Leveraging Chinese Stock Markets: Tracking the Performance and Return Deviation of U.S.‐listed Chinese LETFs

• DOI: http://doi.org/10.1111/ajfs.12033
• Published date: 01 December 2013
• Author: Xiaoqing Eleanor Xu,Hongfei Tang
• Date: 01 December 2013

Leveraging Chinese Stock Markets: Tracking

the Performance and Return Deviation of

U.S.-listed Chinese LETFs*

Hongfei Tang

Stillman School of Business, Seton Hall University

Xiaoqing Eleanor Xu**

Stillman School of Business, Seton Hall University

Received 10 January 2013; Accepted 14 July 2013

Abstract

This paper presents a comprehensive examination of the tracking performance and return devi-

ation of U.S.-traded Chinese Leveraged Exchange-traded Funds (LETFs). Our results suggest

that investors should be mindful of the fact that these Chinese LETFs actually track U.S.-based

benchmarks rather than their Chinese index benchmarks, and consequently suffer from tracking

errors due to “benchmark substitution” and nonsynchronous trading between the U.S. and Chi-

nese markets. As for the Chinese LETFs’ ability to track their target return, market inefficiency

accounts for the majority of daily return deviations, but this effect does not accumulate over

time due to the creation/redemption feature; the net asset value (NAV) deviation is small on a

daily basis, but accumulates over time. Over multiple trading days, there is a sizable, cumulative,

and generally negative compounding return deviation owing to the daily rebalancing nature of

these funds and high volatility in the benchmark return during the sample period.

Keywords Leveraged ETFs; Chinese stock markets; Price discovery; Compounding effect;

Tracking error; Market efficiency

JEL Classification: G11,G14,G15

1. Introduction

The benefit of portfolio risk reduction through diversification into international

markets has long been documented in academic studies (Levy and Sarnat, 1970;

Solnik, 1974; Jorion, 1989; Pennathur et al., 2002; Goetzmann et al., 2005). As the

*Acknowledgment: The authors thank Kee Chung (the Editor), Fei Leng, Rachel A. Rasmussen,

Minh Vo, two anonymous reviewers, and seminar participants at Sun Yat-Sen University and the

2013 Eastern Finance Association meetings for their comments and suggestions. Tang thanks the

Institute of International Business at Seton Hall University for their generous financial support.

**Corresponding author: Xiaoqing Eleanor Xu, Stillman School of Business, Seton Hall Univer-

sity, South Orange,NJ 07079, U.S.A. Tel: 973-761-9209,Fax: 973-761-9217, email: xuxe@shu.edu.

Asia-Pacific Journal of Financial Studies (2013) 42, 845–879 doi:10.1111/ajfs.12033

©2013 Korean Securities Association 845

largest emerging market and one of the fastest growing economies, China has

attracted tremendous attention from investors around the world and is widely per-

ceived as one of the most strategic international investing destinations in global

portfolio management. With an average 10.1% economic growth from 1990 to

2011, China’s gross domestic product (GDP) has increased to US$7.32 trillion as of

2011, equivalent to 49% of the U.S. GDP during the same period. Although China’s

stock market did not take off until 1990, the number of listed firms reached 2,342

in 2011, with a total market capitalization of US$3.41 trillion as of year-end 2011.

In addition, if including the US$5.67 trillion market capitalization from stocks

traded in Hong Kong exchanges, China’s total market capitalization is equivalent to

36.25% of its U.S. counterpart as of year-end 2011. For U.S. investors, investing in

Chinese stock markets can provide diversification benefits and result in exposure to

China’s economic growth engine.

However, U.S. investors investing in Chinese stock markets encounter substan-

tial regulatory and ownership barriers. First, the domestic Chinese A-share market

is not open to foreign investors, with the exception of a limited number of Quali-

fied Foreign Institutional Investors (QFII).

1

Second, although Chinese domestic B

shares and Hong Kong-listed H-shares are not subject to the same capital restric-

tions, investing in these shares is associated with higher brokerage costs, informa-

tion asymmetry, nonsynchronous trading hours, and substantial price discounts

(see Poon et al., 1998; Fung et al., 2000; Chan et al., 2008; Lee, 2009).

To overcome these barriers, U.S. investors have turned to American Depository

Receipts (ADRs) of Chinese shares traded on U.S. exchanges (see Xu and Fung,

2002), but ADRs are limited in number of listed firms, liquidity, and their represen-

tativeness of Chinese stock markets. As an alternative, open-end mutual funds and

closed-end funds (CEFs) dedicated to investment in China have emerged.

2

How-

ever, for U.S. investors aiming at passive investing in the broad Chinese marke t

with more transparency and liquidity, Chinese Exchange-traded Funds (ETFs) can

be a much more effective channel.

In 1993, the first ETF that traded the S&P 500 Index as a stock was born in the

U.S., marking a major milestone in the history of financial market innovations. In

1997, ETFs tracking MSCI country indices, initially known as World Equity Bench-

mark Shares and later renamed iShares, were introduced to the market to provide

investors with easy access to targeted foreign markets. While international mutual

funds can only be bought or redeemed on a daily basis, international ETFs such as

1

Prior to 2001, China A shares could only be purchased by domestic investors, while China B

shares were denominated in Hong Kong dollars (HKD) or U.S. dollars (USD) and could only

be purchased by foreign investors. Since 2001, China opened up the A share market to limited

QFII and the B share market to domestic investors with foreign currency. H shares are Chinese

shares issued in Hong Kong, many of which are cross-listed with A-shares in Mainland China.

2

Closed-end funds are publicly traded investment companies with a fixed number of shares.

They are often traded at a substantial discount to their NAVs (see Lee et al., 1991).

H. Tang and X. E. Xu

846 ©2013 Korean Securities Association

iShares are traded continuously during the day with the added liquidity features of

stocks and more tax efficiency (see Pennathur et al., 2002; Poterba and Shoven,

2002; Engle and Sarkar, 2006; Tse, 2008). In addition, international ETFs are often

considered more transparent and efficient than country CEFs due to the in-kind

creation/redemption feature, which allows for arbitrage opportunities between price

and NAV to be exploited (see Pontiff, 1996; Miffre, 2007; Rompotis, 2010).

In 2004, FXI, the first Chinese ETF tracking the Hong Kong-based FTSE China

25 Index (XINOU),

3

began trading in the U.S. By the end of 2011, there were 1,140

U.S.-listed ETFs with a total market capitalization of US$1,045 billion, with 25% of

the total net assets invested in international or global ETFs. With the growing pop-

ularity of international investing through ETFs and the rising importance of China

in the world economy and the global financial market, the number of Chinese ETFs

rose to 24 with a total asset under management (AUM) of US$7.48 billion by the

end of 2011.In the summer of 2006, LETFs

4

were introduced to the market. These

derivative-based, publicly traded funds seek to deliver a daily return that is a multi-

ple or inverse multiple of the return on the underlying index. In late 2007, FXP, the

first LETF tracking the Chinese stock market with a 200% multiple of the daily

return of XINOU, began trading in the United States. By the end of 2011, there

were five Chinese LETFs listed in the United States, including the 200%, 200%,

and 100% LETFs tracking the XINOU Index and the 300% and 300% LETFs

tracking the U.S.-based BNY/Mellon China Select ADR Index (BKTCN).

5

The most notable and controversial feature of LETFs is their compounding

effect. Since LETFs intend to deliver a target multiple (also called product multiple)

on a daily basis, LETF target return may deviate substantially from the na€

ıve

expected return (i.e. the product multiple times the benchmark return) for holding

periods longer than 1 trading day. Owing to the daily rebalancing nature of LETFs,

this compounding deviation can be highly negative during periods of high volatili ty

and low absolute return. This compounding effect has been the center of attention

from regulators such as the SEC and FINRA, and a number of recent academic

studies. For example, Cheng and Madhavan (2009) derive the relationship between

the LETF return and the return on its underlying index to shed light on the com-

pounding deviation. Avellaneda and Zhang (2010) construct a similar model on the

LETF return after factoring in financing costs and an expense ratio and provide

empirical support for their model.

Other aspects of LETF return performance have also received attention from

researchers. Charupat and Miu (2011) examine the tracking errors of a set of

3

The FTSE 25 Index consists of 25 of the largest and most liquid Chinese stocks (including

H-shares and Red Chips) listed and traded on the Hong Kong Stock Exchange. The index is

denoted in HKD.

4

See Appendix Table Afor detailed definitions on the key terms and variablesused in this paper.

5

The BNY/Mellon China Select ADR Index is a capitalization-weighted index of all Chinese

ADRs listed on U.S. stock exchanges. The index is denoted in USD.

Leveraging Chinese Stock Markets

©2013 Korean Securities Association 847