China’s leadership has shifted its focus from manufacturing low-cost exports to strengthening demand within its domestic market. As a result, retail sales are expanding in China. At the same time, China has a flourishing ecommerce culture that is driving retail sales online. We believe Chinese technology companies will be the primary beneficiaries of this environment. However, many global indices have excluded Chinese internet companies due to a technicality in the way they define their China investment universe.

Global Investors Underallocated to China Internet Companies

In order to attract a greater international investor base, many of the largest Chinese internet companies choose to list in the United States. These companies, called N-shares, (borrowing the N from the New York Stock Exchange) are currently not included in major index providers' definition of China within their broad-based international indices. This omission is due to a technicality, which excludes companies listed outside of their home market even if the majority of their revenue and business model are derived from that market. As a result, many global investors do not have exposure to U.S.-listed Chinese internet companies.

Alibaba's* initial public offering in 2014 brought significant media attention to this disparity. Alibaba’s IPO was one factor that drove MSCI, a leading provider of index solutions globally, to announce earlier this year that N-shares will be included within their emerging market index on December 1, 2015¹. Currently, the total N-share market cap is $487 billion². The change in index composition will cause a total of $70 billion to be reallocated to U.S.-listed Chinese companies³, which will increase the N-share market cap by 14%⁴.

Our fund, the KraneShares CSI China Internet ETF (NASDAQ:KWEB), primarily consists of U.S.-listed Chinese companies. KWEB's holdings cover 98% of the China N-share allocation slated to be included in the MSCI Emerging Market Index⁵. These 16 stocks represent a 63% weight of KWEB⁶.

For investors interested in learning more about N-share inclusion, we created the N-share inclusion clock to provide additional information.

China’s Internet Expansion Initiative

China’s desire to increase domestic consumption led Premier Li Keqiang to announce the Internet Plus strategy on March 5th at the 2015 National People's Congress Session⁷. The new policy aims to drive economic growth by integrating internet technologies with traditional sectors and will focus on fostering new industries and business development, including ecommerce, industrial internet, and internet finance⁷. The table below underscores the success of this policy. Since Premier Li’s announcement, rates of online sales in China have accelerated.

While total retail sales for the U.S. and China are nearly equivalent, China’s 10.6% year over year retail sales growth rate in June dwarfs the 1.4% June growth rate of the United States, underscoring China’s recent success in moving toward a consumer-based economy. Moreover, China’s online retail sales have grown at a year over year rate of 39.1%, which is more than twice the 14.5% rate of the United States.

We believe Premier Li’s focus on raising the role of Chinese internet companies within its economy has begun to pay off. Beyond the numbers listed above, we have identified three trends in the global internet sector in which China is increasingly becoming a world leader.

Chinese internet companies leading the way in three global trends

Mobile adoption

The adoption and use of mobile phones is a leading trend among consumers around the world. In 2014, the number of worldwide mobile users was 5.6 billion and is expected to reach 6.2 billion by the end of 2018¹². China represents a significant share of this population with 10.7% of all mobile users worldwide¹³. The rise of high quality, low cost cell phone manufacturers have made cell phone use nearly ubiquitous in China’s major cities. A variety of applications and services have emerged to compete for the attention of China’s mobile audience. One such application is WeChat, which has 549 million monthly active users¹⁴. WeChat is owned by Tencent*, a Chinese technology company focused on providing internet and mobile services, and combines the functions of an online messaging system with those of a social media platform.

Online to offline commerce (O2O)

While O2O commerce has existed for a several years, it has recently become a vital aspect of the ecommerce business model. The term O2O originated in the United States, but is more commonly used by Chinese ecommerce companies to explain the next step in the consumer experience. O2O commerce is the principle of connecting the online digital world to the offline world through the integration of internet-connected devices¹⁵.

Baidu owns an O2O product called Baidu Waimai that delivers food to customers and is comparable to Seamless in the United States. For instance, a consumer in Beijing simply has to enter his address into Waimai and choose from a list of restaurants that will provide delivery service. This product benefits both the supply and demand side of the market by providing suppliers with a larger consumer base and giving consumers discount incentives from ordering online.

Recently, Baidu* reported that they increased R&D expenses devoted to O2O operations by 18.6%¹⁶. Baidu is betting that its O2O investments will pay off big in the near future. Evidence of its potential can be seen in the gross merchandise value¹⁷ of its O2O products, which have increased 109% year over year¹⁸. Other ecommerce giants such as Alibaba and Tencent are also investing in O2O development. We believe that there will be more O2O innovations and investment from Chinese tech companies going forward.

Cloud Computing

Mobile adoption and O2O commerce need a storage system capable of holding the vast amounts of new data created every day. Since the amount of data generated is exponentially increasing, old methods of storing information on a computer server in one physical location are outdated and cannot meet these requirements. The use of cloud computing now allows companies to store their data in online servers that have nearly unlimited capacity. Cloud computing benefits large companies because the stored data can be accessed and shared from anywhere, even international offices.

China’s internet companies have latched onto cloud computing because it provides a more practical and efficient way of storing data gathered from the country’s 668 million internet users¹⁹. For example, Alibaba, the largest retailer in China²⁰, owns a cloud computing service called Aliyun, which generated $63 million in revenue for Alibaba during the first quarter of 2015 alone²¹ from selling storage services to consumers. Moreover, Alibaba recently invested $1 billion into Aliyun so that it can expand internationally²². Since Alibaba has already shown its expertise in storing large amounts of data from Chinese domestic users, we believe this investment will pay off as the company expands its international cloud computing market share. Similarly, Tencent and Baidu have cloud products they are looking to expand both domestically and internationally.

With the MSCI inclusion of China N-shares coming in December investors will be seeing an increased allocation to U.S.-listed Chinese internet companies in the near future. Investors can potentially benefit from the subsequent increase in N-share market cap by purchasing KWEB today ahead of the December inclusion. Additionally, we believe China’s shift toward domestic consumption and government support for internet and ecommerce companies will continue to benefit the stocks that KWEB holds today.

*Percent of KWEB net assets for mentioned securities, as of 6/30/2015, subject to change:
Alibaba, 8.97%
Tencent, 11.11%
Baidu, 8.41%

1. 1/15/2015 – MSCI conclusions from the consultation on enhancements to the coverage of the MSCI global investable market indexes
2. Data from Bloomberg as of 6/30/2015
3. Potential inclusion data calculated based off amount of assets benchmarked to affected indices by China weighting as of 3/31/2015
4. $70 billion reallocated to China N-share ($70b) / total China N-share market cap ($487b) = 14%
5. MSCI Provisional EM pro forma
6. Based off KWEB holdings as of 6/30/2015
7. United States Information Technology Office, "China 'Pursues Internet Plus' Strategy"
8. Data from National Bureau of Statistics of China report titled “Total Retail Sales of Consumer Goods in June 2015” released on 7/15/2015
9. Data from US Census Bureau’s “Quarterly Retail E-Commerce Sales – 1st Quarter 2015” released on 5/15/2015 and “Advance Monthly Sales for Retail and Food Services” released on 7/14/2015
10. China Internet Network Information Center’s "Statistical Report on Internet Development in China" released on 7/23/2015
11. Data from Internet Live Stats as of 7/30/2015
12. Data from the Radicati Group’s report “Mobile Statistics Report, 2014-2018” released February 3, 2014.
13. China Internet Network Information Center’s "Statistical Report on Internet Development in China" released on 7/23/2015
14. Data from Tencent Q1 2015 Earnings Report
15. Data from TMO Group, an ecommerce development & mobile development company in China.
16. Data from Baidu’s Q2 2015 Earnings Release
17. Gross merchandise value is a term used in online retailing that is the total sales dollar value for merchandise sold through a particular marketplace over a certain time frame
18. Data from Baidu’s Q2 2015 Earnings Release
19. China Internet Network Information Center’s "Statistical Report on Internet Development in China" released on 7/23/2015
20. Data from Bloomberg as of 7/31/2015
21. Data from Alibaba’s Q1 2015 Earnings Release
22. Data from Alibaba’s Q1 2015 Earnings Release