Better to Get Chinese Stock Exposure Through the iShares MSCI Emerging Markets ETF Instead of MCHI

At $62.9 per share, iShares MSCI China ETF (MCHI) is more than 70% under its February 2021 high. In contrast, the one-month gain of 3.4% shows that there has been a regain of interest by investors for this ETF which mainly provides exposure to the Chinese consumer cyclical, communication, financial, and tech sectors. In comparison, the iShares MSCI Emerging Markets ETF (EEM) which includes about 34% of Chinese assets is up by 3.8%.

Source: Trading View

My objective with this thesis is to understand the reason for this timid rise in the value of MCHI and whether there could be a more sustained upside. I first start with China’s central bank actions which could be beneficial to the ETF’s financial sector holdings.

China’s central bank actions

The People’s Bank of China (PBOC) which had previously taken a restrained approach to monetary stimulus, appeared to change its stance on December 25, when it pledged greater support for the real economy, stating that monetary policy will be more forward-looking and targeted. One of the intended aims would be to “promote the property sector’s healthy growth as well as work to better meet housing demand”. By that time, MCHI shares had reached their lowest point, and the PBOC’s statement did produce a temporary relief for investors.

Interestingly, the central bank’s more recent announcement about lowering interest rates by 10 basis points to 2.85% on Jan 17 constitutes a more concrete step and may preclude other such actions as Chinese authorities try to mitigate the effects of the Omicron variant, and address the downturn in the property sector.

Now, the fact that the PBOC is easing monetary policy despite China’s GDP expanding by 8.1% in 2021, supposes that the economy still faces headwinds. At the same time, the U.S. and the rest of the world are looking more towards tightening. Thus, the PBOC may have a narrow window of opportunity to provide stimulus before it has to start tightening again. Hence, while there are near-term positives for MCHI’s bank and industrial holdings, the longer-term picture looks more uncertain.

Some big investors favor China for investment

Now, REITs constitute just 4% of MCHI’s holdings and the ETF provides exposure to giants like Alibaba (BABA), also referred to as the “Chinese Amazon (AMZN)”. Interestingly, Charlie Munger, the vice-chairman of Berkshire Hathaway (BRK.B) controlled by Warren Buffett has augmented his stake in Alibaba during the recent months. Now, Berkshire is considered as the “epitome of value”, and for this matter, MCHI’s uptrend also somewhat coincides with the rotation from growth to value stocks which has been gaining momentum from the beginning of this year.

Source: iShares.com

Along the same lines, billionaire investor Ray Dalio, who has reportedly raised $1.3 billion for its third China fund according to the Wall Street Journal is highly optimistic that the Asian country is winning the economic race against the U.S.

Now, Dalio’s remarks have sparked some controversy. To this end, those who have invested in Chinese tech and educational technology companies know something about the propensity of authorities in that country to bring in abrupt regulations, such as those implemented as from July last year. These quickly decimated the valuations of stocks operating in these sectors.

Exploring further, Dalio’s remarks are reminiscent of the 2005-2006 period when the U.S. had dropped from 4th to 13th position in the global rankings for broadband internet usage, all at the benefit of Japan and South Korea. At that time some Wall Street gurus predicted that this drop would result in the U.S. losing in productivity and innovation. Eventually, these predictions never materialized and twenty years later, the U.S is home to the biggest tech companies the world has ever known.

Thus, basing an investment solely on the moves of big investors makes no sense and anyone investing in China should be aware of the risks.

The risks

First, the delisting fears whereby NYSE and NASDAQ listed Chinese firms will be all removed and relisted in Hong Kong appear overblown as even if a stock delists from the U.S., possibly as a result of Chinese authorities stepping up supervision, it would eventually be converted to Hong Kong Stock Exchange shares, so one still owns the company. This was the case with ride-hailing group Didi Global (DIDI) at the start of December last year, but news about the event still trimmed some percentage points off MCHI’s share price.

Second, both the US and China are heavily invested in each other as the two countries’ supply chains are highly interdependent. On the one hand, with American citizens depend to a large extent on consumer items from China, and on the other, the latter’s factories depend on capital goods like semiconductor producing equipment from the U.S. Now, semiconductors remain highly sensitive items and the U.S. has brought in legislation which limits the type of chips which can be exported to China, out of fear that the Chinese military may use these to produce sophisticated weapons. These could be used against Taiwan, one of America’s strategic allies in the region.

Better to go for partial exposure through EEM

Therefore, in addition to economic and regulatory uncertainty within China itself, there are geopolitical risks that can impact the country’s trade with the U.S. This can result in MCHI becoming highly volatile. However, China remains the second largest economy in the world and value investors like Charlie Munger and venture capitalists like Ray Dalio have been in the game since a long time. Consequently, from the balanced risk perspective, partial exposure to Chinese stocks, either individually, or through an ETF start to make some sense.

Thus, for those wanting exposure to some of the specific Chinese tech names like Tencent (TCEHY) and Alibaba which are significantly undervalued with respect to their western counterparts, there is the EEM alternative, which is also diversified in Taiwanese, South Korean, Indian stocks as well as other countries. The ETF’s holdings should benefit from record high U.S. inflation favoring cheaper alternative products from emerging economies. This said EEM has a slightly higher expense ratio of 0.68% compared to MCHI’s 0.57% but has shown a better one-month performance.