I last wrote about the KraneShares CSI China Internet ETF (NYSEARCA:KWEB) almost three months ago. In that article, I argued that KWEB’s excessive regulatory and economic risk outweighed the fund’s strong growth prospects and cheap valuation. The risk was not worth it, in my opinion at least.

Since then, KWEB has fallen around 30%, significantly underperforming its peers, due to increased regulatory risk and the prospect of delisting from US stock exchanges. Seems like it was the right choice, at least at the time. As conditions have changed significantly for KWEB since then, I thought an update on the fund was in order.

The fall in KWEB’s share price means that fund prices and valuations are lower, while expected returns are higher. Significant, strong, above-market returns are a distinct possibility.

On the other hand, the risks of KWEB remain exorbitant. Chinese tech giants are facing increased regulatory scrutiny from US and Chinese regulators. Sentiment remains bearish. Losses could pile up.

In my view, KWEB continues to present an unfavorable risk-reward profile. The risks are simply too high and too difficult to quantify. KWEB would be a purchase for me in a more favorable, flexible and certain regulatory environment. Although there has been some movement in this direction, conditions remain broadly negative. KWEB is not a buy under current conditions, at least in my opinion.

KWEB – Quick introduction

A quick overview of the fund and its holdings before analyzing the current regulatory environment, the subject of this article.

KWEB is a China Internet equity index ETF. It is administered by KraneShares, a small investment management firm focused on the Chinese and Asian markets. KWEB tracks the CSI Overseas China Internet Index, an index of Chinese companies focusing on the Internet and Internet-related activities, products and services. It is a relatively simple index and fund, which broadly tracks the Chinese internet equity market.

Overall, KWEB’s underlying holdings are fantastic companies, with strong fundamentals and future prospects. KWEB’s underlying holdings have enjoyed strong double-digit growth in revenue, earnings and cash flow for years. The growth is above the stock average, but the results are roughly on par with most US tech giants.

Growth is expected to continue, as China remains a (relatively) underdeveloped country, at least compared to most Western countries, but rapidly catching up with the West.

KWEB’s underlying holdings are also trading at relatively low prices and cheap valuations. The fund’s PE and PB ratios are both slightly lower than those of the S&P 500, even though KWEB’s holdings are growing much faster than average US stocks. The fund’s valuation metrics are also slightly lower than those of most US tech stock indices, although growth rates are roughly comparable between them.

KWEB’s fundamentals are incredibly strong and could conceivably lead to dizzying, above-market returns. Double-digit growth plus a double-digit valuation reset could easily lead to +30% annual returns for years, enriching investors. Although it seems to be a plausible scenario, there are also significant issues and risks to consider. Let’s look.

KWEB – Chinese regulatory risk

The underlying holdings of KWEB are fantastic companies, at least in my opinion, but the Chinese government seems to disagree. Top Chinese government officials want the country to focus on “hard tech”, including high-tech manufacturing, semiconductors and chips. This means reducing the importance of consumer technologies and services, including most consumer apps, video games, delivery services, etc. Chinese tech companies are primarily focused on the latter, due to the economies of scale inherent in providing software products and services to over a billion Chinese. consumers.

The de-emphasis on consumer technologies is a blow to many Chinese tech giants, and that includes several KWEB holdings. As an example, we have Tencent (OTCPK:TCEHY), the largest holding in the fund. Tencent has many business segments, including a large video game development arm. Video games are an industry that Chinese leaders want to minimize, and they have taken drastic measures to achieve this. China drastically reduced the time teenagers, a key gaming demographic, can play multiplayer games last year. The settlement remains in effect, significantly reducing the popularity of video games among a key demographic. China has also frozen new video game approvals for nearly a year. No new video games means a drop in sales, because customers won’t buy the same games twice. Both of these actions are incredibly damaging to video game developers, which helps explain Tencent’s significant underperformance over the past year or so.

It’s a similar story for other industries and stocks. China effectively banned private tutoring services for school-aged children, shutting down most of the industry overnight. The industry’s losses were large, rapid and effectively irrecoverable.

Chinese leaders are also emphasizing “common prosperity,” which means focusing on (what they perceive to be) the prosperity of ordinary Chinese workers and consumers above that of tech giants. Chinese regulators are cracking down on the industry’s excessive 9-9-6 working hours system, offering greater benefits to the country’s labor army and fomenting union organizing drives in the industry. These policies (all aim to) benefit Chinese workers and consumers, but increase the costs of technology, reducing profit margins and revenues.

Due to the above, Chinese technology companies have significantly underperformed over the past year. KWEB itself has fallen over 60% in the last year, appalling results.

Chinese regulators continue to crack down on the industry and losses continue to mount. There have been no signs of a softening of the regulatory stance from the country’s leadership. As such, investors should assume that the crackdown will continue, leading to further losses and underperformance.

KWEB – US Regulatory Risk

KWEB’s underlying holdings have also come under increased regulatory scrutiny from US regulators, primarily due to the country’s lax financial reporting and auditing standards. To trade on US stock exchanges, foreign stocks must comply with US regulatory standards, including (review of) audits by US regulators. Several Chinese stocks have failed to meet those standards, and the SEC has hinted they could be delisted. Although delisted shares can still be traded over-the-counter, meaning investors won’t lose their investment, being delisted significantly reduces liquidity, and therefore prices. KWEB itself around 5% since the SEC hinted that Chinese stocks could be delisted for non-compliance with applicable regulations. These are relatively large losses over such a short period, although they are not significantly above the stock market average.

At the same time, companies that are delisted for failing to comply with US financial reporting standards are at increased risk of accounting problems, including fraud. Companies hide their books for a reason, and that reason could very well be fraud. Such was the case for Luckin Coffee (OTCPK:LKNCY), a Chinese stock and something of a canary in the coal mine for current industry woes. Luckin Coffee’s accounting was fraudulent. Accounting fraud means disbarment, for non-compliance with regulations, and as a sanction/deterrent. Accounting fraud also means significant financial penalties, which led to Luckin Coffee’s bankruptcy. Technically Bankruptcy has little to do with stock delisting, but only dangerous and extremely risky companies are delisted, and these are prone to bankruptcy. Being delisted from US stock exchanges is simply a huge red flag, and one that investors should avoid.

KWEB – Uncertainty

The risks of KWEB are quite clearly significant, but difficult to estimate or quantify with precision. Chinese stocks are at the mercy of regulators, especially Chinese regulators, and I have no inside knowledge or informed opinion of their expected future actions. As such, and in the interest of risk reduction, I assume the worst. It is Something of a judgment call, and therefore other investors may assume differently.

Conclusion

KWEB’s regulatory risks are excessively high and difficult to estimate accurately. As such, I would not invest in the fund at this time.