Invesco has launched two new ETFs in Europe targeting different size segments of China’s onshore equity market.

The ETFs provide exposure to large and mid-cap Chinese A-share equities using synthetic replication.

The Invesco S&P China A 300 Swap UCITS ETF (C300) tracks the S&P China A 300 Index which consists of 300 of the largest companies that are domiciled in Mainland China and trade on the Shanghai or Shenzhen stock exchanges.

Stocks with negative earnings-per-share in both of the last two 12-month trailing periods are ineligible for inclusion.

The Invesco S&P China A MidCap 500 Swap UCITS ETF (C500), meanwhile, is linked to the S&P China A MidCap 500 Index which focuses on mid-cap equities by targeting the 500 largest firms outside of the S&P China A 300 Index.

Both indices avoid companies that have been sanctioned by the Office of Foreign Assets Control, the financial intelligence and enforcement agency of the US Treasury Department.

Constituents are weighted by float-adjusted market capitalization using a weighting factor that reflects the proportion of shares available to Chinese mainland investors. The S&P China A 300 Index also incorporates a sector diversification requirement that limits the deviation in GICS sector weights to within 5% of their weights in the broad market China A-share universe.

Commenting on the ETFs’ targeted exposures, Gary Buxton, Head of EMEA ETFs and Indexed Strategies at Invesco, said: “China already boasts the second-largest equity market in the world, and it’s increasingly diverse. Our ETFs aim to provide investors an opportunity to be more precise with their exposure. For example, if they wish to focus on companies driven by domestic consumption, they’re more likely to find them in the mid-cap space, whereas larger companies tend to have more international exposure.”

The ETFs have been rolled out across Europe including listings on London Stock Exchange in US dollars and pound sterling, on SIX Swiss Exchange in US dollars, and on Xetra and Borsa Italiana in euros.

Each fund comes with a management fee of 0.35%.

Performance enhancement

The ETFs track their indices using synthetic (or swap-based) replication which, according to Invesco, offers potential structural advantages compared to physical replication due to the dynamic nature of China’s onshore equity market.

Notably, the funds may deliver a significant performance enhancement compared to their physically replicating counterparts due to supply and demand levels in the market for China A-share swaps, which have been favourable from the ETF’s perspective.

The favourable supply and demand dynamic stems from restrictions on securities lending in the China A-share market for offshore investors. Unable to borrow stock, foreign investors managing long-short or market-neutral strategies typically use index derivatives such as swaps to achieve their short exposure

The investment banks that serve as counterparties on the other side of these swaps (receiving the performance of China A-share indices) typically look to hedge their exposure. The synthetic ETFs (which agree to receive the performance of their China A-share indices) provide an efficient means of doing so.

In recent years, long-short and market-neutral strategies have proved fertile strategies when investing in China’s A-share market. Consequently, investors engaging in these strategies have driven up the demand for swaps that provide inverse China A-share performance. These investors are willing to pay a significant premium to gain this inverse exposure, reflected in high swap spreads for these markets.

According to Invesco, over the past four years, the level of swap spreads has varied between 0-8% for the S&P China A 300 Index and 4-15% for the S&P China A MidCap 500 Index, equating to an average of 3.1% and 8.9% outperformance per annum, respectively, for these two exposures.

As long as the constraints on stock lending remain and investors continue to run long-short and market-neutral strategies on China’s A-share market, this performance benefit is likely to persist.

Historically, the main drawback of synthetic replication has been the introduction of counterparty risk; however, Invesco, which runs one of the largest synthetic ETF platforms in Europe, takes notable steps to manage this risk.

The firm only deals with high-standard counterparties with Goldman Sachs currently engaged as the counterparty for the two ETFs. Additionally, the funds also invest in baskets of quality collateral and utilize tight reset triggers when rebalancing counterparty exposure.