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The Bull Case For Bearish China ETFs

August 31, 2015 11:48 am
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August went down as the worst one-month showing for Asian stocks in three years and China is a big reason why. The Shanghai Composite was lower by 2.6 percent on Monday, while Hong Kong's Hang Seng was off 0.8 percent.

The Shanghai Composite, the benchmark index for mainland Chinese equities, is looking at an August loss of 13.1 percent. Monday's declines could be a sign that recent departures from inverse China exchange traded funds, including the Direxion Daily CSI 300 China A Share Bear 1X Shares (NYSE: CHAD) and the Direxion Daily FTSE China Bear 3X Shares (NYSE: YANG), may prove to be hasty. The two ETFs have lost $84 million combined this month.

Hanging CHAD

CHAD is the only U.S.-listed inverse answer to A-shares stocks, acting as the bearish equivalent of the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSE: ASHR) and the Market Vectors ChinaAMC A-Share ETF (NYSE: PEK). Those ETFs track the CSI 300 Index, the index CHAD tries to deliver the daily inverse performance of on a percent-for-percent basis.

Related Link: Why China Isn't Killing Alibaba

Market participants are not feeling enthusiastic about near-term upside for A-shares, the stocks trading on mainland China.

"Puts that pay out on a 10 percent drop in the fund cost 7 points more on Friday than calls betting on a 10 percent gain, according to implied volatility data on one-month contracts. As recently as August 24, the bullish contracts were more expensive. For the U.S.-listed Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, the skew reached a record 38 points on Aug 27 and closed the week at 28 points,” according to Bloomberg.

Even after a significant stumble, A-shares are still pricey, trading at 53 times earnings, according to Bloomberg. That is nearly triple the multiple on the S&P 500 and almost five times the price-to-earnings ratio on the MSCI Emerging Markets Index.

Making matters worse for Chinese and better for ETFs like CHAD and YANG is that over the weekend, China Construction Bank, the country's second-largest bank, reported second-quarter profit growth of zero.


Here's where YANG comes into play. China Construction Bank is nearly 8.6 percent of the FTSE China 50 Index, the index YANG attempts to deliver triple the daily inverse performance of. The FTSE China 50 Index is the underlying benchmark for the iShares China Large-Cap ETF (NYSE: FXI), the largest U.S.-listed China ETF. All FXI does is allocate 49.4 percent of its weight to financial services stocks, nearly quadruple the ETF's second-largest sector weight.

So if China Construction zero profit growth report is a pervasive theme for Chinese banks, FXI will likely come under increased pressure while YANG flourishes.

There is good news for CHAD as well because the CSI 300 Index has a 35.5 percent financial services allocation and seven of that index's 10 largest holdings hail from that sector.

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