With only six China ETFs listed in Europe, picking one shouldn’t be a struggle. But the choice is not as straightforward as it sounds. In investment terms, ‘China’ can refer to a number of different markets, all of them relatively new. As a result, established benchmarks like the S&P500 and the FTSE100 don’t yet exist and many of the indices now in use by ETF providers appear flawed. Investors need to take a careful look at what underlies each product before making their decision – and some may conclude that nothing yet on offer really meets their needs.

First, investors need to be familiar with the different types of Chinese stocks. Starting with the domestic market, there are two classes of share – A and B – traded on the mainland stock exchanges in Shanghai and Shenzhen. A shares are priced in renminbi and are only available to Chinese citizens and a very limited number of qualified foreign institutional investors, while B shares are priced in foreign currencies (US dollars in Shanghai and Hong Kong dollars in Shenzhen) and are intended for foreign investors.

However, B shares have always been unpopular investments. The market for them is generally thin and shares trade at a discount to equivalent A shares. What limited appeal they have comes from the belief that the Chinese government will sooner or later relax restrictions on the convertibility of the renminbi and merge the two markets on an equivalent basis; speculation about this has been going on for many years with few signs of change.

Consequently, most foreign investors choose to invest in China through companies listed elsewhere, often in Hong Kong where all shares can be freely traded by international investors. There are three classes of mainland Chinese firms on the Hong Kong exchange: H shares are firms that are incorporated in China but listed in Hong Kong; Red Chips are incorporated in Hong Kong but have substantial mainland interests and are controlled by the Chinese government; and P Chips are Hong Kong-incorporated firms with substantial mainland interests that are not government controlled (the P stands for private). These distinctions can be significant in index selection, as we’ll see later.

Firms incorporated outside the mainland can also list on other exchanges apart from Hong Kong, the most popular choices being New York and Singapore (where they’re called S Chips). Such companies usually incorporate in an offshore jurisdiction such as the Cayman Islands or Bermuda. Generally, the hottest floats (such as search engine Baidu) have tended to end up in New York, while less glamorous businesses have listed in Singapore.

So that’s the overall universe – but what are the choices for a European ETF investor?

The most popular index here is the FTSE/Xinhua China 25, which consists of the 25 largest H shares and Red Chips. There are three European ETFs tracking this index, with total assets under management of €900m. The leader is a physically replicated fund in the iShares range with almost €700m under management. The fund has quarterly dividend distribution, is listed in most major European markets, and has a total expense ratio (TER) of 0.74% per annum.

The db x-tracker range offers a swap-based alternative that capitalises dividends at a slightly lower TER of 0.6% per annum. It currently manages around €200m. The third option is under BNP Paribas’ EasyETF brand and is a swap-based capitalising fund with around €20m under management. Currently listed only in Paris, it has a TER of 0.6%.

The catch with these ETFs is in the underlying index. The FTSE/Xinhua China 25 reflects the dominance of a few sectors and companies in the H share and Red Chip market; at the moment, it has around 50% weighting in financials, while telecoms account for around 17% and oil and gas, basic materials and industrials together add another 30%. That means there is minimal exposure to more consumer-driven themes, which increasingly tends to be what investors in China are looking for.

In addition, the largest H shares and Red Chips are huge state-owned enterprises that are not necessarily outstanding businesses. Many investors are still worried about the quality of Chinese banks’ balance sheets, especially given the huge government-mandated increase in lending this year to help cushion the economy in the global recession. Other constituents such as the Aluminium Corporation of China (known as Chalco or Chinalco) are certainly not global leaders in terms of efficiency or low costs. Investors should question whether an index like this really represents the future potential of the Chinese economy rather than the dinosaurs of its command-economy past.

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