CHN - China Fund: Gain Exposure To The China Recovery At A Wider Than Usual Discount

Summary

• China Fund offers investors an investment vehicle to gain exposure to the Chinese post-COVID reopening theme.
• The fund is overweight consumer discretionary and real estate, so it is particularly levered to the economic trajectory and consumer sentiment shifts.
• At the current NAV discount, the fund is worth a look.

After a dismal year of performance, the China Fund ( CHN ), a closed-end fund focused on long-term capital appreciation via investments in China-related equities, saw total fund assets decline significantly to ~$151m (vs. ~$210m prior) per its year-end fact sheet . Since inception in 1992, this means the fund has returned ~9% annualized since inception – still a respectable return, all things considered. The rationale for investing in the fund hasn’t changed - this is still a closed-end fund that gives investors exposure to a cross-section of the Chinese economy, albeit at a wider than usual ~13% discount to NAV as of the last reporting date. With China finally reopening and a buy-back program in place, expect this discount to narrow as sentiment on the region improves alongside the underlying equities performance.

Fund Overview

Per data from the December 31, 2022, factsheet, the fund’s key characteristics are as follows:

What sticks out here is the fund’s much smaller size this year at ~$151m, a reflection of its poor underlying performance in 2022 as well as increasing investor aversion to China risk. This has two undesirable implications. For one, it limits the manager’s ability to undertake a tender offer on a major scale, like in the past. Secondly, lower assets mean a higher total expense ratio ((TER)) from the current 1.25% level, as the expense ratio will rise as a proportion of the overall fund. While the ongoing distribution of realized gains to shareholders will pressure the TER % higher, this should hopefully be offset by a revaluation of assets under management or from more inflows; given the strong January performance for Chinese equities, I don’t expect a material TER headwind going forward.

Fund Holdings – Still Overweight Consumer Discretionary

For the year ending December 31, 2022, China Fund returned -24.1%, slightly below its benchmark, the MSCI China All Shares Index, at 23.5%. The breakdown of the top ten fund holdings is as per the graphic below. All four of the fund’s top holdings are in consumer discretionary/tech – Pinduoduo ( PDD ) at 8.1%, Alibaba ( BABA ) at 7.3%, Meituan ( MPNGF ) at 6.4%, and JD.com ( JD ) at 5.2%. By sector, the fund continues to be most overweight the consumer discretionary sector at + 17.4%pts vs. the benchmark and real estate (+5%pts vs. the benchmark); interestingly, it is most underweight consumer staples at 6.7%pts vs. the benchmark.

Fund Performance – Sector Concentration Weighs on Relative Performance

The overall performance on an absolute basis (-24.1% NAV; -26.1% Market Price) and relative to the benchmark MSCI China All Shares Index (-23.5%) are as follows:

A key reason for the relative underperformance in 2022 is the portfolio’s biggest overweights, the real estate and consumer discretionary sectors, which detracted the most from performance. The fund’s concentration didn’t help - the top ten equities, mainly consumer discretionary, accounted for almost half of the fund. Meanwhile, the portfolio’s limited energy exposure proved to be the biggest positive contributor on a relative basis.

The monthly single stock commentary indicates the managers’ continued bullishness on consumer discretionary/internet stocks. In particular, Bilibili ( BILI ), the ‘YouTube’ of China, contributed the most to December's performance, alongside the real estate digital platform KE Holdings ( BEKE ). While the former is flipping the switch on profitability, the latter seems to be benefiting from “warmer” real estate sentiment in December and remains a core fund holding despite near-term concerns about commission rate caps. All in all, I wouldn’t expect material sector allocation changes anytime soon.

Fund Outlook – Levered to Post-COVID Mean Reversion

While Chinese stocks have re-rated higher following President Xi Jinping’s zero-COVID U-turn, the latest data out of China for December have not matched the bullish sentiment. PPI remained in negative territory at down 0.7% YoY, while retail sales were also down 1.8% YoY, culminating in slowing real GDP growth at +2.9% YoY in Q4 2022. Still, the key issue for the Chinese economy, and given its property overweight, CHN holders, is whether demand for property returns anytime soon. Thus far, residential floor space sold is down 28.3% YoY , while land area purchased by developers declined ~53% YoY to a multi-year low at ~101m sqm in 2022.

The real test is what happens after the Chinese New Year holiday next week. Since the government support package in November, market action has turned positive on Chinese property stocks, but with no material recovery yet in the sector data (e.g., residential floor space sold), the clock is ticking. Property has long been a major component of Chinese household wealth, so a lack of demand here could signal a wider hit to consumer confidence and put the brakes on the post-COVID mean reversion trade in Chinese stocks. CHN’s relative concentration in consumer discretionary/Internet leaves the fund vulnerable to any disappointments in the economic data going forward (and vice versa).

Gain Exposure to the China Recovery at a Wider than Usual Discount

While a challenging 2022 has driven the assets under management for CHN down significantly, the investment thesis for the fund remains the same. At its core, this is still a concentrated CEF providing investors with a vehicle for China exposure but at a wider low-teens discount to NAV. While the fund has always traded at a NAV discount, there is room for a narrowing from here amid a favorable turn in sentiment following a post-COVID reopening in China and an ongoing buy-back program (>108K shares through October 2022 per the annual report ).

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