Bank Issues Continue To Plague Some China-Focused ETFs

The Vanguard FTSE Emerging Markets ETF VWO and the iShares MSCI Emerging Markets ETF EEM, the two largest emerging markets exchange traded funds by assets, are up an average of 13 percent year-to-date.

That's an impressive showing considering that lagging China is the largest country weight in those and other diversified emerging markets ETFs. However, the iShares China Large-Cap ETF FXI, the largest China ETF trading in New York, is up just 1.2 percent so far this year. Of the four major single-country, BRIC-tracking ETFs, from three different issuers, FXI is the worst performer this year.

A familiar problem is pressuring FXI and some other China ETFs: Significant exposure to Chinese banks. This issue has been addressed many times over the years, but here it is 2016 and with global investors expressing concern about Chinese credit markets, it is again worth noting that FXI allocates 51.5 percent of its weight to financial services. That is more than quadruple its second-largest sector weight, telecom.

“China's credit-to-GDP, as measured by Fitch-adjusted total social financing, has roughly doubled over the past eight years, while credit/GDP productivity rates since 2008 indicate substantial malinvestment (wasted assets) and further increases in problem credit,” said Fitch Ratings in a recent note.  Fitch believes Chinese authorities will continue to allow credit to drive growth and will likely restructure debt rather than allow mass defaults, regardless of the size of problem credit in the economy.

In recent years, FXI has endured concerns about China's shadow banking system, non-performing loans and overall liquidity in the world's second-largest economy, among other issues. Still, this is a $3.65 billion ETF, indicating that there is plenty of professional money in the fund.

Indeed, FXI, due to its size and liquidity relative to some competing China ETFs, is a favorite of professional investors. Amateur or professional investors embracing FXI are arguably embracing defeat as they embrace the plus side of most ETFs: diversity in holdings. Many ETFs help investors dodge individual stock risks, but FXI certainly exposes investors to single-sector risk by being a de facto bet on Chinese banks.

“Chinese banks' viability ratings, which range from 'bb' to 'b', reflect substantial but varying risks to capital and asset quality. Fitch's base-case assessment of banks' intrinsic profiles considers relative loss-absorption capacity rather than subjectively adjusting reported NPL data,” adds Fitch. “This is due to uncertainties relating to on-and-off balance sheet asset quality.”

Todd Shriber owns shares of VWO.