China A Shares: Keeping a Long-Term View Despite Recent Volatility

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1 SPDR SPOTLIGHT China A Shares: Keeping a Long-Term View Despite Recent Volatility by David B. Mazza, Head of Research, Jared Rowley, CFA, Research Strategist and Matthew Bartolini, CFA, Research Strategist, SPDR ETFs and SSGA Funds Research Team Introducing the SPDR MSCI China A Shares IMI ETF (XINA). For years, China s A share domestic equity market remained largely off limits to most investors and off their radars. No more. After a tumultuous 12 months that has seen the Shanghai Stock Exchange Composite Index rocket up about 150 percent before drawing down significantly since its June 2015 peak, 1 China A has become as much a part of the investing lexicon as Grexit or the Federal Reserve s dot plot. The high hopes that had accompanied reforms announced last year aimed at opening China to more foreign investment have now been eclipsed in many investors minds by fresh memories of market turmoil that at one point this summer saw half the mainland-listed stocks suspend trading. After subsequent disappointing growth reports and moves by the Chinese central bank to devalue the renminbi helped trigger an August roller coaster for equity and currency markets worldwide, there probably isn t an investor alive who is not aware of the crucial impact China and its A share market have on the global economy. Yet, they re right to wonder what place it has in their portfolios. Figure 1: Index Performance Characteristics Index Annualized Return (%) Standard Deviation (%) Sharpe Ratio (%) CSI 800 Index S&P China BMI MSCI EMF (Emerging Markets) MSCI The World Index MSCI EAFE S&P Source: FactSet. Period: August 2011 to September 2015, which represents the history of returns available for the CSI 800 Index. The tracking index for XINA is the MSCI China A International IMI Index, which was launched on September 2, Past performance is not a guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot directly invest in an index.

2 We Believe China s Long Term Growth is Still Intact At State Street Global Advisors, we think the answer comes down to whether you view the China A share market as a trade or an investment. If the events of the past year illustrate anything, it s that the volatile China A share market remains a difficult environment in which to time tactical short-term bets. With Chinese individual investors accounting for about 80% of trading in China A shares 2 the market has been highly susceptible to market psychology and policy decisions. The number of retail brokerage accounts and the amount of margin lending activity have risen sharply in the past year. The move toward liberalization and gradual opening of the market to a greater percentage of international investors more focused on underlying fundamentals is expected to eventually change those dynamics, but the transition won t happen overnight. Figure 2: China s A Share Market Exchange Market Cap ($T) # of Listed Companies Shanghai 4.1 1,071 Shenzhen 2.7 1,729 Source: World Federation of Exchanges, data as of August 31, Still, despite the recent market gyrations, the China A share market is a vital portal into one of the most compelling long-term secular growth stories in the world today. The wealth effect from the recent A share sell-off and a greaterthan-expected slowdown could have an impact. Yet, China s economy is projected to grow at an annualized rate of 6.9 percent in the second half of 2015, 6.9 percent for the full year in 2015 and 6.7 percent in 2016, 3 or roughly twice the rate of the US. Over the longer term, China is expected to overtake the US as the world s largest economy by China is in the midst of a difficult transition from an economy based on exports and investment to one based more on consumer spending and entrepreneurship. But as the country continues to reorient around this more sustainable growth model, we believe the A share market remains the most direct way of accessing the kinds of companies that stand to benefit most from the shift. In contrast to the Hong Kong-listed, or H share, companies that have traditionally dotted Western portfolios, the A share market has relatively fewer financial stocks and a higher percentage of consumer staples, discretionary, health care and information technology stocks. If you believe as we do in the long-term viability of the Chinese domestic growth story, the A share market becomes an essential tool for harnessing that growth potential. The recent volatility and market dislocations, as unnerving as they seem, can be seen as less of a deterrent and may be more of an opportunity to establish a long-term strategic positioning at a somewhat better price. A Missing Piece of the Puzzle For all its recent turmoil, we d argue that the China A shares market encompassing companies listed in mainland China and denominated in renminbi are a missing piece of the puzzle in many investor portfolios. The China A share market, introduced in the early 1990s to privatize the country s state-owned companies, has become one of the largest equity markets in the world. 5 Even after their summer sell-off, the Shanghai and Shenzhen stock exchanges had a combined market capitalization of nearly $7 trillion at the end of August 2015, second only to the US equity market, according to data from the World Federation of Exchanges. 6 Yet, until recently, only a small fraction of the total was made available to foreign investors. Access came through several different types of Chinese equity shares, including: B shares Chinese companies incorporated in mainland China that are open to overseas ownership, listed on the Shanghai exchange and denominated in US dollars. These can also be listed on the Shenzhen exchange and denominated in Hong Kong dollars. H shares Chinese companies incorporated in mainland China and listed on the Hong Kong exchange. Red Chips State-owned Chinese companies incorporated outside mainland China and listed in Hong Kong. N shares Chinese companies incorporated outside mainland China (often in Bermuda or the Cayman Islands) that are listed on the New York Stock Exchange (NYSE) or Nasdaq. N shares may also refer to American Depositary Receipts (ADRs) of H shares or Red Chips. P Chips Private companies (not state-owned) incorporated outside mainland China and listed in Hong Kong. This alphabet soup of share classes comprise a relatively limited selection of stocks concentrated in a handful of sectors. In contrast, the A share market represents all the sectors and more than 2,800 stocks listed on China s two main exchanges in Shanghai and Shenzhen. In fact, there are those who make the analogy that investing in China without exposure to the A share market is akin to investing in the US and ignoring the S&P 500 Index. But for many years that s exactly what international investors were forced to do. State Street Global Advisors 2

3 Opening the A Share Market: A Work in Progress The situation started to change early last decade when Chinese authorities began implementing a system that allows primarily large foreign institutions with Qualified Foreign Institutional Investor (QFII) or Renminbi Qualified Foreign Institutional Investor (RQFII) status to apply for quotas to purchase shares listed in Shanghai or Shenzhen. As of last year, the total quota available via the QFII and RQFII programs had grown to almost 2 percent of China s total market capitalization. Plans call for that to increase to percent in the next few years. 7 Then, in April 2014, China announced the implementation of the Shanghai-Hong Kong Stock Connect program, or Express, establishing the first direct trading link between Shanghai and Hong Kong. As part of the program, investors with a Hong Kong brokerage account can now tap an aggregate daily market quota to trade and settle mainland-listed shares. (Mainland investors utilizing the southbound route also have an easier time investing in companies listed on the Hong Kong exchange.) This Shanghai-Hong Kong Stock Connect was viewed as a game changer by many market observers. It stirred excitement among investors in China, who stood to gain from the technical tailwind effects from potential foreign investment. Individual Chinese investors poured into the A share market, bidding up share prices in a frenzy reminiscent of the US dot-com bubble of the late 1990s. As in the dot-com era, investors using margin debt to plow even more money into the market helped feed the mania. 8 And in June, when Chinese authorities, alarmed at the excesses, tightened margin requirements, a dramatic sell-off ensued. The volatility tapered off only after the government stepped in with a series of extraordinary measures. 9 In addition to utilizing more standard interventions such as bans on short sales, the government has at one time or another this summer banned selling by large investors, ordered state-owned companies to purchase stocks and encouraged the country s largest brokerage houses to form a fund to buy up shares. For the first time, it also allowed the country s pension funds to become equity investors. Taking a Long Term View of China A Shares On one level, the government s interventions and trading suspensions have added to the overall concerns about the A share market. Regulators who had been pushing for a more open, market-oriented system have set a precedent for more intervention. A market that seemed headed toward greater access and fewer controls appears to have taken a step back. But in our view, it is just that: a step back. The underlying strength and vitality of the Chinese economy as well as the long-term drive for liberalization haven t changed in any fundamental sense, in our opinion. A substantial portion of the world s unicorns tech start-ups that achieve $1 billion in venture capital and private equity financing have germinated in China over the past two years. 10 In early July 2015, during a steep market sell-off, Chinese ride-hailing app Didi Kuadi raised $2 billion in domestic and foreign funding in two weeks. (The company originally planned to raise $1.5 billion, but drew so much interest that it raised another $500 million.) 11 One question many are asking is how large institutional investors will react to elevated volatility in the China A share market. The early evidence is that many institutions with access to A shares have used this summer s sell-off as a buying opportunity. 12 For example, during the first week of July, China posted the highest inflows of any global market with $13 billion moving in, primarily in exchange-traded funds that invest in A shares. 13 Nor has there been any sign from global benchmark providers that they plan on backing off their plans to eventually include China A shares in widely followed indices tracking emerging markets. In late May 2015, FTSE announced a transition plan to include China A shares in its global benchmarks with the introduction of two transitional indices for emerging markets. FTSE indicated the initial weighting of China A shares in the FTSE emerging inclusion indices will be approximately 5 percent. That is expected to increase to 32 percent when China A shares are fully available to international investors. Together with the other Chinese share classes already included (H, N, etc.), that will put total China representation at 50 percent of the FTSE Emerging Market Index, according to the benchmark provider s own estimates. 14 Figure 3: China A Share Index Comparison Index MSCI China A International IMI FTSE A50 CSI 300 CSI 800 Description Large-, mid- and small-cap representation of stocks listed on the Shanghai and Shenzhen exchanges 50 largest A share stocks listed on the Shanghai and Shenzhen exchanges 300 largest and most liquid A share stocks listed on the Shanghai and Shenzhen stock exchanges No. of Constituents 1, Combines CSI 300 and CSI 500 Largest Sector Financials (27%) Financials (66%) Financials (41%) Financials (33%) Source: FactSet, SSGA, as of September 30, The CSI 300 Index and the FTSE China A50 Index are the indices tracked by the three largest China A shares ETFs listed on US stock exchanges: db x-trackers Harvest CSI 300 China A-Shares ETF [ASHR]; Market Vectors ChinaAMC A-Share ETF [PEK]; and CSOP FTSE China A50 ETF [AFTY] (based on net assets as of September 30, 2015). State Street Global Advisors 3

4 In June 2015, MSCI said it, too, expected to include China A shares in its global benchmarks once some important issues related to market accessibility have been resolved. 15 With $1.5 trillion currently benchmarked to the MSCI Emerging Markets Index, 16 that would mean billions of dollars in foreign investment funneling into the market automatically. We Believe Broader is Better When Investing in China SPDR MSCI China A Shares IMI ETF (XINA) gives investors broad, low-cost exposure to a portion of Chinese equity markets they may have been missing. XINA s tracking index provides broad and deep coverage to China A shares. This wide coverage encompasses not just the largest, state-owned and private enterprises, but also includes the full range of large-, mid- and small-cap firms. That breadth gives investors a much greater diversity within the China A share market, compared to China A share indices with narrower ranges (see Figures 4 and 5). We believe this is critical for a market where, as the recent price swings have shown, volatility can spike quickly. In addition, we believe that investors can broaden their exposure even more by combining XINA and SPDR S&P China ETF (GXC), which offers comprehensive exposure to all of the Chinese companies not listed in Shanghai or Shenzhen, including N share companies listed in New York. GXC s tracking index is the S&P China BMI Index. Figure 4: Sector Allocations of China Indices Economic Sector Consumer Disc Consumer Staples Energy Financials Health Care Industrials IT Materials Telecom Utilities MSCI CHINA A IMI International Index Portfolio Weight FTSE China A 50 China Securities Index 300 Source: FactSet, as of September 30, Holdings Data as of: MSCI CHINA A IMI International Index 9/30/2015, China Securities Index 300 9/30/2015, FTSE China A 50 9/30/2015. The CSI 300 Index and the FTSE China A50 Index are the indices tracked by the three largest China A shares ETFs listed on US stock exchanges: db x-trackers Harvest CSI 300 China A-Shares ETF [ASHR]; Market Vectors ChinaAMC A-Share ETF [PEK]; and CSOP FTSE China A50 ETF [AFTY] (based on net assets as of September 30, 2015). Index allocations are as of the date indicated, are subject to change and should not be relied upon as current thereafter. Potential Diversification Benefits of A Shares There is no question the China A shares market marches to its own drummer when compared to the world s other major equity markets. From the behavior of the market s large percentage of retail investors during the incredible run-up in share prices earlier this year to the heavy hand of the government in stemming the rout, recent events have only served to underscore that point. However, one side benefit of these idiosyncrasies is the diversification it may help provide to a portfolio s other equity holdings. At a time when the diversification of emerging-market equities has waned because the asset class has become more closely correlated with developed-market equities, China A shares remain a distinct outlier. The market maintains a very low correlation with US and European equities as well as with other emerging markets (see Figure 6). We think the added diversification benefits of combining GXC with XINA can potentially be significant. Because of the S&P China BMI Index s heavier exposure to the types of companies that have historically chosen to list offshore, it has a low correlation of 0.64 to the A share market as measured by the CSI 800 Index (see Figure 6). In other words, GXC may experience stronger relative performance during times of potential weakness for A shares and vice versa. Those considering an investment in China need to understand that in the overall scheme of things, the volatility of the past year is not that unusual. While China may already seem at times like a developed economy, its domestic equity market is still in the relatively early stages of development, with capital controls, a mix of market participants and a level of government intervention that in many ways share more in common with the world s frontier markets. Those patterns are evolving rapidly, but not in a straight line. In the meantime, as China continues on its relentless path to first-world status, we think the best way for investors to harness that growth potential is to gain their exposure as comprehensively and patiently as possible. State Street Global Advisors 4

5 Figure 5: Market Cap Allocations of China Indices Percentage of Total Holdings MSCI CHINA A IMI International Index Market Cap Quintile (1=Largest, 5=Smallest) China Securities Index 300 FTSE China A 50 Source: Bloomberg, FTSE, MSCI, FactSet. Data as of 9/30/2015. Holdings Data as of: MSCI CHINA A IMI International Index 9/30/2015, China Securities Index 300 9/30/2015, FTSE China A 50 9/30/2015. The CSI 300 Index and the FTSE China A50 Index are the indices tracked by the three largest China A shares ETFs listed on US stock exchanges: db x-trackers Harvest CSI 300 China A-Shares ETF [ASHR]; Market Vectors ChinaAMC A-Share ETF [PEK]; and CSOP FTSE China A50 ETF [AFTY] (based on net assets as of September 30, 2015). Index allocations are as of the date indicated, are subject to change and should not be relied upon as current thereafter. 1 Foreign Investors Flood Into China Shares, wsj.com, August 27, China Enters Stock Frenzy as Rookie Traders Open Record Accounts, Bloomberg, March 31, Consensus as of August 18, 2015, as reflected by the median of 11 estimates by professional forecasters on Bloomberg. 4 Building the dream, The Economist, April 19, China A-shares: Too Big to Ignore, MSCI, March World Federation of Exchanges, as of July 31, Shanghai Stock Exchange, as of August 31, Chinese Investors Pull Back from Margin Financing, The Wall Street Journal, July 9, China Unleashes $483 Billion to Stem the Market Rout, Bloomberg, July 17, Asian Tech Start-Ups Quietly Earn Backing, The New York Times, July 12, Asian Tech Start-Ups Quietly Earn Backing, The New York Times, July 12, China s Stock Rally Continues as Foreigners Jump Back In, TheStreet.com, July 13, Global Stock Markets Saw Massive Inflows Last Week Despite Selloff, ThinkAdvisor.com, July 13, Press release: FTSE starts transition to include China A Shares in global benchmarks, FTSE, May 26, Press release: Results of MSCI 2015 Market Classification Review, MSCI, June 9, MSCI, data as of March 31, Figure 6: Correlation Matrix Description CSI 800 Index S&P China BMI MSCI EMF (Emerging Markets ) MSCI The World Index MSCI EAFE FTSE China A CSI 300 Index CSI Smallcap 500 Index S&P Source: FactSet. Period: August 2011 to September 2015, which represents the history of returns available for the CSI 800 Index. The tracking index for XINA is the MSCI China A International IMI Index, which was launched on September 2, The correlation coefficient measures the strength and direction of a linear relationship between two variables. It measures the degree to which the deviations of one variable from its mean are related to those of a different variable from its respective mean. Past performance is not a guarantee of future results. State Street Global Advisors 5

6 Definitions CSI 800 Index An equities benchmark that aims to comprehensively reflect the price fluctuation and performance of the large-, mid- and small-cap companies in the Shanghai and Shenzhen securities markets. CSI Small Cap 500 Index An equities index designed to track 500 small-cap stocks in the Shanghai and Shenzhen securities markets. Diversification Benefits In modern portfolio theory, diversification is an approach used to potentially reduce the overall risk of the portfolio by holding a mix of assets with low correlations to each other. The potential benefit of holding uncorrelated assets is that some investments may rise while others fall. H Shares Chinese companies incorporated in mainland China listed on the Stock Exchange of Hong Kong. MSCI ACWI Investable Market Index (IMI) An equities benchmark designed to capture large-, mid- and small-cap representation across 23 developed-market and 23 emerging-market countries, covering approximately 99 percent of the global equity investment opportunity set. MSCI China A International IMI Index A free-float adjusted, market capitalization weighted benchmark designed to capture large-, mid- and small-cap representation across Chinese securities with A share listings on the Shanghai or Shenzhen stock exchanges. The index is comprised solely of A shares and aims to capture approximately 99 percent of the investible Chinese domestic A shares equity universe. MSCI China Index An equities benchmark that captures large- and mid-cap representation across China H shares, B shares, Red chips and P chips. MSCI EAFE Index An equities benchmark that captures large- and mid-cap representation across developed-market countries around the world, excluding the US and Canada. N Shares Chinese companies incorporated outside mainland China (often in Bermuda or the Cayman Islands) that are listed on the New York Stock Exchange (NYSE) or Nasdaq. N shares may also refer to American Depositary Receipts (ADRs) of H shares or Red Chips. Price-To-Earnings Multiples A valuation metric that uses the ratio of a company s current stock price vs. its earnings per share. Shanghai Stock Exchange Composite Index An index that tracks the performance of all A and B shares listed on the Shanghai stock exchange. Sharpe Ratio A commonly used metric for measuring risk-adjusted performance. The ratio calculates the excess return over the risk-free rate, divided by standard deviation. It is designed to show the excess return per unit of risk. A higher Sharpe Ratio denotes better risk-adjusted performance. S&P 500 Index A popular benchmark for US large-cap equities that includes 500 companies from leading industries and covers approximately 80 percent of available market capitalization. S&P China BMI A comprehensive benchmark that defines and measures the investable universe of publicly traded companies domiciled in China, but are legally available to foreign investors. Standard Deviation Measures the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility. A higher standard deviation means the security has tended to show higher volatility or price swings in the past. Technical Tailwinds Positive factors for a particular market generated by specific market influences, such as deregulation, that could open a market to more potential investors. MSCI Emerging Markets Index An equities benchmark that captures large- and mid-cap representation across 23 emerging-market countries. State Street Global Advisors 6

7 ssga.com spdrs.com For public use. State Street Global Advisors One Lincoln Street, Boston, MA T: Important Risk Information ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns. Chinese securities A shares involves certain investments risks and investment considerations including, (i) the small size of the market for Chinese securities relative to the US market, low volume of trading relative to U.S. securities, lack of liquidity and in price volatility, (ii) currency devaluations and other currency exchange rate fluctuations or blockage, (iii) the nature and extent of intervention by the Chinese government in the Chinese securities markets, whether such intervention will continue and the impact of such intervention or its discontinuation, (iv) the ability of Chinese issuers to unilaterally suspend trading of their securities, and (v) custody risks associated with investing through a RQFII. Foreign (non-u.s.) Securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets. Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions. Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Derivative investments may involve risks such as potential illiquidity of the markets and additional risk of loss of principal. Concentrated investments in a particular industry or sector may be more vulnerable to adverse changes in that industry or sector. Non-diversified funds that focus on a relatively small number of issuers tend to be more volatile than diversified funds and the market as a whole. The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data. The views expressed in this material are the views of the SPDR ETFs and SSGA Funds Research Team through the period ended September 30, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment. Standard & Poor s, S&P and SPDR are registered trademarks of Standard & Poor s Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation s financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index. Distributor: State Street Global Markets, LLC, member FINRA, SIPC, a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call or visit spdrs.com. Read it carefully. Not FDIC Insured No Bank Guarantee May Lose Value 2015 State Street Corporation. All Rights Reserved. ID4633-IBG Exp. Date: 07/31/2016