YAO: A Whole New China ETF

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Claymore certainly doesn’t seem to be resting on its laurels following last week’s announcement that Guggenheim Partners has agreed to buy the firm, including its line of about 35 ETFs with nearly $2 billion in assets. The Lisle, Illinois-based firm has filed with the SEC for approval of the Claymore/AlphaShares China All-Cap ETF. The proposed fund would trade on the NYSE Arca Exchange under the ticker YAO, and would invest in public companies in mainland China. YAO would join two existing Claymore China ETFs based on AlphaShares indexes: the China Real Estate ETF (TAO) and the China Small Cap Index ETF (HAO). TAO and HAO are among the best-performing ETFs so far in 2009, rising 67.6% and 81.1%, respectively.

Crowding The Market?
There are a number of China ETFs available presently, including the aforementioned Claymore funds, S&P China SPDR (GXC), and PowerShares Golden Dragon Halter USX China Portfolio (PGJ). And then of course there’s the $11 billion elephant in the room, iShares’ FTSE/Xinhua China 25 Index Fund (FXI). So the first question is: do we really need another China ETF? The short answer: absolutely. There’s still plenty of room for additional China equity ETFs, especially considering the size and current growth of the Chinese economy.

Although there are a number of options in the space, Claymore’s product will set itself apart in a number of different ways. First, the proposed ETF would invest in only shares available to foreign investors, eliminating “A” and “B” shares that are sold in local markets. Hong Kong-listed securities, including China H-shares and Red Chips will be eligible for inclusion, as will N-shares traded in New York and their equivalents trading in other foreign markets. Second, as its name states, the proposed fund would invest in companies of all sizes. Most of the existing China equity ETFs have a significant lean towards equities of a particular size. GXC and FXI are dominated by large (and even mega) cap companies, while HAO focuses exclusively on small cap companies.

The Problems With FXI
Despite its popularity, there are some serious flaws with the index underlying FXI, a fact that Claymore no doubt hopes to exploit with its proposed fund:

FXI has huge concentrations in the financials and energy sectors, which means it has big holdings in state-owned banks and oil companies.
FXI has no consumer discretionary or consumer staples stocks, meaning that it lacks exposure to a major growth area in China/
FXI has no technology exposure, meaning it doesn’t hold Tencent (TCEHF.PK) (China’s largest Internet service portal) or Baidu (BIDU) (sometimes referred to as “China’s Google”).
With only 25 holdings, FXI has heavy concentrations in specific firms (almost a 10% holding in China Mobile Ltd.). Moreover, with a market capitalization of more than $11 billion, there is potential for the fund to move the market if it needs to add or drop a component.
As presented below, the index on which the proposed Claymore ETF would be based offers much broader exposure to the Chinese equity markets:

Sector FTSE Xinhua 25 Index AlphaShares China All Cap Index
Consumer Discretionary 0% 5%
Consumer Staples 0% 4%
Energy 20% 19%
Financials 47% 32%
Health Care 0% 1%
Industrials 8% 13%
Technology 0% 8%
Materials 4% 5%
Telecom 18% 11%
Utilities 3% 1%

The General Case For China Equities
Despite the tremendous run-up in Chinese equity markets this year, there is reason to be very optimistic for the future. While A share market sells at a P/E of more than 30x, H and N share markets are trading at less than 20x earnings, a seemingly reasonable level given the rate at which the Chinese economy is expanding. And then there’s the issue of the Chinese currency valuation. “To the extent that one believes the Yuan is undervalued, it makes sense to consider what that says about valuations,” says Kevin Carter, Chief Executive Officer and Chief Investment Strategist of AlphaShares. “For example, if a company is selling at a reported PE of 15-16x, but all of its revenue and earnings are in the Yuan, perhaps you are paying less than you think.”

Of course, the fund is still pending approval and its launch is not yet certain. Assuming all goes as planned, however, we’ll likely be covering this fund quite a bit in coming months as its launch approaches.

View the filing here.

Disclosure: No positions at time of writing.
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