In my last article, “Why Investors are Underweight China Equities, But Should Reconsider,” I demonstrated why China is a rising world power, yet investors are underweight relative to China’s stature and economic footprint. I cited seven reasons Chinese equities are attractive, including its overall stature, economic growth, improving regulatory conditions, equity market performance, portfolio diversification, valuations, and rising institutional ownership.

This led to the question: What is the best way to capitalize on this opportunity? Below, I consider seven funds that passed my initial screen. I provide a comparison via key metrics and analyze my top pick, the Wisdom Tree China ex-State-Owned Enterprises ETF (CXSE).

Leading Chinese Equity ETFs

Those who follow me know that I utilize a passive, index-based investing strategy. In the spirit of that approach, I focused my analysis on seven leading China index ETFs.

Top China Equity ETFs

I created this shortlist using the following screening criteria:

  • China only, passively managed equity ETFs
  • Size of at least $500M AUM (larger size tends to drive higher liquidity and provides a track record)
  • Inception date at least four years ago (well-established with track record and data analytics)

Why Invest in Wisdom Tree China ex-State-Owned Enterprises Fund

Once a fund passes my initial screen, I look carefully at the following factors to arrive at my top pick:

  • Fund composition: index construction, sectors, style box, and market cap
  • Valuation and Fundamentals: P/E, P/B, Price to Cash Flow, earnings growth, return on equity, and return on assets
  • Performance: Total return, category rank, Sharpe ratio, and capture ratio
  • Fund family/asset manager

Let’s look at how CXSE stacks upon each of these factors.

Top China Equity ETFs’ Composition

CXSE Excludes State-Owned Enterprises (SOEs)

The table below depicts key elements of the funds’ composition.

Top China Equity ETF holdings

CXSE seeks to track the investment results of Chinese companies that are not state-owned enterprises (SOEs), which is defined as government ownership of greater than 20%. This is a major differentiating factor versus the other funds. Wisdom Tree makes the case in their white paper:

Some argue that government ownership can negatively impact the operational efficiency of a company. Government-owned and influenced companies typically run their businesses with a broader set of interests, appealing more to government wishes than generating the maximum possible return for shareholders. Over time, these influences can lead to quite large but fairly inefficient businesses, and as such, have the potential of stagnating the long-term growth potential of these companies in their respective emerging markets economies. Often these companies are referred to as “state-owned enterprises” (SOEs).”

CXSE is also differentiated from its peers by its growth orientation, which is in large part due to the non-SOE factor. CXSE is amply diversified with 176 holdings and its stocks are of average quality according to Morningstar’s metrics.

CXSE Favors New Economy Growth Sectors

The table below highlights the composition of the funds across industry sectors.

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China Equity ETF Industry allocations

CXSE has a higher than category average weighting across sectors that benefit most from economic growth, including consumer cyclical, communications, and healthcare. It also has a healthy stake in the technology sector, although less than the category average. FXI, GXC, and MCHI also carry heavier than average weights in consumer cyclical and communications sectors. CXSE has the lowest allocation to the financial sector.

The table below shows that the “New Economy” stocks are predominantly non-SOE companies. This is consistent with the CXSE weightings. Since a component of my thesis is to invest in a rising and rapidly growing China, CXSE represents the best vehicle within this group to do so.

China State Owned vs Non State Owned sector exposures

Source: Wisdom Tree

The other advantage of excluding SOEs is the potential to avoid sanctions on these firms from the U.S. and other countries. SOEs are more likely vulnerable to sanctions due to unfair competitive advantages stemming from state support.

CXSE’s Top Ten Holdings Emphasize Growth Companies

The table below shows CXSE’s top ten holdings. It reflects a strong concentration in technology and e-commerce. These companies have experienced strong growth and have considerable upside as the Chinese government fosters increased consumption by its 1.3 billion consumers.

CXSE top ten holdings

CXSE Valuation and Fundamentals

CXSE Has Superior Fundamentals

CXSE has more attractive fundamentals than its peers. The chart below from Wisdom Tree compares Return on Assets (ROA) for state-owned and non-state-owned companies since 2007.

CXSE Return on Assets ROA

Source: Wisdom Tree

Non-SOEs demonstrate a superior ability to generate higher return on assets (ROA) than SOEs. This also translates into faster earnings growth, which is a key driver of stock performance. Similarly, non-SOEs generate higher Return on Equity (ROE).

CXSE Return on Equity ROE

Source: Wisdom Tree

Of course, higher ROE and ROA tend to be associated with richer valuations. The table below shows this to be true for CXSE.

China Equity ETF fundamentals

CXSE is clearly a growth rather than value play. It carries the highest P/E ratio, price to cash flow, and price to book values. However, I believe its strong earnings growth of 18% per year easily justifies the valuation at 24 times forward earnings. Its price to cash flow of only 18 signals that companies are reinvesting cash to drive stronger earnings growth in the future. When compared to the S&P 500 at a forward P/E of 24, Shiller P/E of 32 and historical earnings growth of only 5.6% per year for the past ten years, it is a relative bargain. Finally, as described in my last article, China equities also provide favorable portfolio diversification benefits.

Value investors might prefer to look at FXI, GXC, or MCHI, which have lower valuations, albeit decent representation in new economic growth sectors. But for those who agree with the thesis of a rising, rapidly growing China, CXSE is best positioned to reap maximum benefits.

CXSE vs. Other China Equity ETFs’ Performance

The Wisdom Tree chart below shows how non-SOEs have trounced SOEs since 2008.

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Returns of China State owned enterprises vs non-State Owned

The table below shows performance metrics for all the funds. The results validate the Wisdom Tree thesis and show that CXSE has been the top performer in recent years.

China Equity ETF performance CXSE

CXSE not only has the highest returns by far over each period, but it also has the best risk-adjusted performance. It has the highest Sharpe ratio of 0.63 and the best capture ratio of 148/86. If you aren’t familiar with that metric, it comes from Morningstar. Upside capture ratio measures a manager’s performance in up-markets relative to the index. A value over 100 indicates that a fund has outperformed the benchmark during periods of positive returns for the benchmark. Downside capture ratio measures the manager’s performance in down-markets relative to the index. A value of less than 100 indicates that a fund has lost less than its benchmark when the benchmark has been in the red.

Having touted the virtues of CXSE, I have to say that its recent performance is also a concern. I don’t like to chase momentum and am a proponent of mean reversion. History shows that at some point, high-performing asset classes (and funds) tend to be laggards. The reverse is also true – the laggards eventually perform above average. I describe this phenomenon on my website and in my article Mean Reversion + Valuation = Opportunity.

Nonetheless, I believe CXSE still has lots of upside. The thesis is a long-term one, not a short-term momentum play. It is very likely China will continue to grow more rapidly than most countries for years to come, driving CXSE’s performance.

CXSE’s Asset Manager Wisdom Tree

CXSE is managed by Wisdom Tree, a very capable and solid fund company. The firm was launched in 2006 and has net assets of $63.8B. It had $459 million in net asset inflows year to date. While it has a relatively small industry market share, the company is known for being an innovator in “Smart Beta,” or what Wisdom Tree calls “Modern Alpha” ETFs. Wisdom Tree says their “approach combines the outperformance potential of active management with the benefits of passive management to offer funds built for performance.” The prominent Wharton Finance Professor, Jeremy Siegel, is a Senior Investment Strategy Advisor for the firm.

Morningstar rates 10% of Wisdom Tree funds five stars, 41% four stars, 18% three stars, 25% two stars, and CXSE is rated five stars. Another example of their products I have reviewed and own is the Wisdom Tree Emerging Markets Small Cap Dividend ETF (DGS).

Risks

With high performance comes high risk. Ongoing trade tensions, the emerging second wave of Covid, possible sanctions, Chinese government controls and financial market restrictions, and geopolitical tensions with the U.S. all weigh on Chinese equities. As I mentioned above, momentum has been strong and there hasn’t been a meaningful price pullback since the late March liftoff.

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Also, Seeking Alpha reported that “China’s internet sector saw a $260B selloff on Wednesday after Beijing signaled its strongest intention yet to rein in Big Tech by drafting a slew of new anti-monopoly laws.” Morgan Stanley said this has negative implications for major internet companies with dominant positions, e.g. Alibaba and Tencent.

I view CXSE as a core holding, yet not a dominant one in a portfolio, as described below. In my view, the considerable rewards outweigh the risks of a measured portfolio allocation.

Entry Point and Allocations

For more value conscious and contrarian investors like me, it may be difficult to buy CXSE right now given its big runup. However, as a long-term investor who has conviction about the macro thesis and the fundamentals of CXSE, I think now is a reasonable entry point. Market timers and those who utilize technical analysis may certainly have other views. I initiated my first long position in CXSE a few weeks ago at $60 per share. I was conflicted (because I want to buy more) yet pleased when it quickly ran away to about $64 per share last week. As of this writing, CXSE trades at 61.34.

What percentage of a portfolio is appropriate to allocate to CXSE? It is a matter of conviction about the thesis and personal preference, but I will share my approach. In my last article, I suggested investors consider allocating 10-15% of the equity component of their portfolio to China. I also own VWO and DGS, which allocate 45% and 14% of assets respectively to China. As a result, these two comprise 2.9% of my total portfolio equities allocated to China. My plan is to allocate at least 10% of equities to China near term. Therefore, I am building a position of at least 7.1% of my equities in CXSE as a pure play.

Conclusion

There are many viable ETFs for investors to participate in the China equity markets. The Wisdom Tree China ex-State-Owned Enterprises ETF is my top choice for several reasons. The exclusion of state-owned enterprises has produced stronger fundamentals and outperformance versus other funds. CXSE has low expenses, strong exposure to China’s growth sectors, excellent risk-adjusted performance, reasonable valuation, ample liquidity, and a solid asset manager.

Recent momentum suggests investors might wish to consider a more attractive entry point before jumping aboard. But I believe long-term, buy and hold-oriented investors will be rewarded as CXSE rides a multi-decade rise in China, already a world juggernaut.

I look forward to your comments. If you found this article useful, please consider liking it, following me, and forwarding it to a friend.

Disclosure: I am/we are long CXSE, DGS, VWO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com