ETF Edge - Chinese Stocks & Tax Day

Episode Date: July 13, 2020

CNBC’s Bob Pisani speaks with Brendan Ahern, chief investment officer at KraneShares, and Dave Nadig, chief investment officer and director of research at ETF Trends. They discussed the path forward for Chinese stocks and how tax day impacts ETF's. In the 'Markets 102' section, Bob discusses active nontransparent ETFs. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange traded funds, you're in the right place. Every week, we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host, Bob Pisani. China's bull market has been on a tear as the nation's government tries to talk up the markets.

Today on the show, we'll dive into what's driving the surge in China stocks and tell you what you need to know about ETFs and tax day. It's coming up. Here's my conversation with Brendan Ahern, CIO at Crane Shares and Dave Notick, CIO and Director of Research at ETF Trends and ETF Database. Brendan, let me start with you. What is up with China? Look at here. We're looking at the Shanghai Stock Exchange here.

This is essentially two multi-year highs here, up 15 percent, I think, in the last two weeks. Can you sort of encapsulate why the markets rocketed up in the last two weeks over in China? contained coronavirus. They've gone back to work, you know, without a cure, without a vaccine. And we're getting that V-shaped recovery. It's happening right now in China today. And stocks are anticipating that economic rebound. And yet, Dave, I know you like to watch this as well. It's rather remarkable that all of a sudden in the last two weeks, it's just shot up. And it seems to have corresponded with some attempts by Chinese authorities sort of talk up the market here. I noted a week ago, the China Securities Journal, which is a government organ, came out and said it was time for a healthy bull market.

And then last Friday, China Economic News came out and said, we have a crazy bull market. There seems to be constant attempts to sort of talk up the market here. People accuse government officials here of doing the same thing. I know that. But it does seem to have had an effect on the market over there. Yeah, well, no, and it's a little bit more deliberate than what we try to pull off in the United States. I mean, here you have the actual organ of the state writing front page opeds in widely read newspapers and magazines saying the stock market is going to be great. Everybody should get in now.

And if you talk to the folks who are really doing on the ground research there, you know, while things have improved in China, I don't think it is quite the rosy picture that we're going to see when China, say, drops their next GDP number. Everybody is expecting that to suggest that year over year, China's claiming strong GDP growth. Nobody actually believes that that's the case. None of the deeper underlying data coming out is that good. It is better. Brandon's right. It is improving. And Asia in general and China in particular is doing better at this than most Western countries and definitely better than the U.S. So there's reason for optimism, but the kind of jawboning and then we suspect a fairly doctored print on things like GDP to follow.

They have a bit of a self-fulfilling prophecy in terms of driving up asset prices, but they won't change the long-term underlying economic reality here, which is probably less sanguine than the Chinese Communist Party is letting on. You know, I mean, just look at a chart of copper, Dave. I mean, why is copper? I mean, I completely disagree. You know, high-frequency data shows China's back to work, and it's going to show up in earnings and markets are recognizing that. It's 2020. I don't need

government data. We have real-time data on the ground in China. Come on, it's ridiculous, you know, to say that the data doesn't prove that we're seeing a great rebound here. I'm not suggesting things aren't better. I'm agreeing with you. I think things are better, but nothing that would justify the sort of violent 15% recovery we've seen in the market here. We've suffered from some of this in the United States as well. Again, I'm not trying to be all sour here and suggest that everything's going awfully, right? Valuations in China are still favorable. There are lots of reasons to like the China trade, but what we've seen very recently is so clearly a direct attempt to jawbone this market up that I'm skeptical of its long-term legs.

I think, obviously, China is in better position than many other countries. And we also saw a lot of folks leaving China, a lot of money coming out, particularly in the ETF market. A lot of money came out of China in emerging markets, the ETS in the first half of this year, that money is coming back in space. We had nearly a billion dollars in inflows into China-driven EM and China-specific funds just last week. That actually moves the needle. So there are favorable things there, but I'm skeptical of the violence we've seen in this rally. Yeah. Brendan, you've often tried to distinguish between two different types of investors over in China. That is the retail investor, which is a potentially huge market and still relatively small investments in the stock market, generally, and then

international investors who often come in through that Hong Kong Connect market. Do you think this recent rally, and it is notable, I mean, Dave is right, this is a pretty violent move all of a sudden in the last week and a half. Is this move related to retail interests or international interest? Where do you think this is coming from? Well, you know, so Stock Connect, as you know, Bob, you know, this venue for foreign investors to go in through, like we hold in KBA, that actually year to date cumulative inflows is up over $25 billion. So U.S. to Dave's point, which is a great point, which is U.S. investors have totally missed this liquidated a lot of their China investments. They've been scared off by some of these headlines.

politically, and they've missed this big rally. I do think it's worth noting that this northbound stock connect. These flows have been really, really strong. So I think someone is in there buying from a foreign investor. Now, mainland China, 80% of trading by individual investors, only it's down to about 50% of stock ownership, Bob. Those investors see a strong economic rebound driven by a very strong quarantine. Yeah, one thing, Dave and Brendan, China investors have in common with American investors is they all love the internet. I know that you've got your China internet ETF branded K-W-E-B. That is at a historic high. I think it started only in 2013. So it looks like Chinese investors are doing the same thing American investors, which is

throwing everything into things that make it easier to shop online, buy online, do social media online, cloud computing, etc. There's your there's your ETF there. Yeah, yeah. I mean, like we're doing today, we're using, you know, the Netflix and the Amazon's and the Chinese equivalents, you know, Alibaba, Tencent, Ten Duo, Duo, you know, online music, like Tencent Music Entertainment, Hu, do. You know, a lot, you know, Hong, China really does validate that these online companies had very strong earnings, right? They've already reported Q1, which was during their quarantine. Alibaba and Tencent, $500 billion market. companies grew over 20, which grew revenue over more than 20%. It's really indicative. It's a

validation for what some of the activity we see from the U.S. perspective. And yet, and Dave, maybe you could address this. One of the things that's amazing to me is we always talk about the great potential for China, but China stocks has far underperformed the United States in the last 10 years. I looked at the Shanghai. It's up 42% in the last 10 years or so. The S&P is up 200% in the last 10 years. Can you make a case, and Brendan, jump in if you want, but is there a case that can be made for that China is suddenly going to outperform the S&P or the U.S. stocks? Well, I mean, I think there's absolutely a bull case for China over a longer time frame that, yeah, their economy is probably going to be more of a driver than the U.S. economy.

I think that's a tale that we've been telling now for at least a decade. You know, I think part of the issue with, you know, how much can you? you trust the long-term rally here is, will the Chinese Communist Party sort of induce volatility by precisely what they're doing now, which is sort of trying to job-own the market in different directions, trying to manipulate public opinion? Over the long term, that tends not to actually be that useful or helpful because the economy itself is going to be the economy, right? Goods and services are going to be produced and consumed, and at the end of the day, that's all that really matters. And that is, I think, still very much a bull case for China. And, finally,

like Kweb that have sort of been at the front end of this transition toward the more service-based economy, towards a more local-based economy as well. I think those are phenomenally great ways to make those long-term plays. Yeah. And Brendan, you've often told me that China is in its infancy in investing. We've been talking about this, you and I for many, many years. I want to just see if we can put up something here today. You had an interesting point that only 2% of Chinese household wealth typically is invested in stocks or mutual fund, and that's a lot different than the U.S. was a bigger percentage.

And even China's seems like their household wealth was largely in real estate, for example. Here you see 66%. These are statute provided and the U.S. 26%. So I guess my question is, this seems to tell me that there's an awful lot of space for the average China investor, particularly in the mainland China, to get interested in the stock market in a longer term way. Can you address that? Yeah, most definitely.

I think one reason I'm constructive on KBA, you know, despite this big rally, is that we're coming out of kind of a five-year basing period for technical analysts that say that this is a breakout. And I think, you know, we're seeing just this small shift in asset allocation within China. We've actually seen the 10-year Chinese Treasury. It was at 2.48 percent yield in April. Today it's up over 3 percent. So you're seeing this shift within asset. All small movements of these big pools of assets, Bob, could really send this market higher.

Well, let's hope that's the case. I want to move on to a different subject, Brendan. You and I have talked about as well. The SEC had a roundtable last week. They looked into China's reluctance to allow audit inspections by U.S. regulators of Chinese companies that listed in the United States. Now, this has been an issue. We've known about this for many, many years. but there's sudden confluence of events here that sort of brought it to a boil.

Obviously, the whole disputes on trade, the COVID-19 issues, but there seems to be some momentum behind the idea of getting tougher on the Chinese on this. There's been some discussions about even potentially delisting companies that don't allow access to U.S. regulators who want to inspect the audit books here. Brendan, what's your position on this? Is this a reasonable concern that, Chinese do seem to have effectively blocked U.S. regulators from looking at audit records. Is there a way to resolve this problem?

Yeah, I mean, this has been a long-running issue. I think 100 percent these Chinese companies listed in the U.S. should be allowed to show these audit books. There's simply no reason for it not being allowed. I do think, though, that this has been political-sized. And there's a view that you're hurting China by going out. after these companies. But you're talking about $1.2 trillion of U.S. savings. U.S. investors are in those names. You're not hurting China. You're hurting U.S. investors. And I think there's no greater example of some of the irony here is lead lawyers. He's literally on the front page of Alibaba's

IPO perspective. And I just feel like there's got to be a little bit of a cooling off period, give China the opportunity to basically change the rules to allow this, which they should. And Dave, what's interesting here is, I think there's a broader issue about to what extent the U.S. should be telling U.S. investors what to invest in, but they do. Regulators do have a point here. We really don't have a very good view, not only in the state-owned companies, but even many other smaller Chinese companies that are out there.

We don't have the same degree of confidence. So how do you address that? I just want to mention something here. John Tuttle, who is the chief commercial officer at the NYSC, suggested in the hearing last week in this roundtable discussion that one way out of this would be added indicator to the company's stock tickers, noting that their audits are not inspected by U.S. regulator. Sort of a caveat saying, listen, buyer beware like a qualified investor kind of thing. Is that one way to address this? I mean, what's your thought on this? I mean, after all, we're not actually talking about having to put those kinds of markers on, say, any fund that's investing in local Chinese stocks, which obviously are not subject to U.S. audit regulations either, right? So I think Brendan's right. I think this is largely a political football, just like the sanctions we saw today, keeping Marco Rubio from flying to Beijing. I don't think that was a big risk either. So this is a political football that's going back and forth. I agree completely. The idea that you're going to delist Baba, et cetera, I think is ridiculous. If they get delisted, it should be for breaking the rules of their listing venue of that exchange.

I think we can tighten up those rules. We can increase transparency, but I do think this has become over-politicized. And Brendan, just a brief answer to this. We've seen Chinese companies now list in Hong Kong. Alibaba did. J.D.com did. Is this just a coincidence that they're getting dual listings? Or is this a way to sort of backstop themselves?

say if there's any problem with the U.S., maybe we should just do it in Hong Kong at all. You know, I think it is separate that I think because of the trade war, you know, Alibaba's over the last three years, the revenue doubled and the stock was flat. So they're going back to Asia because they don't have to explain themselves, how great the companies are, what an opportunity they have. And so I think it is more about, it's not about this PCAOB issue, about getting a better valuation. But it's a big problem, you know, for those of us,

particularly you and I, Bob, living in the New York metro area, you know, New York as a financial capital of the world, you know, if Ant Financial goes public in Hong Kong, U.S. investment banks will lose $200 million. That's a big problem in terms of fees lost. And so I think, you know, I'd like to see some of this political temper, you know, just because, you know, you want Ant Financial through to U.S. Yeah, I would agree with that. Let me just move on because it's tax time. And Dave, I've got to do the same little drill we do every year about this. The lowdown on ETFs in taxes just in 20 or 30 seconds. Why exactly are ETFs more tax efficient? Why do we like ETF so much for this reason?

It's really pretty simple. When you think about it, you're running a portfolio. You're buying and selling stocks. That's what you do or bonds in this case. And in an ETF, when you acquire new securities, you don't go buy them. You generally get them in a creation unit. And the same thing happens when you get rid of securities. They go out in a redemption. And when you do that, you're constantly resetting the basis of the fund. That means when they come to the end of the year, they haven't realized any capital gains inside the fund that they have to pass out. Because of that, the vast majority of ETFs never make a capital gains distribution, particularly if they're index-based.

So the gains that you're going to have to pay are the ones when you decide to sell, which is just generally more fair. There's no avoidance here. They're simply deferring the tax event to when you as the investor make the decision. That's why ETFs continue to have this tax advantage. Yeah, and I think the key point is no capital gains distributions essentially, and you don't owe capital gains until you decide to sell. That's the simple way I just drive it to everybody. Are there any other place you need to be careful? Like certain things are collectibles, right? Gold, for example, are they still considered a collectible? What's the tax rate? Yeah, none of that's changed. ETS are generally tax.

by the IRS based on what they own. So if your fund just owns gold, you're going to get taxed as if you just bought bullion. And that means no matter how long you hold it, you're going to pay a 28 percent tax on that gain. It's not short term, it's not long term. It's just the collectibles tax. The only other real place is some of the commodities funds that just own futures. That can be a little bit trickier at the end of the year. Some of those funds put out a K-1 that you'll get a partnership statement and you'll pay a blended

60-40 rate. If you're getting into those kinds of funds, you probably need to be having a kind of somebody look at your taxes anyway. Yeah, same with MLP ETFs, right? Same thing, right? Yeah, MLPs have their own special treatment where they do return of capital, which can be really great for your taxes.

You don't even have to report that. It just resets your basis. But again, when you're starting to get into slightly more tax-complicated vehicles like MLPs, like commodities, it's probably a good time to get some advice. I will point out, though, that the ETF structure is still the most effective way

to own those kinds of investments. And what if you own your ETS, in an IRA or a 401k or a SEP plan, tax deferred accounts? Yeah, I mean, you certainly can. You lose that tax advantage because you simply don't care. So what I tend to tell people is if you're going to do some sort of trading activity where you're going to generate gains on your own, or if you're going to own something like, say,

an actively managed mutual fund that trades all the time that's going to throw off capital gains, do that in your 401k, do that in your IRA rollover, for your money that you're keeping in a tax account, keep that in ETFs. Okay. We're going to have to leave it there, guys. Fascinating discussion. I really appreciate it. I always learn something, and I've been doing this a long time.

We get the best people here, folks. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs. This is our Markets 102 portion of the podcast. Today we'll be touching on one emerging trend that's gaining traction in the ETF space. Once again, here's my producer, Kirsten Chang. Chang. Bob, let's talk about a relatively newfangled term in the world of

ETFs, active, non-transparent. Can you explain what exactly an active, non-transparent ETF is and why ETF investors should care? You know, Kirsten, the ETFs are said to be non-transparent, and for the most part, what that means is they publish what their holdings are each day. So you can see what they're investing in at all times. People love that about ETS. This is different than most of the mutual funds, particularly

the actively managed funds, they don't publish their holdings on a daily basis, and sometimes you have to wait months to find out what's in these mutual funds. So if ETFs, and as they've grown in popularity, more mutual fund managers have wanted to open up these parallel ETF funds to attract the crowd that like the tax efficiency and the lower cost that an ETF wrapper has. But the active managers have a very big problem. They don't want everyone seeing what they own every day. They're afraid that others are just going to copy their work. This is a classic worry for active management. So the hybrid they've come up with is this so-called active, non-transparent ETFs, anti-ETFs, where you have the lower cost than the tax efficiency of an ETF, but at the same time, you can't

see exactly what the fund owns until the reporting period is up, and that can be several months later. So this is good news if you have an active fund manager that you really like, but you don't want to pay the typically much higher fees or higher taxes that you might have with an actively managed fund. And what would be the appeal of owning something that blatantly has the term non-transparent in its name or semi-transparent in some cases? You're right. It's a terrible name, Kirsten. I've said many times, this is the worst marketing term ever invented.

Active, non-transparent ETFs. AND ETFs. Could you think of something worse? It sounds like a CIA front. I mean, who wants non-transparent the first place? Does anybody? Who's going to vote yes for non-transparent?

So it's a terrible term. What this is all about is the collapse of the mutual fund structure because everybody is moving to ETFs and the active managers for their own survival. They want to move into that ETF wrapper without showing the world

their secret sauce. And this is what they've come up with. So as far as the name goes, I'm willing to entertain a new name for this, anything but ant ETFs. I'm waiting for your votes. That's it for today. I'm Bob Bazani. Thank you for listening. And make sure you tune in next week. And in the meantime, you can tweet us your questions or topic ideas at ETF Edge, CNBC.