Investing in China is tricky. There are now more than 20 China-focused ETFs to choose from, ranging from size and style funds to sector-specific funds. As if sifting through expense ratios, liquidity and holdings isn't enough, China investors have another big, fundamental factor to consider: Chinese share classes.

Foreign investment in China is still restricted: A U.S. investor cannot simply open a brokerage account and trade locally listed Chinese shares. As a result, there are multiple shares classes of Chinese companies floating around on various exchanges, allowing investors different ways to access this complex market.

Depending on the underlying index that an ETF tracks, some funds are eligible to hold only a certain type of shares. This matters because the different share classes an ETF is eligible, or ineligible, to hold can significantly impact the fund's performance, and ultimately determine the type of Chinese companies in the portfolio.

Chinese share classes, especially as they relate to ETFs, are often misunderstood—or worse, ignored altogether. We at IndexUniverse think investors deserve better, so we prepared this document to provide insight and guidance on the topic to help investors make an informed decision on choosing the right China ETF.

Our guide comes in a PDF version too, and in an abbreviated "cheat sheet" as well.

Share-Class Descriptions

For the most part, local investors in China buy what are known as "A-shares." These are the shares of companies traded on the domestic Shanghai and Shenzhen stock markets, quoted in renminbi. Except for a select few qualified foreign institutional investors (QFIIs)—and via some unusual products —most investors cannot readily buy A-shares.

Due to this restriction, most ETFs currently access the Chinese market through shares of Chinese companies listed in Hong Kong, the U.S. or a special "B" share class traded in Shanghai or Shenzhen. These "investable" shares consist of H-shares, red chips, P-chips, B-shares and N-shares.

Let's look at each of these shares below, because grasping their differences is crucial.

• A-shares: Chinese companies incorporated on the mainland and traded in Shanghai or Shenzhen, quoted in RMB.
• B-shares: Chinese companies incorporated on the mainland and traded in Shanghai and quoted in USD or traded in Shenzhen and quoted in HKD (open to foreign ownership).
• H-shares: Chinese companies incorporated on the mainland and traded in Hong Kong.
• Red chips: State-owned Chinese companies incorporated outside the mainland (mostly in Hong Kong) and traded in Hong Kong.
• P-chips: Nonstate-owned Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions (Cayman Islands, Bermuda, etc.) and traded in Hong Kong.
• N-shares: Chinese companies incorporated outside the mainland, most often in certain foreign jurisdictions, and U.S.-listed on the NYSE or Nasdaq (ADRs of H-shares and red chips are also sometimes referred to as N-shares).

Share Classes And ETF Breakdown

It may come as a surprise that some of the most popular China ETFs are not eligible to hold all investable shares. For example, the $6.1 billion iShares FTSE China 25 Index Fund (NYSEArca: FXI), which holds 25 of the largest and most liquid Hong Kong-listed Chinese shares, is only eligible to hold H-shares and red chips.

This means China's largest Internet company, Tencent Holdings, is excluded because it's classified as a P-chip, even though Tencent has a market capitalization of $64 billion, which would put it within the 25 largest H.K.-listed Chinese companies.

The key to knowing which share class a fund is eligible to hold lies in knowing which index the fund tracks. FTSE, a leading index provider in the space, to date has considered P-chips to be Hong Kong companies, and has listed them in developed market Hong Kong indexes instead of their China index series.

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