As China A-share exchange traded funds gain popularity, investors need to understand the risks of holding this particular class of assets, notably the potential indirect trading costs associated with higher premiums.

Market-makers, or liquidity providers, of Renminbi Qualified Foreign Institutional Investor funds see a dearth of available hedging tools because of their limited access to the Chinese market, reports Justin Lee for Risk.

“If they are unable to hedge their positions then they will often have to execute a swap with an investment bank and that can be expensive,” Ko Tseng, managing director at E Fund Management, said in the article. “This can drive up the cost of the ETF and it is not economic. There needs to be a cheaper and easier way to hedge A-share exposure.”

Market makers help provide secondary market liquidity for ETFs by creating or redeeming baskets of ETF shares. These authorized participants provide manageable bid-ask spreads for ETFs, but the lack of hedging instruments is holding them back.

“This issue generates situations where ETFs will trade at a premium to their fair value, as demand is bigger than the available QFII and RQFII quotas,” Antoine de Saint Vaulry, deputy head of equity derivatives trading, Asia at Commerzbank, said in the article. “These premiums can be pretty significant, very volatile and ETF specific.”