The Hidden China Risk Inside Your ETF

The Multi-Layered ETF Exposure Problem

The ETF universe offers investors many ways to access China — but the vehicle matters. Some ETFs, like PGJ, hold U.S.-listed ADRs exclusively, while others like KWEB blend ADRs with Hong Kong-listed H-shares. Still others — such as MCHI, FXI, and ASHR — primarily hold locally listed shares, including both H-shares and A-shares listed in Shanghai or Shenzhen — according to the funds pages.

As of April 2025, ETF Central shows that PGJ has just $131 million in AUM, but its direct ADR exposure makes it highly vulnerable to delisting disruptions. Meanwhile, KWEB, with $5.94 billion in AUM, also carries meaningful U.S.-listed exposure to names like PDD Holdings (PDD) and Tencent Music Entertainment Group (TME) — according to the fund's site.

On a larger scale, VWO and IEMG hold $75.43 billion and $76.89 billion, respectively, and include Chinese exposure through both ADRs and local shares. Popular China-focused ETFs like MCHI ($5.33B), FXI ($5.58B), and ASHR ($1.70B) round out the picture — each carrying varying levels of indirect risk even if they don’t directly hold U.S.-listed ADRs.

This list is by no means exhaustive — it reflects just a sample of the ETF exposure to Chinese equities. Investors should also be aware of significant fixed income exposure to Chinese issuers through emerging market bond ETFs, corporate bond ETFs, and global aggregate funds, all of which could face liquidity challenges or regulatory complications in a worst-case scenario.

The Spillover Risk: Local Shares Aren’t Immune

Even ETFs that hold no ADRs could feel the impact. If broad passive mandates and institutional portfolios are forced to sell ADRs due to regulatory risk or index removal, this could pressure the underlying Chinese companies themselves, especially if their U.S.-listed and locally listed shares are fungible.

In short, you don’t have to hold a delisted ADR to feel the pain — market contagion, correlation shifts, and volume dislocation can impact all holders of Chinese equities, regardless of listing venue.

Passive Indexing Meets Regulatory Firestorm

Most ETF investors assume their fund will simply “follow the index.” But what happens when an index must abruptly remove dozens of Chinese companies due to delisting or sanctions?

• Tracking error may spike
• Turnover rises, affecting performance
• Liquidity can evaporate as underlying names shift from highly liquid U.S. venues to harder-to-access OTC or foreign listings

This risk is especially acute for passive ETFs with rigid rules. Active ETFs may have more flexibility — but investors should review their exposures closely.

Forced Selling = Potential Tax Bomb

Another often-overlooked consequence of forced ADR sales is the potential for capital gains distributions. If ETFs are required to sell appreciated Chinese ADRs due to delisting or index changes, those gains don’t vanish — they’re passed along to shareholders.

In taxable accounts, this could result in unexpected year-end capital gains, even if the investor hasn’t sold a single share. Funds with low turnover that have held ADRs for years may carry substantial embedded gains, meaning a regulatory shift could trigger a taxable event for everyone still holding the ETF.

This is especially problematic in:

• Large index-tracking ETFs where redemptions or rebalances are out of the manager's control
• Taxable brokerage accounts where gains aren't deferred
• Smaller or concentrated funds where one or two ADR positions drive much of the fund's historical performance

Investors should consider not only what their ETF holds — but what might happen if those holdings are suddenly forced to exit.

The Critical Role of ETF Capital Markets Experts

In moments of regulatory uncertainty or market disruption, ETF Capital Markets professionals aren’t just helpful — they’re essential. It's their job to work closely with issuers, product managers, portfolio managers, and risk teams to prepare for scenarios like mass ADR delistings, sanctions, or trading halts.

These conversations start with key questions:

• Do we liquidate ADR exposure immediately?
• Do we begin transitioning to local listings or ordinary shares?
• What are the liquidity, tax, and operational impacts of each choice?
• How will this affect NAV, spreads, and the ability to create/redeem shares?

Capital Markets teams act as the bridge between internal decision-makers and the broader ETF ecosystem — coordinating with authorized participants, custodians, market makers, and exchanges to maintain fund functionality even under stress.

But planning shouldn't start after the news breaks.

ETF issuers should consider establishing formal policies and procedures in advance, outlining the fund’s response to delistings, sanctions, or severe trading restrictions. These should include guidance on:

• Orderly liquidation vs. conversion strategy
• Thresholds for moving from ADRs to ordinary shares
• Communications protocols with shareholders and regulators

Where possible, issuers should also seek regulatory clarity and guidance from the SEC, especially for more complex decisions involving redomiciling exposure or suspending create/redeem functionality.

Having a plan — and a person responsible for executing it — could be the difference between a resilient product and a failed one.

Worst-Case Scenario: From Trading Risk to Legal Risk

While regulatory uncertainty often creates pricing dislocations, in a worst-case scenario, U.S. policy could escalate to outright restrictions on holding or trading Chinese securities, especially in sectors tied to national security, technology, or military development.

We’ve seen how quickly such moves can unfold. In 2022, U.S. Executive Orders and OFAC (Office of Foreign Assets Control) directives made it illegal for U.S. persons to purchase, hold, or transact in Russian securities — even on the secondary market. ETF custodians, index providers, and trading desks were forced to halt activity, freeze redemptions, and ultimately liquidate assets due to legal non-compliance.

While a similar escalation against China may seem unlikely in the near term, a military conflict — such as an invasion of Taiwan — could change that calculus quickly, prompting sweeping sanctions and regulatory bans that mirror the actions taken against Russia.

If similar action were taken against certain Chinese companies — or entire sectors — the ETF ecosystem could again be forced into emergency unwinds, NAV dislocations, or outright shutdowns.

In such a scenario, issuers who haven’t pre-defined their policies, secured regulatory guidance, or assessed convertibility options for ADRs and Chinese shares would be left scrambling — putting investors, performance, and brand reputation at serious risk.

ETF Capital Markets professionals, again, are the front line — but they need executive-level support to pre-plan for the unthinkable.

Lessons from RSX/ERUS: Market Access Can Vanish

We’ve seen this movie before. During the Russia-Ukraine crisis, funds like RSX and ERUS saw trading halted, NAVs diverge wildly from prices, and capital markets functionality grind to a halt. While China is not Russia — and its stocks are more globally integrated — the mechanism of disruption could be eerily similar.

Delisting doesn’t just affect price — it affects tradability, valuation, custody, and the ability to create/redeem ETF shares.

A Glimmer of Global Liquidity Reform?

Ironically, while the U.S. contemplates delisting Chinese names, China itself is taking steps to modernize and globalize its ETF ecosystem. Reuters recently reported that firms like Citadel Securities, Jane Street, and Optiver may soon be allowed to become official market makers in China — a potential breakthrough for improving ETF liquidity and reducing spreads — according to a Reuters report.

But geopolitics may slow this progress. As long as U.S.-China tensions linger, the ETF ecosystem sits squarely in the crossfire.

Final Thoughts: Know What You Own

ETF investors must go beyond tickers and look under the hood.

• Are you holding ADRs directly?
• Could forced selling in ADRs affect your fund’s other holdings?
• Is your ETF manager prepared to manage through dislocations?

As regulatory pressure mounts and the global market structure continues to evolve, ETF transparency and capital markets preparedness will be more important than ever.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs.

At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at VanEck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community.

Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

Disclaimer

Please note that this article reflects the author's personal views and does not represent the opinions of the publication or its affiliates. It is for informational purposes only and does not constitute investment advice. It is essential to seek guidance from a registered financial professional before making any investment decisions.