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Investing in China: Exchange-Traded Funds vs. American Depositary Receipts

China allows foreigners to invest in its companies via exchange-traded funds (ETFs) and American Depositary Receipts (ADRs). Although foreigners are able to purchase H-shares on the Stock Exchange of Hong Kong (SEHK), not every Chinese company issues H-shares on the (SEHK). Also, some large companies like Alibaba Holding Group have chosen to only list on American stock exchanges. Whether investors decide to invest in ETFs, ADRs, or ETF-ADR hybrid instruments, they should know the differences between each type of investment vehicle.

ETFs

Currently, Chinese ETFs account for US$37.39 billion in assets under management. They are second only to Japan’s ETFs, which are valued at US$309 billion.

Chinese ETFs, like mutual funds, allow investors to spread their risk among different stocks within a specific index. Since they track the performance of that index’s components, ETFs tend to perform as well as the index itself, protecting investors from unexpected drops in any one of the component stocks.

This investment strategy is excellent for people who are conservative investors, risk-averse, or do not want to spend a lot of time and energy researching specific companies and markets. (Get more information on the differences between ETFs and mutual funds.)

Chinese ETFs work like other stocks on American stock exchanges: They can be traded throughout the trading day, whereas funds only trade once daily after market close; investors pay commissions to trade them; ETFs can be shorted and leveraged; and they have bid/ask spreads. Like mutual funds, ETFs do carry expense ratios.

ETFs also make it easy to invest in certain regions or countries, and to ultimately diversify a likely domestically heavy portfolio. (For more detailed information on ETFs follow this link.)

Investors should know that China has several different share classes: A-Shares, B-Shares, H-Shares, red chips, P-chips, and N-shares. Furthermore, Chinese regulations permit most ETFs to only have access to Chinese equities listed in Hong Kong, the US, or as B-shares traded on the Shanghai and Shenzhen stock exchanges. ETFs are generally composed of H-shares, Red chips, P-shares, N-shares, and B-shares.

Lastly, the kinds of shares that a Chinese ETF can hold are restricted to the type of fund it tracks. So, a fund that tracks FTSE China indexes, such as the iShares FTSE China 25 Index Fund (NYSE Arca: FXI), is only eligible to hold H-shares and red chips.

Chinese ADRs

As for the Chinese ADR market, in 2014, it represented US$898 billion of the Asia-Pacific region’s US$1,268 billion and global US$3.3 trillion ADR market.

Chinese ADRs allow investors to invest in specific Chinese companies via US stock exchanges and OTC Bulletin Boards or Pink Sheet trading systems.

There are four types of Chinese ADRs: one type of unsponsored ADR, and three types of sponsored ADRs – Level I, Level II, and Level III. (For more detailed information on ADRs follow this link.)

ADRs have varying levels of risk and associated corporate transparency. They differ in terms of whether their financial statements have been reconciled to generally accepted accounting principles (GAAP), and whether the company is registered with the Securities and Exchange Commission (SEC). Only Level II and III sponsored ADRs are traded on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and NASDAQ.

Chinese ADRs are not stocks, nor do the holders of them have the same rights as traditional stockholders in the USA. A Chinese ADR can represent any number of shares. Investors would have to review a company’s filing documents to know how many shares are represented by a Chinese ADR and how much they are paying per share.

Also, Chinese ADR holders have neither voting rights nor any right to the assets of the company that the ADR is based on, nor do they own any part of the company on which the ADR is based.

Hybrid ETF-ADR Investments

For investors who can’t decide which one is best for them, there is a hybrid option. It is possible to invest in ETFs that are made up of ADRs.

Foolish Bottom Line

The most conservative and risk-averse investors should invest in ETFs. They spread you’re your risk over many different companies. Also, the investor’s primary job is to research the index that the ETF is tracking, the kinds of companies being selected for the ETF, and how the ETF or the fund managers have performed relative to the market and other investment vehicles. That’s a lot easier and less time-consuming than researching individual stocks.

Investors who are willing to take the time to carefully research companies and the markets in which they operate, and accept the risk that comes with putting their investment in one place with no hedge, may prefer ADRs. These vehicles offer both greater returns and greater risks.

If you want exposure to the ADR market with less risk, you can invest in ADRs via ETFs. The ETFs spread the risk, and the ADRs give you the opportunity to get a great return on your investment while you familiarize yourself with Chinese companies

Invest with care and know the risks.

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Disclosure: Alisa Hopkins has no position in any stocks mentioned in this article. Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance.