BlackRock's new China license could give its ETFs a leg up

BlackRock Inc.'s new license to invest directly in China's capital markets could prove a key to fending off increasingly fierce competition for the A-share exchange-traded fund business the giant New York money manager pioneered a decade ago.

The firm's $7 billion iShares FTSE A50 China Index ETF — launched in 2004 to provide offshore investors with synthetic exposure to China's effectively sealed domestic stock markets — remains king of the hill. But Chinese asset managers offering physically backed ETFs over the past two years have succeeded in grabbing a 30% chunk of an expanding A50 ETF pie, according to a recent research note by Shanghai-based consulting firm Z-Ben Advisors.

For BlackRock and its competitors, positioning their ETF offerings correctly could be a matter of some import this year. While the outcome is far from certain, MSCI Inc. is slated to decide in June whether to include an initial sliver of China's domestic A-shares market in the New York-based firm's widely tracked emerging markets equity index.

In an interview, Peter Alexander, Z-Ben's founder and managing director, said the iShares ETF's relatively high tracking error — reflecting the costs of obtaining synthetic exposure from banks through “China A-shares access products” — has left an opening that the Hong Kong-based affiliates of Chinese managers have moved to exploit aggressively.

BlackRock's fact sheet for its Hong Kong Stock Exchange-listed iShares FTSE A50 shows its performance, after fees and other costs, trailing its benchmark of the 50 largest companies on the Shanghai and Shenzhen stock exchanges by just more than three percentage points a year, on an annualized basis, for the five years through March 31.

By comparison, performance of the CSOP FTSE China A50 ETF, which has gathered more than US$3.5 billion in assets since its August 2012 listing on the Hong Kong exchange, has trailed the benchmark by 1.8 percentage points over its 18 month life, according to a CSOP spokesman.

CSOP Asset Management Ltd., an affiliate of Shenzhen-based China Southern Fund Management Co. Ltd., has been the most successful local manager in the A-shares ETF market, but seven other Chinese money managers have taken advantage of the relatively new renminbi qualified foreign institutional investor program to offer physically backed A-share ETFs.

Launched at the end of 2011, the RQFII program initially allowed only the Hong Kong-based affiliates of Chinese money managers to invest renminbi accumulating in that territory back into China, in pursuit of the longer-term goal of the renminbi's internationalization.

With China's regulators moving quickly to extend RQFII privileges to foreign money managers as well, it's not just Chinese managers that are looking to horn in on BlackRock's A-shares ETF prize now.

In an e-mailed response to questions, Frank Henze, Hong Kong-based managing director and head of exchange-traded funds, Asia Pacific, with State Street Global Advisors, said SSgA got an RQFII license in February and is in the process of designing A-shares offerings now.

“Given that synthetic A-shares products often show high premiums and discounts,” SSgA has refrained from offering them, believing their “disadvantages outweigh their benefits,” said Mr. Henze. But with the introduction of RQFII, “we can now build products that don't suffer” from that volatility, he said.

On April 15, BlackRock announced it had obtained its own RQFII license. The company now will apply to China's State Administration for Foreign Exchange for a specific quota.

Z-Ben's Mr. Alexander predicts BlackRock's license will help the firm push back some of the competition from physically backed products by switching its flagship ETF's synthetic exposure to direct investment as and when it gets enough quota capacity to do so.

With China's regulators doling out quotas in discrete dollops of roughly US$150 million to US$300 million, timing is likely to be a key issue. Whether BlackRock will enjoy the kind of expeditious response to requests for additional RQFII quota capacity that's enabled CSOP's ETF to grow so quickly will be a key to determining the competitive landscape for physical ETFs, said Mr. Alexander.

Aaron Costello, a Singapore-based managing director with investment consultant Cambridge Associates, said several considerations — from uncertain tax treatment on capital gains to the superior liquidity BlackRock's existing synthetic ETF enjoys as a first mover — make the synthetic vs. physically backed choice a multilayered one today.

All other things being equal, however, the lower fees and tracking errors of physically backed A-share ETFs should give them the edge for long-term institutional investors seeking pure beta exposure to China's domestic market, he said.

In an interview, Jane Leung, a Hong Kong-based managing director with BlackRock and head of the firm's Asia ETF business, noted that the rising tide of investor interest in China has continued to lift iShares synthetic FTSE A50 ETF along with its newer physically backed competitors. Since the start of 2014, “we've seen about US$1.2 billion” of mostly institutional net inflows for the iShares offering, she said, citing its liquidity and BlackRock's reputation for risk controls as contributing factors.

Jack Wang, the Hong Kong-based head of sales for CSOP Asset Management, likewise predicted that synthetic ETFs and physically backed offerings such as his firm's can continue to co-exist because they appeal to different investor segments.

The relatively low tracking error and volatility of CSOP's FTSE A50 ETF is extremely important to investors with long-term investment horizons such as insurance companies and pension funds. But for retail investors or traders, the greater volatility of synthetic products could be an advantage, said Mr. Wang.

Asked for their best estimates for the institutional-retail split of their respective flagship ETFs, executives at CSOP and BlackRock both said 60-40. But CSOP's Mr. Wang said if that institutional portion could be analyzed further, he would expect CSOP's client mix to have more long-term investors and a smaller proportion of trading-oriented institutional investors, such as hedge funds, compared to BlackRock's.

If the two ETFs appeal to different investor segments, then rather than migrate the iShares FTSE A50 ETF's synthetic exposure to physically backed exposure, BlackRock might to better off offering a physically backed ETF to complement its existing synthetic one.

Ms. Leung declined to comment on BlackRock's plans, but she didn't close the door to fielding two FTSE A50 ETFs, noting “it's great to be able to provide investors with as many options as we can.”

And following BlackRock's garnering of US$200 million in quotas over the past year in the qualified foreign institutional investor program China launched more than 10 years ago, April's RQFII license provides the firm with further options “we can utilize within the (iShares FTSE A50) fund and in new funds to be able to provide more choices to investors,” she said.