This is shaping up to be a lost year for the largest exchange-traded funds targeting China. For example, since hitting a peak in late January the iShares China Large-Cap ETF (FXI) and the SPDR S&P China ETF (GXC) have slid roughly 20 percent and 15 percent, respectively, placing them in bear market territory.
Yet China ETFs that deliver a more targeted focus on specific corners of the economy are faring relatively better. The companies in their portfolios are better insulated from the headwinds roiling the Chinese economy, and they hold a nice blend of value and growth prospects.
A burgeoning trade war with the U.S. is about the last thing China needs right now. Prior moves to tighten credit are already slowing the economy, and a sharp plunge in the yuan in recent weeks is bringing added pressure.
That last factor is creating rising stress for many firms that have issued bonds denominated in dollars. “If you look at the universe of China ETFs, there’s a negative correlation between year-to-date returns and debt/equity levels,” says Nick Kalivas, senior equity product strategist at Invesco. If the Chinese economy slows sharply, then some firms with a lot of dollar-priced bond exposure may become hard-pressed to meet their debt obligations.
So when it comes to comparing various ETF portfolios, Kalivas adds that it pays to be cognizant of leverage.
While Invesco offers five different China-focused ETFs, he cites the Invesco Golden Dragon China ETF (PGJ) as an example of a fund that largely sideswipes the debt concerns. Companies in that fund, which charges a 0.70 percent expense ratio and has $267 million in assets, have an average debt/equity ratio of 0.38. Moreover, these firms “are not as economically sensitive as China’s larger firms that focus on exports or banking,” says Kalivas, adding that many of them are U.S.-listed tech firms and are perceived to have higher accounting standards.
The Golden Dragon fund has delivered an impressive 8.2 percent average return over the past 10 years, besting the broader Chinese market returns by nearly two percentage points during that time, according to Morningstar.
The sell-off in Chinese equities gained steam in early June, as the yuan began to slide at a more rapid clip. That’s partially due to the growing concern of a larger trade war between China and the U.S. As a quick recap, the U.S. government will impose a 25 percent duty on $34 billion worth of Chinese products on July 6, and China has retaliated with a 25 percent tax on U.S. goods worth the same amount.
The yuan’s slide is also due to signs that the Chinese economy may be slowing. Exports to the U.S. grew at a slower rate in June, compared to the first five months of 2018. You would think that smaller Chinese firms, which tend to have more limited global exposure, would hold greater appeal in the current environment. But companies in the Invesco China Small Cap ETF (HAO) tend to have large amounts of debt leverage, according to Kalivas. So the sliding yuan and the nation’s tighter credit have created greater risk for these firms.
In past periods of rising economic stress the Chinese government has moved to stimulate the economy, and may be poised to do so again. A recent Bloomberg article indicates that China is going soft in its ongoing campaign to reduce financial risks due to a market slump and a slowing economy.