China through the mosaic of its share classes
China’s global competiveness is not a recent phenomenon. The “Opium Wars” of 1839-1860 left China aspiring to the technological and industrial capabilities of Britain and France. Needing fresh capital in order to fund the desired advancements, the concept of a joint-stock company was introduced. This development led to the formation of the Chinese Steam Merchant’s Company; and its shares began trading in Shanghai teahouses. More companies followed, and by 1890 Shanghai had formally established a stock exchange. Fast forward one-hundred years, past several more wars and a redefining political revolution, and China was again on the path towards the formation of a stock exchange.
Beginning around 1980, a series of reforms were initiated with the overarching goal of improving the performance of state owned enterprises (SOEs). These reforms included making local governments the de facto owners of SOEs, introducing managerial performance incentives, and market-based pricing. Partly in response to the rapidly increasing competitiveness of China’s companies, the Shanghai Stock Exchange was founded in November 1990, shortly followed by the Shenzhen Stock Exchange. The ownership of publicly listed companies remained mostly in the hands of the government, but “free float shares” were made available exclusively to domestic investors. The domestic-only “A-share” class, denominated in Renminbi was soon followed by the “B-share” class which was created to facilitate foreign ownership of Chinese companies. B-shares were still traded on the mainland but paid dividends and were settled in either US or Hong Kong dollars, allowing global investors to gain access to Chinese domestic companies. However, B-shares’ usage and popularity was overshadowed almost immediately by another China share class, the H-share.
H-shares, as the first letter in the name suggests, are Hong Kong listings for companies that commonly have a corresponding mainland China A-share line. H-shares became the preferred route of China exposure for global investors because they were denominated in Hong Kong dollars and traded on the more familiar Hong Kong Stock Exchange (HKEX). Historically, H-shares also frequently traded at a discount to their corresponding A-share line making them even more popular with many investors. , In recent years, some companies with B-share listings have taken the step of converting them to A- and H-shares in order to broaden their potential pool of shareholders. Some China market observers have speculated that B-shares may eventually be folded into the A- and H-share markets as a way to consolidate liquidity and simplify the range of options available to foreign investors.
A-, B-, and H-shares are all linked to companies incorporated inside China. There are four additional stock types whose businesses and/or ownership can be traced to China but are incorporated outside the country: Red-chips, P-chips, S-chips and N-shares. So-called Red-chip stocks were developed as a method to reform SOEs by encouraging competitiveness and improved governance. Listed on the Hong Kong Stock Exchange, the ownership of Red-chip companies can be linked to a mainland government entity, and historically have been subject to adhering to the listing and regulatory requirements of the HKEX and Securities and Future Commission (SFC).
P-chips, S-chips and N-shares share many similarities but can be easily differentiated by where they are listed: P-chips in Hong Kong, S-chips in Singapore, and N-shares in New York. Companies listed using one of these three share types have a majority owner and are most often incorporated in a tax-advantaged country like the Cayman Islands or Bermuda. These companies can be formed using complex legal structures that may limit voting rights. Where these companies decide to list also reflects the perceived attractiveness of a particular exchange. Hong Kong, Singapore and New York have all competed in the beauty contest for non-domestically listed Chinese companies – sometimes raising questions about the standards to which these companies are held. The Hong Kong Stock Exchange has attempted over the years to facilitate the listings of dual-class shares but has been prevented by the Hong Kong regulator, the SFC, most recently in 2015.
Organizing the constellation of China-based share types together may seem as far flung as the listings themselves. But in the remaining sections of this report, we will endeavor to do just that by comparing and contrasting all seven China share classes. The paper will explore: the performance of each share type and in relation to the others, the characteristics of each share type and how those look when brought together in a combined index, the historical ownership profiles of the share classes, and survey the current landscape of usage within ETFs and mutual funds.
The performance of the China share classes as represented by the corresponding FTSE Russell index has varied, in some instances dramatically. Looking at the historical total return index values for the share classes, shown in Exhibit 2, a three-tiered pattern emerges. Red-chips and H-shares indexes finished our sample period with the highest total return index values of the seven share classes. These two Hong Kong-based share types may have benefitted from their combination of domestic exposure gained through a well-established international exchange. B-shares, P-chips and A-shares indexes comprise the middle tier of historical index values. N-shares and S-chips indexes ended the time period with the lowest index values, with S-chips notably diverging from the pack. S-chips were affected after a series of high profile corporate governance scandals beginning in 2010. N-shares have also received scrutiny for the complexity of their corporate structures and have been excluded from standard global and emerging market indexes.
In order to get a better sense of how the different share classes have performed relative to one another, we can use a common start date and base value (1000) for all. The earliest common start date from which monthly returns are available for all share types was December 2006, when the FTSE N Share All-Cap Capped Index began. As shown in Exhibit 3, the hierarchy of cumulative returns across the share classes can perform somewhat differently. The A-shares index stands out as having the highest cumulative return since 2007 despite two periods (2007-2008 and 2015-2016) of deep drawdowns – the B-shares index tracked closely behind. The cumulative performance of the S-chips index was lowest, falling more than 50% over the nearly 10-year time period evaluated.
Our final look at the share classes using index performance data will be through the lens of 36-month periods of rolling returns. Rolling returns are entry and exit time-dependent, but may more closely approximate the experience of investors transitioning into and out of asset classes and market segments. The three-year rolling returns make clear why A-shares have attracted so much attention as they cycled through three distinct periods (2007, 2011, and 2015) where the index return exceeded 100% – Exhibit 4. However, these index returns were short lived as most or all of those index gains were lost in subsequent periods. These cycles underscore:
- the impact the timing of holding periods;
- the implications of treating A-shares as a long-term vs. short term investment (see Exhibit 2); and
- the potential benefits of a having a broad exposure to China that includes multiple share classes – something we will explore in greater detail in the sections below.
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