• U.S.-listed Chinese companies are under a rising cloud of controversy and suspicion as critics claim they exploit U.S. capital markets at the expense of investors
• Over the past decade, New York-listed Chinese companies have outperformed their Mainland China-listed peers and global (ex-U.S.) stocks
• Attempts to broadly label foreign-listed Chinese firms as fraudulent and damaging to U.S. investors are not supported by the facts

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

First impressions are hard to shake, and many U.S. investors’ first encounter with Chinese stocks was tainted by fraud. Starting in the mid-2000s, a wave of small Chinese companies listed on the New York Stock Exchange and NASDAQ via a process called reverse merger.

Many of these companies were highly speculative, and a public listing via reverse merger allowed them to bypass the standard disclosure requirements that are part of the initial public offering (IPO) process. A great number of these stocks initially soared, driven by speculation and hype over China’s economic potential.

Chinese reverse merger stocks eventually attracted the attention of short sellers who highlighted the serious fraud and corporate governance problems present in many of the companies. This led to a collapse in share prices and the delisting of many companies.

Figure 1 shows the performance of an index of Chinese reverse merger stocks during this six year period. While the index shows a cumulative loss of around -6%, an investor who bought these companies at the height of their valuation would have lost more than half of his or her money.

Source: Bloomberg.¹

Past performance does not guarantee future results.

In the 2010s, the number of reverse mergers declined substantially, and the makeup of Chinese companies listing in the U.S. evolved to mainly encompass larger firms that have undergone the traditional IPO process.

Nevertheless, controversy continues to shadow Chinese companies listed in the U.S., including:

• A protracted dispute over access to audit workpapers by U.S. regulators.
• An effort by the U.S. government to ban investment in Chinese companies alleged to have links to the Chinese government.
• Scrutiny over the variable interest entity (VIE) structure used by many foreign-listed Chinese companies.
• Fallout from the fraud exposed at Luckin Coffee and ongoing short seller attacks against other U.S.-listed Chinese stocks such as iQiyi.

Given this history and the persistent controversies, some loud and public voices have argued that Chinese companies continue to exploit U.S. capital markets at the expense of investors. Such sentiment helps explains the muted response from the investment industry to efforts by the U.S. government that would potentially force delisting of these companies.

As with many things, a look at the underlying data can help provide clarity and context. Figure 2 uses indices to compare the performance of foreign-listed Chinese stocks with three groups of equities over the past decade: mainland-listed Chinese stocks, global stocks (ex-U.S.), and U.S. stocks.

Source: Bloomberg.

Past performance does not guarantee future results.

Foreign-listed Chinese Stocks (excluding reverse merger companies)
New York-listed Chinese Companies	MSCI Overseas China IMI Gross Total Return Index USD2
Foreign-listed Chinese Companies (listed in Hong Kong, New York, and Singapore)	MSCI International China IMI Gross Total Return Index USD
Other Equity Indices
Mainland-listed Chinese Companies	MSCI China A Onshore Gross Total Return Index CNY
Global Stocks (ex-U.S.)	MSCI ACWI ex-USA Gross Total Return Index USD
U.S. Stocks	S&P 500 Index

Figure 2 above reveals several important findings:

• As measured by the indices, foreign-listed Chinese stocks have produced positive returns for investors over the past decade.
• The Chinese companies listed in New York have outperformed both their Mainland-listed peers and Chinese companies listed in Hong Kong.
• Foreign-listed Chinese stocks have outperformed global stocks (ex-U.S.).
• The Chinese companies listed overseas have outperformed their domestically-listed peers.
• The performance of Chinese companies listed in New York has roughly matched the S&P 500 Index – no easy feat given the exceptionally strong performance of U.S. large cap stocks over the past decade.

There are several important caveats to this analysis to keep in mind:

• Investors cannot invest directly in an index. Investors’ returns may vary from that of an index due to investors’ differential portfolio weights versus the index.
• While the returns of foreign-listed Chinese companies have been attractive over this period, it has occurred alongside significant market volatility.
• The sector compositions of the indices are not identical. Many Chinese technology companies have listed overseas and play an outsized role in the MSCI Overseas China and MSCI International China indices.
• The MSCI Overseas China and MSCI International China indices exclude reverse merger companies. As mentioned above, many of these companies performed poorly or went bankrupt. Although they are a relatively small portion of the total market cap of Chinese companies listed in the U.S., heavy exposure to these companies would have resulted in poor performance.
• Past performance is not a guarantee of future returns and foreign-listed Chinese companies face an unprecedented series of new risks, ranging from the economic fallout of the pandemic to the threat of sanctions by the U.S. government.

Corporate fraud invariably attracts significant attention and many of the early wave of reverse merger Chinese stocks were rightfully exposed for their corporate failings. However, as a whole, foreign-listed Chinese firms, especially those listed in the U.S., have provided attractive returns for investors over the past decade. Attempts to broadly label foreign-listed Chinese firms as fraudulent and damaging to U.S. investors are not supported by the facts.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of June 30, 2020, the Seafarer Funds did not own shares in the entities referenced in this commentary.

1. The Bloomberg China Reverse Mergers Index was discontinued effective August 22, 2014.
2. The index contains a small weighting of Chinese companies listed in Singapore, accounting for around 0.50% of the total index.