China and the U.S. took steps toward decoupling as regulators in both countries this month set into motion plans to delist some Chinese companies from U.S. exchanges, the latest warning that the investment backdrop is changing, especially for do-it-yourself retail investors.The Securities and Exchange completed rules paving the way for delisting Chinese companies that don’t comply with U.S. auditing disclosures over a three-year transition period this month. In the same week, ride-hail giant Didi Global (ticker: DIDI) said it plans to delist from the New York Stock Exchange and seek a new home in Hong Kong months after its highly anticipated U.S. public offering was spoiled by Beijing’s cybersecurity probe as China tightens control over data. The two developments underscored that the U.S. and China may have one area they are aligned on: Increased scrutiny of Chinese companies listed in the U.S.
Barron’s has been writing for months about risks to investors as China grapples with an economic slowdown and policy makers tighten control over the private sector, especially data-oriented companies—and as intensifying competition between the U.S. and China push both countries to become less interdependent.That splintering relationship is a reason some investors see an allocation to China as a necessary form of diversification for portfolios—and the sharp selloff in Chinese stocks this year have drawn bargain-hunters. But the push toward delistings means retail investors who have relied on U.S.-listed Chinese stocks should start considering other ways to invest in China.
As Barron’s warned in July, the nearly 250 Chinese companies that Congress said were listed in the U.S. as of this summer are at the epicenter of changing geopolitical priorities.
Regulators in both countries are scrutinizing the variable interest entity, or VIE, corporate structure that many Chinese companies used to list in the U.S. and skirt China’s foreign ownership restrictions. The structure, which gives investors a stake in a shell company with a contractual relationship with the operating company, has long been a source of controversy. It’s drawn increased scrutiny of late as the U.S. and China reassess their relationship.While institutional investors can convert from ADRs to Hong Kong listings relatively easily, it’s harder for retail investors. Some brokerages like Vanguard, Robinhood and E-Trade don’t offer users the ability to trade on foreign exchanges directly. However, a Vanguard spokesman said the firm would explore options to assist their clients in liquidating positions in the event of a delisting scenario. The SEC rule calls for plenty of notice, with analysts not expecting forced exits before 2024. And while Congress is looking at narrowing the window for compliance, regulators could still strike a compromise. But the threat is real enough that many Chinese companies, including Alibaba Group Holding (BABA), JD.com (JD) and NetEase (NTES), have already secured secondary listings in Hong Kong, and institutional investors, including active fund managers, have been converting their holdings. Even the MSCI recently swapped American depositary receipts of JD.com and NetEase for Hong Kong listings—a trend that is likely to continue, eventually impacting liquidity.
“The Didi situation obviously has brought home the point the stocks will be moving. If you are a retail holder and can’t take Hong Kong shares, then you are left in a situation where you liquidate,” says Leon Eidelman, manager of the J.P. Morgan Emerging Markets Equity fund, which mainly owns Hong Kong and A-listed shares.A lot of money is still at stake: Goldman Sachs Group estimates institutional investors own about $700 billion of Chinese stocks—across different exchanges. And of that, $250 billion is in Chinese ADRs. KraneShares Chief Investment Officer Brendan Ahern says the firm hasn’t yet converted the ADRs that have Hong Kong listings in its funds like the KraneShares CSI China Internet exchange-traded fund (KWEB), in part because the underlying index hasn’t yet made the change. He says he has his “finger on the conversion trigger” as the movement toward Hong Kong is likely.Retail investors still holding Chinese ADRs may want to assess their options. It’s unclear exactly how these delistings could play out—though Didi will offer a guide. Chinese companies could go private and buy out existing shareholders, opt for dual listings and eventually delist from the U.S. They could possibly get the ADR canceled by the custodians in return for stock traded on the Hong Kong or another exchange, Herald van der Linde, HSBC’s Asia Pacific strategist, said in an email.
The largest companies that don’t yet have a secondary-listing in Hong Kong, like Pinduoduo (PDD), will likely find a new home, especially as the Hong Kong Exchange loosens listing standards. Less clear is the fate of smaller companies—a good chunk of the ADR universe, though a fraction of the market value. Muddy Waters’ short seller Carson Block thinks Beijing could facilitate the acquisition of smaller companies since Hong Kong may not have the liquidity to absorb all of the companies.
The uncertainty is reflected in performance. While the iShares MSCI China ETF (MCHI) is down 19% this year, the Invesco Golden Dragon China ETF (PGJ) that holds U.S. listed shares has doubled that decline.
All that red is attracting bargain hunters, especially as China begins to ease monetary policy as its economy slows and the rest of the world begins to raise rates. But some managers are bypassing hard-hit companies like Alibaba amid concerns about the longer-term implications of China’s regulatory scrutiny, especially on its cloud business, and the likelihood the stock could see further pressure as it is often used as a proxy for China.
Instead, money managers favor beneficiaries of Beijing’s policy shifts, like semiconductor, hardware, electric vehicle and battery companies. Though pricier, TS Lombard economist Rory Green expects such companies to grow into valuations as Beijing tries to green and digitize its economy. For retail investors, finding funds that can more easily navigate the delisting logistics may be an easier way to capitalize on the opportunities.
Write to Reshma Kapadia at [email protected]