Representatives Brad Sherman, D-California, and Victoria Spartz, R-Indiana, introduced four bills that would restrict or disincentivize U.S. investors from investing in China. The bills were referred to the U.S. House Committee on Financial Services on March 20.
The No China in Index Funds Act would forbid funds that track an index from holding any Chinese securities starting 180 days after the bill is passed. Sherman’s office explained that passively managed index funds do not exercise the same due diligence in asset selection or monitoring as do active funds and therefore do not carefully examine the unique risks of Chinese companies.
As such, the bill does not affect actively managed funds. The bill also makes no distinction between an index fund that tracks an index that specializes in Chinese securities and an index fund that merely contains Chinese securities. This is an important distinction because index funds are only required to match 80% of an index in order to be considered an index fund, per the Securities and Exchange Commission’s requirements.
As an example of how broadly such a ban would apply, the MSCI All Country World Index is a global equity index that measures the equity performance in 23 developed markets and 24 emerging markets. According to information from MSCI, the index included nearly 3,000 companies and covers approximately 85% of the global investable equity opportunity set, as of February. In the MSCI ACWI Index, excluding U.S. investments, (a version of the index), Chinese companies accounted for 7.12% of the index weighting as of last month. There were nearly 90 funds in the U.S. that used that fund as their benchmark, according to February data from Simfund, which, like CIO, is owned by ISS STOXX.
Another bill in the package, the No Capital Gains Allowance for American Adversaries Act, would subject income derived from securities in “countries of concern” to income tax, rather than to capital gains. “Countries of concern” are defined in the legislation as Belarus, China, Iran, North Korea and Russia.
A spokesperson for Sherman’s office clarified that in the case of pooled investment vehicles, such as mutual funds, the manager must track what proportion of the fund is from a “country of concern,” and only growth attributable to those holdings would be taxed as income. For example, a mutual fund with 40% exposure to China and 60% exposure to countries that are not “countries of concern” would have 40% of its gains taxed as income and 60% taxed as capital gains when a distribution is made.
The spokesperson also clarified that the bill would not affect the tax status of retirement plans or other tax-advantaged accounts.
The China Risk Reporting Act, another in the package, would require public companies in the U.S. to disclose the material risks that come from their supply chain’s reliance on China, and this would have to include a narrative disclosure of the company’s actions to minimize the risk. Sources of potential China risk identified in the bill include: rule of law issues in China, biased judicial proceedings, intellectual property theft and conflict between the U.S. and China.
Lastly, the PRC Military and Human Rights Capital Markets Sanctions Act would require the president to make a list of covered entities within 90 days of the bill’s passage. U.S. investors would be forbidden from trading in securities offered by those entities and would have to divest any of those securities. The list would include entities on the Specifically Designated National and Blocked Persons List, the non-SDN Chinese Military-Industrial Complex Companies List and other Chinese military companies.
The sanctions bill carries a 20-year maximum sentence for any U.S. investor “who willfully violates, willfully attempts to violate, willfully conspires to violate, or aids or abets in the commission of a violation of this Act.” It is the only one of the four to carry a criminal penalty.
H.K. Park, a managing director at Crumpton Global, a risk advisory firm based in Washington, D.C., says the volume of bills related to Chinese investment makes it difficult for investors to prepare for compliance because they often carry “different approaches and definitions. As a result, some GPs have asked us to conduct ‘national security assessments’ of all future target companies with Chinese or Russian links, inside and outside those two countries.”
Park adds that even the potential of successful legislation concerns investors, and “some LPs have asked us to conduct national security assessments of their current portfolio so that they can apply a hedging strategy for companies that might decline in value due to future geopolitical actions—for example, ByteDance—due to the proposed forced sale of Tik-Tok.”
The American Securities Association strongly endorsed the package of bills. Chris Iacovella, the ASA’s president and CEO, said in a statement that “prohibiting Chinese stocks from being included in index funds will protect American investors and prevent the Chinese Communist Party from using American capital to fund its military technologies, indiscriminate climate destruction, and gross human rights violations.”
Tags: China, index funds