Some Chinese stocks may disappear from the US.

The giant warning sign for investors owning Chinese stocks has been blinking for months. It’s about to become a blaring warning sign.

Individual investors who still own or are considering owning individual shares of US-listed Chinese stocks should heed this warning. Barron’s has written about the challenges facing Chinese companies on multiple fronts: Beijing has steadily intensified regulatory scrutiny of its largest tech companies, as tensions between the US and China escalate, giving rise to investment restrictions and legislation that further impacts the market.

Yes, there are strong arguments for investing in China, especially in the long term. China’s rapid economic growth is generally attractive and has resulted in a burgeoning middle class which in turn has fueled many emerging industries. In addition, many Chinese homegrown tech companies are benefiting from government investment and tensions between the US and China. But if Barron’s wrote earlier this month, the way to navigate this landscape is to hire a mutual fund guide or exchange-traded fund manager who can manage the growing complexity.

Every week makes that case even stronger. Owning individual shares of Chinese companies listed in the US, whether traded over-the-counter (rather than on a major exchange) or as American Depositary Receipts (ADRs), would increasingly be a risky proposition. could be. Institutional investors who have the option of owning shares on a Hong Kong or mainland China stock exchange are well on their way to that transition, which could increase pressure on US-listed stocks and ultimately lead to liquidity problems.

The ADR-heavy

Invesco Golden Dragon

exchange-traded fund (PGJ) is down 13% in the past three months. The iShares MSCI China (MCHI), which also owns Hong Kong-listed shares, is down 4%, and the iShares MSCI China A-shares (CNYA), which focuses on China-listed companies, is up 7%.

The latest cloud looming over US-listed Chinese companies is uncertainty about how US regulators will enforce last year’s Holding Foreign Companies Accountable Act, which requires foreign companies to adhere to US auditing standards to trade on US exchanges. The Chinese government has long prevented Chinese companies from providing the necessary information to comply with US audit requirements.

The enforcement process is underway; The feedback period for a proposal from the Public Company Accounting Oversight Board (PCAOB) closes this week, and policymakers expect a rule to be released soon. A PCAOB spokeswoman declined to comment. The rule will pave the way for the Securities and Exchange Commission to enforce the law. Currently there is a three year period for compliance; the Senate passed a bill last month that would speed the timeline to just two years — another indication of bipartisan support for China’s measures.

Despite the urgency of policy makers, policy makers note many open questions. There are some 248 Chinese companies listed on US exchanges with a combined market value of more than $2 trillion – so the delisting process can be messy and painful. “If a delisting is imminent, the stock price will plummet and those who control the company can buy out public investors for a bargain, go private and relist in Asia at a much higher valuation and make a ton of money – at Americans ‘cost’, says Jesse Fried, a Harvard Law School professor who has researched the regulation of Chinese companies trading in the United States.

There’s also no precedent for the kind of massive delisting that could stop in a worst-case scenario — a factor that could lead to an elusive compromise between the two nations. “Despite ongoing, heightened tensions between the US and China, this could be the final salvo that will bring both sides back to the table to work out a deal where there is just enough access to audit personnel and working papers so that nuclear power option has been avoided and the PCAOB will be able to meet its core obligations under the Sarbanes-Oxley Act,” said Shas Das, counsel for King & Spalding, who was the PCAOB’s chief negotiator with Chinese regulators between 2011 and 2015. Previous negotiations yielded some cooperation and access to audit working papers, but not consistently, he adds.

Investors would do well to wait to see if a compromise materialises, especially as tensions between the US and China continue to mount. On Thursday, the Senate passed a bill to ban imported products from China’s Xinjiang region over charges of forced labor, and the US added Chinese companies to a blacklist, cutting them off from US investment.

Investors got a painful look at the havoc these measures could wreak if widely adopted

China mobile

was delisted by the New York Stock Exchange in January, following an executive order from President Donald Trump banning investment in companies the US said had ties to the Chinese military. Institutional investors were able to convert their shares into Hong Kong-listed stocks, but many retail investors are stuck in limbo – even now, many investors can’t make a sale with their current broker, and some are told to look for foreign brokers. Others have run into dead ends with no clarity as to who to reach for help, and face a loss. The SEC did not respond to a request for comment.

While regulators can find a way to compromise or find a way to help smaller investors, it’s better to just avoid landing in a potentially tricky spot. “It puts people in this Kafka situation where they can’t move on,” said Andy Kapyrin, co-head of investment at RegentAtlantic, which oversees $5.5 billion in assets. “For typical individuals who own Chinese ADRs, there is a risk: if they are not aware of how this legislation is evolving, they may find themselves owning a deprecated ADR that becomes very difficult to trade.” Kapyrin uses an ETF to allocate its clients to China.

Many major Chinese companies, including Alibaba Group Holding (BABA),

JD.com

(JD), and

Yum China

(YUMC) have sought secondary listings closer to home and many US fund managers have moved to those listings. That’s a relatively easy move for mutual fund managers; less for retail investors, as some brokers do not allow direct access to foreign markets.

Another reason to avoid Chinese stocks: The long-controversial corporate structure used by many Chinese companies to circumvent foreign ownership restrictions in Beijing, known as a floating rate, is receiving renewed attention as Chinese regulators tighten control over foreign listings. Most analysts do not expect the structure to be disrupted, but more focus could emphasize risks and weigh down valuations of US-listed Chinese stocks.

In the short term, these clouds are enough for Kapryin to reduce customer allocation to China from an overweight position to a market weight. He is not alone. China’s weighting in Cathie Woods’

Ark Innovation

ETF (ARKK) has fallen below 1% from 8% in February.

However, short-term volatility can be a good opportunity to build long-term positions. Investors should stick to China-focused mutual and exchange-traded funds that can navigate the ongoing complexities of the US-China relationship, and identify the companies that may be less vulnerable to blacklisting and regulatory changes.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

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