How to Make 23% Betting Hedge Funds Are Wrong on Chinese Stocks

Wagers against Chinese stocks have become so popular that banks are offering returns exceeding 20 percent to anyone prepared to take the other side.

The potential payouts, from firms including BNP Paribas SA and JPMorgan Chase & Co., come in the form of structured products tied to the CSOP FTSE China A50 exchange-traded fund in Hong Kong. The ETF, one of the world’s largest tracking domestic Chinese equities, is a favorite target of hedge funds and other bearish speculators who pushed short interest to a one-year high last month.

For BNP’s most popular such product, the manager buys shares of the CSOP ETF, which it then lends to short sellers for annual fees of as much as 5 percent at prevailing rates. It also purchases a bullish call option on the ETF, while selling a put option. If the ETF rises at least 0.1 percent in 12 months, investors get their principal back and a payout of 22 to 23 percent, plus any returns on the ETF that exceed those levels. If the fund falls, the principal shrinks by an equivalent amount.

Potential Upside

BNP has sold more than $100 million of structures mainly tied to the CSOP ETF over the last 10 months as some investors look past gloomy China predictions by hedge fund luminaries from George Soros to Kyle Bass. After tumbling as much as 49 percent from its peak last June through Jan. 28, the Shanghai Composite Index has since rebounded 10 percent amid speculation that monetary stimulus and stock purchases by state-owned funds will prop up the market.

“This product is interesting because an investor just needs to get the direction right to get a 23 percent payout," said Etienne Grisey, head of equity derivatives structuring for Asia Pacific at BNP. “Compared to buying the ETF, the potential upside is much bigger.”

Demand for the notes has been a rare bright spot for structured products in Asia. Regional sales of equity derivatives, including structured products, plunged by 55 percent in the first quarter from a year earlier, according to data from 12 global banks compiled by Coalition Development Ltd. JPMorgan sold similar ETF products earlier this year, according to Greg Yu, the bank’s head of equity derivatives marketing in Asia excluding Japan. 

Products tied to China "are the only reason why volumes haven’t dropped even further," said Amrit Shahani, a research director at Coalition Development.

Still, there are plenty of reasons to worry that Chinese stocks will fall. After expanding at the weakest pace since 1990 last year, China’s economy shows few signs of recovery. Earnings at Shanghai Composite companies have declined by 13 percent since last June, while corporate defaults are spreading and the yuan is trading near a five-year low. The median price-to-earnings ratio on the nation’s exchanges is 60, higher than that of U.S. technology shares at the height of the dot-com boom in 2000.

Bulls point to the scope for further stimulus and the presence of state-owned funds, which have been buying shares since last summer to stabilize the market. Other potential catalysts for gains include this month’s MSCI Inc. decision on whether to include mainland shares in its international indexes and the anticipated start of an exchange link between Hong Kong and Shenzhen.

The CSOP ETF slipped 0.7 percent on Wednesday.

To contact the reporter on this story: Viren Vaghela in Hong Kong at vvaghela1@bloomberg.net. To contact the editors responsible for this story: Andrew Monahan at amonahan@bloomberg.net, Richard Bedard at rbedard2@bloomberg.net, Michael Patterson