Sharp A-share ETF discounts seen in China market rout

Offshore A-share ETFs have struggled to keep up with volatile indices amid the large recent falls in China equities and subsequent trading restrictions and government interventions, new research has revealed.

The volatility which saw China’s CSI 300 index plunge by at least 30% over the course of a month between June 12-July 8 (after a meteoritic year return of 147% at its June peak) meant that exchange-traded funds saw sharp discounts in relationship to their net asset value (NAV).

In a recent client note by research house Morningstar, ETF strategist Jackie Choy noted that most China A-share ETF shares traded on average at a 10% discount during the turmoil.

The most extreme case was CSOP’s ChiNext ETF, which Morningstar singled out as trading at the biggest discount to its peers at 33% to its NAV at the end of July 8, the day which saw China A shares fall by 6.8%.

Explaining the phenomenon, Choy pointed out that large discounts appeared in part because market makers had begun commanding greater risk premiums in the face of market volatility.

Specifically, given that China imposes a 10% down limit on individual stocks, Hong Kong-listed A-share ETFs, which are not subject to such trading limitations, began acting as a price discovery mechanism once many of the index constituents triggered the threshold.

And with days of stocks hitting the 10% daily limit, many corporates started halting trading to stabilise their market capitalisation. At its most extreme, as many as 50% of A shares were suspended, which affected investors’ ability to gauge the ETFs’ true value.

As such, with the suspension of stock trading, asset market values became difficult to judge, leading to rising risk premiums commanded by dealers and market makers, which deterred them from making redemption requests, resulting in wider premiums or discounts.

Indeed, Choy noted that no redemptions were made on July 8, with a recovery in redemptions over the next two days (July 9-10), at which point the market recovered somewhat and the ETF discounts narrowed.

“As far as ETFs in general are concerned, the creation/redemption mechanism is essential in keeping ETFs’ market prices in line with their NAVs,” said Choy. “However, when market conditions reach extremes and other complications exist, such as those associated with A-Share ETFs [eg on quota and cash redemption], the creation/redemption mechanism is less efficient.”

“As a result, ETFs’ market prices can stray from their NAV, potentially by further and for longer than might be the case absent these inefficiencies. However, to a certain extent, in these scenarios [i.e. trading halts], the market price of an ETF could be the only remotely reliable price discovery mechanism available to investors.”

Some funds have resorted to new tactics to work around the market turmoil. The New York-listed KraneShares Bosera MSCI China A Share ETF’s filing to the US Securities and Exchange Commission on July 10 stated that it would be adopting a “representative sampling” strategy, which aimed to replicate the index by buying constituents which were not subject to trading halts and were relatively liquid, as opposed to buying the index in full.

US fund house BlackRock, which provides Hong Kong’s most traded ETF under the iShares FTSE A50 China Index ETF and which suffered some of the sharpest discount, declined to comment.

Meanwhile Marco Montanari, Deutsche Asset & Wealth Management’s head of Asia-Pacific passive asset management, noted that “bid-offer spreads on the exchange have in some situations widened to reflect the underlying market volatility”.

However, he stressed that China A shares have continued to trade robustly in secondary markets and that there continues to be “plenty of liquidity in the market”.