’s assets have doubled to $44.9 million this year, while the Deutsche A-shares small-cap fund’s jumped 45 percent to $43.4 million. The Deutsche ETF that tracks the 300 biggest mainland-traded stocks has increased 21 percent to $1.2 billion.

Stocks in the small-cap ChiNext Index sell for an average 45 times projected 12-month earnings, compared with a multiple of 14 for the Shanghai Shenzhen CSI 300 Index of mainland stocks with the largest market capitalization and liquidity.

“There is a fair amount of doubt that the rally in these small-cap funds was driven solely by fundamentals,” Jay Jacobs, a research analyst in New York at Global X Funds, which manages about $4 billion in ETFs, said by phone on March 30. “There is a lot of concern that the small-cap stocks are now overpriced.”

Offshore ETFs

The rally in small-cap stocks was driven mostly by local investors, according to Balchunas. Foreign investors focus on more established industries including banking, insurance and commodities, he said.

ETFs that invest in Chinese stocks traded offshore, which are more accessible to foreign investors, have been lagging behind the onshore market. The iShares China Large-Cap ETF, the biggest China-focused ETF trading in the U.S., has gained only 8.6 percent this year, and the Guggenheim China Small Cap ETF has returned 6.5 percent.

The ChiNext Index has gained 63 percent this year, compared with a 17 percent advance in the CSI 300. Chinese brokerage Shenwan Hongyuan Group Co. last month predicted further gains in the ChiNext of as much as 28 percent.

“You’ve seen a lot of reforms around state-owned enterprises, but the authorities have also made it clear that they want smaller consumer-oriented enterprises to do well,” Brendan Ahern, managing director at Krane Fund Advisors LLC in New York, which oversees four Chinese ETFs, said by phone on March 30. “As a result, the funds that track these small-cap technology and consumer sector names are among the best performers this year.”