The China Play to Avoid

10/05/2009 12:01 am EST


Matt Hougan

CEO, Inside ETFs

Morgan Stanley's popular A-Share closed-end fund sells at a double premium to the value of its assets, warns editor Matt Hougan.

Morgan Stanley’s China A-share closed-end fund (NYSE: CAF) gets a lot of attention. But that doesn’t mean investors should buy it.

It’s the one closed-end-fund that even people who hate closed-end funds like. And it’s easy to see why. CAF is just about the only investment product that lets US investors tap into the domestic Chinese equity market. Most other funds, like the iShares FTSE/Xinhua China 25 (NYSE: FXI) or the SPDR S&P China ETF (NYSE: GXC), invest in China through either ADRs or so-called H-shares, the shares of Chinese companies that trade on the Hong Kong exchange. That’s because US investors are effectively barred from participating in the domestic Chinese markets.

But CAF has an exemption, thanks to a special agreement between Morgan Stanley and the government of China. So, the fund buys the shares of companies listed on China’s domestic Shanghai and Shenzhen stock markets, which are otherwise off limits to US investors.

The marketing pitch is obvious: Invest in the real China. But CAF comes with two problems that most investors (and most media articles) ignore.

First, CAF was [recently] trading almost 5% over its net asset value. Investors should think twice before buying anything trading at a premium; it’s like giving money away. [The premium was at 2.33% as of Friday—Editor.]

And CAF comes with double trouble. In addition to the premium on the fund itself, the domestic Chinese market trades at a premium to what you might call “fair market value.”

About 35 companies list shares on both the domestic Chinese markets and the Hong Kong markets. The shares are virtually identical, and represent the same stakes in the same companies.

But for the past few years, the domestic Chinese shares have traded at a sharp premium to the Hong Kong shares. Whether that’s because of a bubble mentality among Chinese investors or because Chinese investors have limited outlets for their capital is almost immaterial; the companies are overpriced by international, truly open-market standards.

Hang Seng Indexes publishes an index that tracks the premium or discount of these dual-listed companies. It’s ranged as high as 80% in the past. Currently, it’s "only" 13%: the domestic shares are valued 13% above Hong Kong-listed shares on average.

Maybe that will go higher or lower; who knows. But one thing’s for certain: Investors who buy into CAF are paying not just the 5% premium for the fund, but the 13% premium on the domestic Chinese markets.

That’s fine, as long as investors know what they’re doing. But that premium could collapse or even reverse, turning into a discount. The risk is that you buy today when it’s overvalued, and then sell out when it’s undervalued.

In other words, you’re making a bet on the structure of the market, not on the market itself. You’re betting that US investors will continue to want to buy the fund, bidding the shares up over their true net asset value. And you’re betting that domestic Chinese investors will remain exuberant, overpaying for their domestic markets.

Just for kicks, you’re paying Morgan Stanley 1.75% for the privilege.

There have been stretches when CAF has outperformed funds like GXC (my favored Chinese equity ETF), mostly when the China A-share premium is on the rise. In January of this year, for instance, CAF outperformed GXC by more than 25%.

Maybe that will happen again. Maybe Chinese animal spirits will stir and domestic investors will bid shares back up to an 80% premium.

For my money, I’d rather buy a fund that trades at fair value and invests in a truly open capital market. Over the past year, that’s been a better bet, as GXC has outperformed CAF by more than 20%.

The Chinese A-shares market will be more intriguing if and when Van Eck launches its proposed China A-Shares ETF (see article here.) That, at least, would eliminate the premium/discount problem with the fund itself.

But even an ETF would not get around the problem of the inflated domestic Chinese markets, which represent a bigger risk to investors.

In the end, the idea of investing in domestic China is interesting. But for investors, as opposed to speculators, the risks and uncertainty are high.

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