Written by Brenda Nakalema

The SEC Plans to Delist Chinese Stocks. Implication for China Funds

A step further has been taken by the U.S authorities in delisting Chinese companies from its stock exchanges. For a …

A step further has been taken by the U.S authorities in delisting Chinese companies from its stock exchanges. For a few brands, this measure will hurt more than others. The Securities and Exchange Commission listed five companies it plans to delist if they fail to comply with U.S auditing laws by 2024; ACM Research (ticker: ACMR), BeiGene (ticker: BGNE), Hutchmed (ticker: China) (ticker: HCM), Yum China Holdings (ticker: YUMC), and Zai Lab (ticker: ZLAB).

According to the Holding Foreign Companies Accountable Act, which was passed in 2020, U.S listed foreign companies are required to submit an audit that a U.S committee can review. Because the Chinese law currently makes this an impossibility, it is expected that over 200 Chinese companies with end up on the SEC’s list in the next couple of weeks.

Despite all the drama, it doesn’t mean U.S investors will be barred from accessing Chinese stocks. With the future looking quite uncertain for many U.S listed Chinese companies such as Alibaba Group Holding (ticker: BABA), NetEase (NTES), and JD.com (ticker: JD), a secondary listing in Hong Kong by these companies has been undertaken. Among the last to join the list of Hong Kong listings in the electric-vehicle maker NIO (ticker: NIO), the company plans to join in the future.

Of the five companies named by the SEC, four already had listings in Hong Kong. According to a report by a brokerage, China Renaissance, roughly 80 of the 250 Chinese American Depository receipts could adhere to the listing requirements in Hong Kong. These represent about 90% of the group’s total market capitalization.

Although there is much talk on the subject, it must be noted that any delisting won’t be immediate, and the situation could still be saved if any breakthrough is reached between Washington and Beijing. Chinese stock performed well this past Wednesday as China made commitments to roll out market-friendly policies and reported good progress in the talks with the SEC. Still, U.S mutual funds and exchange-traded funds are making efforts to address the risks.

Exposure rate for different funds

Fund / TickerAUM (mil)Exposure to Chinese ADRsReport DateYTD Return
Matthews China / MCHFX$1,2224%12/31/2021-17.7%
Fidelity China Region / FHKCX1,4391301/31/2022-15.6
iShares MSCI China / MCHI5,92893/15/2022-15.0
KraneShares CSI China Internet / KWEB5,1183403/10/2022-42.3
iShares China Large-Cap / FXI5,11403/15/2022-12.3
Invesco Golden Dragon China / PGJ1901003/15/2022-18.7

Note: Data as of March 16

Sources: Morningstar; KraneShares

The Matthews China fund (ticker: MCHFX), one of the largest active funds investing in China, swapped its shares in Alibaba and JD.com, and others to Hong Kong shares. By the close of the year, the company held less than 4% in ADRs, a reduction from more than 20% in early 2020. According to the company, the transfer “helps to manage the technical side and the risk of exposure to events like the ongoing auditing dispute,” said the portfolio manager, Andrew Mattock.

Even with all the buzz, not every company is following suit at quite the same pace. Morningstar reported that the $1.4 billion Fidelity China Region Fund (ticker: FHKCX) maintained 13% of its portfolio in Chinese ADRs of January, including over 700,000 shares in Alibaba- roughly the same position held about two years ago. In an email, portfolio managers Ivan Xie and Peifang Sun stated that they would eventually switch to Hong Kong shares “when deemed appropriate” and prefer to purchase them in new trades when liquidity isn’t a constraint.

Many funds are taking extra precautions amidst all the talk and speculation, including China-focused ETFs and their underlying indexes, which are also changing direction. The ostensible reason they give is liquidity rather than the more likely SEC manoeuvres.

The $5.9 billion iShares MSCI China ETF (ticker: MCHI) lowered its exposure to ADRs to 9% in 2022, a decline from 20% in 2020. The fund tracks an MSCI index that replaces the foreign listing of existing companies with local listings when the latter exceeds a certain trading volume level. Alibaba, JD.com and NetEase are the only companies that met the requirements of the latest review.

FTSE Russell, an index giant in its own right, follows similar rules. “Liquidity is one of the screens applied to FTSE Russell indices to determine index eligibility,” the firm said. The index provider has been switching from China ADRs to their local listings, provided they pass the liquidity screen for two testing periods. Alibaba was the first to pass the screening, and in the most recent review that took place in March, four more Chinese firms joined.

The $5.1 billion KraneShares CSI China Internet ETF (ticker: KWEB), which owns roughly 54 Chinese companies that combine the tech and consumer-discretionary sectors, also reduced its holding in ADRs from 75% last March to approximately one-third of that figure.

There’s likely to be rough waters ahead for the funds that are unable to make the switch with flexibility due to delistings. The $5.1 billion iShares China Large-Cap ETF (ticker: FXI), which previously invested exclusively in Chinese stocks traded in Hong Kong, missed out on opportunities connected to the U.S listed giants like Alibaba and JD.com, but it’s now possible for it to buy those stocks which have significantly changed its fund composition.

On the other hand, the $190 million Invesco Golden Dragon China ETF (ticker: PGJ), which only holds Chinese stocks traded on U.S exchanges, would face it rough if delisting happens since it cannot switch to Hong Kong shares like other funds. Invesco says it plans to fully comply when delisting finally happens in two years.

All this talk could cause worry for some investors, but it shouldn’t, according to Andrew Mattock, portfolio manager at Matthews Asia. He says that even though some big players are exiting Chinese ADRs, investors shouldn’t worry about liquidity in those shares given the amount of cash in the market and the fact that there’s still the potential for the disputes between China and the U.S to be resolved. “These are big companies with enough cash and the ability to borrow, so we don’t think funding the transfer of a listing from the U.S to mainland China would really be an issue for many of these stocks,” he says.

For companies like Alibaba, liquidity isn’t likely to be an issue- at least for the moment. The stock spiked 37% on Wednesday and saw the highest daily trading volume since its IPO in 2014. Still, the shares are lower by more than half from a year ago.