China stock market

Physical ETFs trailing their synthetic peers

A cheaper and more transparent way to buy China stocks - it's just a shame about the tax

PUBLISHED : Monday, 11 March, 2013, 12:00am
UPDATED : Monday, 11 March, 2013, 4:34am

Physically backed A-share exchange-traded funds were the biggest innovation in the local funds market last year. The fund improved access to mainland-listed stocks. In particular, providers said they were cheaper and safer than synthetic A-share ETFs, which use derivatives.

So now that the physical funds have been trading for about eight months, it is a good time to assess their performance. The A-share market has risen about 8 per cent since the first physical ETF rolled out in July. Hongkongers are buying mainland equities again, and ETFs are effectively the only way into this market.

There are four physical A-share ETFs trading in Hong Kong with a quota to invest a combined 43 billion yuan (HK$53 billion). Physical A-share ETFs are a fixed feature of this market and you will likely be soon asked to buy one at your local bank.

In the charts below, we look at the trading performance of physical ETFs compared with the benchmark they track and the synthetic funds linked to the same index.

The charts show the physical funds trailing their synthetic peers, albeit fractionally. The top chart for example shows the CSOP FTSE China A50 ETF (a physical fund) underperforming the iShares FTSE A50 China Index (a synthetic fund) since its launch in August last year. Likewise, in the bottom chart, the China AMC CSI 300 Index Tracker Fund (physical) trails its index and two synthetic funds which track the same benchmark.

But the differences are minor. A fair reading of the charts would say physical and synthetic funds are tightly grouped and each does a good job of tracking its index.

So what, then, can one say about the relative performance of physical versus synthetic funds? Which fund should you use, if you decide to buy A shares?

Let's break this down. The synthetic A-share ETFs use derivatives that involve collateral costs that siphon about 2 to 3 per cent of fund value from investors per year. Physical ETFs do not have this cost, so that is a clear advantage for the physical fund.

However, the physical ETFs withhold 10 per cent of all capital gains, while the synthetic funds do not. The synthetic funds are setting aside tax now on the view that the government will eventually ask for this money. The synthetic funds are gambling that that day of reckoning will never come. If it does, the fund will be hit with a big tax bill, resulting in a potentially huge loss for all current investors in the fund.

You can take your own view on which approach is better. Practically, this means that investors in physical funds earn 10 per cent less on gains than do holders of the synthetic funds. This tax explains at least part of the physical funds' underperformance.

The upshot is that, if you are a personal trader looking for a short-term investment (say, less than one year), the synthetic funds look better. The big disadvantage of synthetic funds - higher costs - does not add up to much if the fund is only held for a few months. However, the physical funds' 10 per cent tax on capital gains is substantial.

Investors in a synthetic ETF have to hope Beijing does not roll out a capital gains tax that crushes their fund's value. But in the short run that seems a safe bet.