Morgan Stanley's pioneer of China investing falls on hard times

[NEW YORK] As bad as the Chinese stock market has been for investors this year, a Morgan Stanley fund has been even worse.

The nine-year-old Morgan Stanley China A Share Fund, the first US closed-end fund to invest in mainland stocks, has slumped 13 per cent this year through Sept 18 on a total return basis, compared with a 6.2 per cent decline in the benchmark it tracks. The underperformance came as investors sold the fund, pushing it to trade at 24 per cent below the value of the assets it holds, the biggest discount among more than 500 closed-end funds on American exchanges, according to data compiled by Bloomberg.

A pioneering product that gave overseas investors access to China's tightly-controlled stock market when it was launched in 2006, the Morgan Stanley fund has been dealt a double blow this year. The 39 per cent selloff in the Shanghai Composite Index since mid-June has reduced demand for Chinese assets, while the opening up of the country's capital markets has unleashed a wave of cheaper and more efficient products, such as exchange-traded funds, luring investors away.

"If mutual funds are like CDs and ETFs are digital music, closed-end funds are cassette tapes," said Eric Balchunas, an analyst at Bloomberg Intelligence. "The Morgan Stanley fund is bouncing around the laws of supply and demand, and now as we have cheaper and more liquid vehicles that track the A-Share market and now that investors are withdrawing from the region amid a massive selloff, the fund is facing a number of challenges."

Closed-end funds, a type of mutual fund that trades on an exchange like a company stock, have a fixed number of shares and don't accept new investors after the initial public offering. While their share prices tend to vary from the value of underlying assets, the concession in Morgan Stanley's US$621 million fund has been extreme.

The discount widened to 33 per cent on Sept 2 from an average of 7 per cent over the past five years. While the gap has narrowed after the fund announced the biggest dividend payment in eight years on Sept 11, it's still double of what is was at the end of 2014. By comparison, the US$1.1 billion Templeton Dragon Fund Inc, a closed-end fund investing in the mainland and Hong Kong markets, has a discount of 16 per cent.

Matt Burkhard, a spokesman for Morgan Stanley, declined to comment on the performance.

Morgan Stanley's fund started by investing in stocks on the Shanghai and Shenzhen exchanges through the Qualified Foreign Institutional Investors license and by using derivatives when the local yuan-denominated equities, known as A shares, were largely off-limits to foreigners almost a decade ago.

Its appeal began to fade in November when China allowed foreign investors to buy stocks directly on the exchange in Shanghai for the first time. The relaxation of the rules opened up access to the A-share market and simplified the process of investing in mainland shares through cheaper and more liquid ETFs.

The widening discount has prompted investors including Kapital Asset Management LLC and WaveFront Capital Management Partners LP to sell their holdings in recent months. Demand for the fund has soured further since June when a stock rout wiped out US$5 trillion in market value on concern the Chinese economy is slowing.

"We went into the fund betting on a growth in the A-Share market, but as things started to fall apart, we had to get out," said Aleksei Belkin, the chief investment officer at Kapital Asset Management, which sold its stake in the Morgan Stanley fund in May.

For some investors, the widening discount creates a buying opportunity because the fund price and its underlying assets are likely to converge eventually.

John Cole Scott, chief investment officer at Closed-End Fund Advisors, said the discount will be cut by half in the next few months as investors realize that the negative sentiment toward China has been overdone.

Excellent Investment "This is still an excellent way to play the China recovery," Mr Scott, whose investment advisory firm specializes in closed-end funds, said by e-mail.

Even with the decline this year, the fund is still up 12 per cent over the past 12 months. While it trailed the 25 per cent gain in the US$383 million Deutsche Bank AG's A-shares ETF, the largest of its kind in the US, it has beaten the 0.6 per cent decline in the Standard & Poor's 500 Index over the past year.

The diminishing status of the Morgan Stanley fund also shows how close-end funds, once one of the most popular investment tools, have fallen out of favor when faced with competition from ETFs. The number of the closed funds has fallen to 565 in June from almost 700 in 2011, according to Morningstar Inc. At 1.8 per cent, the expense ratio of the Morgan Stanley fund is more than twice as high as the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF. Its trading volume is one- seventh of the Deutsche ETF.

Mariana Bush, the Washington-based head of exchange-traded tracking-products research for Wells Fargo Advisors LLC, said the dividend payment schedule at the fund also turned investors away. The fund pays dividends from net investment income twice a year and net realized capital gains at least annually, but only if income is made and net gains are realized.

"Investors want to know that they'll receive a consistent dividend," Ms Bush said. "With this fund they don't know that, and investors are not happy about it."

BLOOMBERG