Why PGJ Fell 4% Tues, As China ETFs Rose

The PowerShares Golden Dragon China Portfolio (PGJ) fell 4 percent on Tuesday, while a number of other prominent China-focused ETFs were up as much as 3 percent—a sharp divergence in performance related to the fact that PGY’s Internet-company-rich portfolio was hit hard by news that one of its constituents was under investigation by U.S. securities regulators.

PGJ showed up in the No. 4 spot on IndexUniverse’s worst-performers list Tuesday because New Oriental Education (EDU), which has a 3.72 percent weight in PGJ, revealed Tuesday that the Securities and Exchange Commission was investigating its financial statements, according to a report published by Bloomberg News.

The company’s ADRs shed more than a third of their value, and the crisis in confidence quickly spread to other firms. It was the latest corruption-related episode in a country said to suffer from endemic corruption. To some, China’s alleged corruption problem is a reason to avoid the Chinese investments. To others, it’s a cost of doing business in a dynamic fast-growing country.

“The majority of the underlyings in that ETF are Internet companies,” said Reggie Browne, a market maker at Jersey City, NJ-based Knight Securities. “FXI, in comparison, has a lot of banks and financials,” Browne added, referring to the iShares FTSE China 25 Index Fund (FXI)

FXI, a $4.5 billion ETF that, unfairly, is frequently considered a proxy for all investment in China, rose more than 3 percent, while the SPDR  S'P China ETF (GXC) gained about 1.3 percent on the day.

The divergent returns stand as a reminder for investors that understanding what’s in a given fund is crucial, and that means taking the time to distinguish indexes by more than their names.

Indeed, portfolio allocation is part of the issue. PGJ tracks the Nasdaq Golden Dragon China Index, and allocates more than 43 percent of its portfolio to information technology companies, according to PowerShares data. FXI, on the other hand, is dominated by financials, as about a third of its underlying benchmark, the FTSE China 25 Index, allocates to financial names.

The single company that triggered PGJ's downfall is nowhere to be found in FXI's 26-securities portfolio, iShares data showed. SSgA's GXC is also heavily tilted towards financials, as it tracks the S'P China BMI Index. But New Oriental Education represents only 0.3 percent of GXC's portfolio.

PowerShares, responding in an e-mail to a query from IndexUniverse, noted PGJ holds New Oriental Holding, and also stressed that PGJ's index has higher exposure to information technology and consumer discretionary stocks than do FXI's and GXC's. The latter two funds have much higher weightings in energy, which traded higher, PowerShares said.

Interestingly, from a sector perspective, New Oriental Education is considered a consumer discretionary company and is listed under PGJ's and GXC's holdings as such.

"The real issue here, and the reason why PGJ is getting hit, is because of how EDU is listed in the U.S.," IndexUniverse's analyst Dennis Hudachek, said. "Many Chinese companies including the huge Internet companies—like Baidu, Sina, Renren—list in the U.S. using what's called a variable interest entity (VIE) to circumvent Chinese laws on foreign direct investment."

The investigation into EDU has raised concerns among investors that similar action might follow for other Chinese companies listed here, he said.

"Now, we don't even know exactly what the SEC is investigating, but investors are selling first and asking questions later," Hudachek said.