Something is afoot with the mainland's physically backed A-share funds. The instruments were the big innovation of 2012. They promised Hong Kong investors cheap, transparent access to mainland shares. However, these funds are experiencing redemptions this year that cannot be simply explained by weakness in the market. Investors are exiting physical funds at a greater rate than they are leaving so-called synthetic funds, which are backed by derivatives (see graph). One of the funds, the E Fund CSI 100, has seen a 70 per cent decline in the number of units held by investors, translating into US$1 billion of redemptions. Investors might wonder if the redemptions are any reflection of the quality of the physically backed A-share ETFs. The question is relevant given that a batch of new physical A-share ETFs are coming to Hong Kong, including one that starts trading today, called the C-Shares CSI 300. The physical A-share ETFs were launched in 2012, following the announcement of the renminbi qualified foreign institutional investor (RQFII) plan in late 2011. The physical funds offered investors a simpler, derivatives-free way to buy A-shares, and one that was cheaper to boot. Investors pay total expenses of about 0.88 per cent for the Harvest MSCI China A, a physical fund, whereas the W.I.S.E. - CSI 300, a synthetic instrument, carries total expenses of 1.39 per cent. Moreover, the synthetic funds involve derivative charges known as collateral costs that are not directly disclosed, and can run up to 2 per cent per annum. In the ETF world, which is all about giving investors cheap access to markets, that's a big difference. But investors are exiting the physical A-share funds, which have lost about US$1.4 billion of their value since the start of the year. The only physical fund that drew in new money this year is the CSOP FTSE China A50 ETF, and that was because the State Administration of Foreign Exchange allocated 2 billion yuan (HK$2.5 billion) in new investment quota to the fund in May. The biggest part of the outflow - about US$1 billion - from the physical ETF market has been from one fund: the E Fund CSI 100. Perhaps not coincidentally, E Fund Management, the Hong Kong firm managing this fund, has in the past year lost its head of business development (Marie Chew), its managing director (Nathan Lin) and its chief executive (Charles Wang). Jackie Choy, an ETF analyst with data firm Morningstar, says investors have been turned off by the fund's unusual benchmark, the CSI 100. It is the only Hong-Kong-listed ETF to track this index. The other ETFs track more conventional indices, namely the FTSE China A50, the CSI 300 and the MSCI China. "The less relevant index has seen more redemptions [in the ETF tracking it]," says Choy. "The CSI 100 is less well known while the A50 has been around for a long time, and people quote the CSI 300 for general market trends." Hugh Hang, an E Fund spokesman, says there is nothing wrong with the CSI 100 and that, indeed, the main indices are largely interchangeable. The CSI 100 tracks all the stocks included in the A50, and the CSI 100 is a subset of the CSI 300, he says. "We have done some analysis on the A50 and the CSI 300, and from 2007 until 2013 their correlation is about 0.98. So they move in the same direction," Hang says. However, there is one important difference. There are big futures instruments linked to the FTSE A50 and the CSI 300, but none that track the CSI 100. Henry Lee, a director of sales and marketing for China Asset Management (Hong Kong), an issuer of a physical A-share ETF, says professional traders such as hedge funds are buying the A-share ETFs with listed futures, to capture the valuation differences with futures that track the same index. "The hedge funds and traders have come in to benefit from the arbitrage between the ETFs and the futures, that's why we have seen high [trading] volume of A-share ETFs with listed futures," Lee says. Firms that issue warrants, structured products and futures linked to the FTSE A50 and the CSI 300 would want to buy ETFs linked to the same indices, as a hedge against their positions. Because the CSI 100 has no such major instrument linked to it, dealers have little need for E Fund's CSI 100 ETF as a hedging tool. It's also plausible that institutions are favouring the synthetic ETFs over the physical ones even when they track the same index, just because the synthetic funds tend to trade in higher volume, and do not involve a withholding tax for capital gains, as do the physical funds. In other words, if you are a professional trader looking for a liquid instrument to hedge short-term trades in the volatile A-share market, the synthetic ETFs are for you. But this would mean little to the average individual investor looking to buy A-shares. There is little difference between synthetic and physical funds in terms of performance. Even the E Fund CSI 100, although walloped by redemptions, is performing just fine, faithfully tracking its index and delivering returns well in line with the other A-share ETFs. And for individual investors, that is really all that matters.