KLIP: A Conservative Way To Obtain China Exposure (NYSEARCA:KLIP)
The Kraneshares China Internet And Covered Call Strategy has successfully navigated the challenging Chinese equities market in 2023. Learn more on KLIP ETF here. The KraneShares CSI China Internet ETF (KWEB) is a conservative approach to obtain China exposure. This comes amidst a significant economic slowdown in China, driven by a cooling off in the property sector. The property sector is also struggling, with house prices continuing to decline. The Russian capital markets saw an unprecedented flight of capital and outright sanctions, leading to a significant drop in value and inability to transfer the funds back to investors. The iShares MSCI Russia Capped ETF's current holdings of Russian equity securities cannot be liquidated and distributed back to the investors due to Western sanctions following the Russia/Ukraine conflict. Political risk can be difficult to accurately price, but market participants must adjust valuation metrics to account for uncertainty surrounding the jurisdiction where a business operates.
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China equities have had a very rough ride this year, down substantially when compared to virtually all other equity markets around the world:
We are comparing here the KraneShares CSI China Internet ETF (KWEB) with the SPDR S&P 500 Trust ETF (SPY), the Vanguard FTSE Europe ETF (VGK) and the iShares Latin America 40 ETF (ILF). KWEB sticks out like a sore thumb in terms of a deep negative performance.
China has been experiencing a significant economic slowdown, mainly driven by the cooling off in the property sector:
GDP growth slowed down significantly in 2022, and despite hopes for a post-Covid re-opening, the economy has been very sluggish instead. The property sector is an ailing one, with house prices continuing to decline in China. After years of overbuilding and speculative action in real estate, the bubble is bursting. Property developers are trading distressed, with Country Garden being the last one to default:
We are living in an increasingly polarized world, where the world's superpowers are asserting themselves politically, economically, and territorially. We are referencing here the U.S.A., China, and Russia. The Russia/Ukraine conflict is a staple of the evening news, with an independent country in Ukraine having been invaded by its larger neighbor.
The Russian capital markets saw an unprecedented flight of capital and outright sanctions. As an American investor, if you held Russian ADRs or ETFs, you would have seen a massive drop in value and then an inability to actually get your cash back:
The iShares MSCI Russia Capped ETF previously suspended new creations of ERUS shares on March 1 and stopped trading altogether on March 4 2022 after Western sanctions on Moscow in response to the invasion of Ukraine made it all but impossible to access Russian financial markets. According to a BlackRock note, Russia's invasion of Ukraine has triggered a range of sanctions and other capital controls that impeded BlackRock and other non-Russian investors from accessing Russian markets. Consequently, ERUS's current holdings of Russian equity securities cannot immediately be liquidated and distributed back to investors - ETFs hold a basket of underlying assets, or in this case, the difficult to access Russian equity market. Consequently, BlackRock warned that the full liquidation process of the fund will take an unknown period of time.
Geopolitics are now being priced in valuation metrics, with the market keenly aware of the possibility that something similar could happen for Chinese equities if there is any event surrounding China and Taiwan.
Political risk is very difficult to correctly price, but market participants must be aware of it and correctly adjust valuation metrics, specifically P/E ratios to account for the higher uncertainty surrounding the jurisdiction where a business operates. A business on its own is fairly straightforward to judge, irrespective of the jurisdiction. Assets are fungible, growth is transparent, and free cash flow is the same when utilizing the same accounting standards. The ability of the business to disburse its dividends or actually generate the same level of revenue due to circumstances around the jurisdiction where it is incorporated is a political risk.
Let us just take a simple example, namely Alibaba (BABA):
The stock is down -13% year to date, and currently trades with a P/E ratio of 9x. Alibaba is the Chinese 'Amazon', and AMZN is currently trading with a 58x P/E ratio. Why the massive gap? Political risk.
Political risk not only keeps a lid on P/E ratios but also introduces volatility in returns. As events unfold where this type of jurisdictional risk is brought back into the common consciousness, price action becomes choppy.
What does KLIP actually do?
The Kraneshares China Internet And Covered Call Strategy ETF (NYSEARCA:KLIP) is an equities exchange-traded fund that seeks to provide current income by following a "covered call" strategy. As per its literature:
The current fund portfolio shows us that KLIP layers a ladder of short-dated calls on all of its KWEB holdings:
The first collateral line represents the fund holdings in KWEB, while lines 3 to 15 are the individual call options which have been sold. We can observe a maximum maturity date of 11/24, meaning only one month out.
We like this structure because it takes advantage of the large theta decay that occurs in the last 30 days of an option's life, and the staggered maturity gives the fund managers the opportunity to take advantage of skew events as they occur. We do not like very well-defined systematic options strategies because more often than not they leave alpha on the table. An option strategy with a bit of embedded flexibility like the one utilized here is best in our view.
In a year when KWEB lost nearly -20%, KLIP is flat:
KLIP's covered call strategy was executed to perfection this year, allowing the ETF to stay positive while the outright exposure has suffered a deep loss. If done right, covered call strategies can work very efficiently. In the U.S. equity space there are a number of buy-write ETFs and CEFs (some of which we have covered as well), which are systematic in nature, and thus tend to underperform long term.
A covered call strategy works very well when you leave the portfolio manager the ability to make adjustments in terms of tenors and hedge ratios and when the underlying equity is volatile:
The KWEB 30-day volatility was consistently above 40% this year (it has only recently dipped), while the SPY one has been stuck below 20%. You want to sell calls (i.e., short vega) when volatility is high. Volatility is the main input in options pricing, and a high volatility translates into a high option premium.
KLIP has been able to fully take advantage of the high volatility exposed by KWEB, and has been able to generate a 20% return from option premiums, thus offsetting the loss in price on the underlying ETF.
The only downside to KLIP will be observed during an aggressive bull market. If prices rally very fast, KLIP will start lagging KWEB significantly, whilst still generating a high positive return though. We do not think that is in the cards for now. We believe we are witnessing a long bottoming process for China equities, and in the current environment, KLIP will continue to offer tremendous value and outperformance.
KLIP is a covered-call exchange-traded fund. The vehicle offers investors exposure to Chinese tech companies via its KWEB holdings and subsequently takes advantage of the high volatility in the space to write covered calls. The fund has done tremendously well in 2023, being flat when KWEB is down roughly -20% year to date.
KLIP is a glaring example of a buy-write fund that does everything well. The fund has overwritten its entire KWEB position, it structures short-dated options so that it benefits from theta decay while at the same time laddering its written call options.
China has been an underperformer this year on the back of a sluggish economy and ailing real estate sector. We believe we are going to see a protracted bottoming process in the jurisdiction, which is going to be marked by more volatility. The current environment is ideal for KLIP and its structure, with the fund being the ideal choice in making a conservative investment in China at the moment in our view.
Topik: Markets, China