How Not to Short China Stocks

The ProShares UltraShort FTSE/Xinhua China 25(FXP Quote) is a "double short" ETF based on a basket of 25 Hong Kong-listed stocks. Many investors seem to incorrectly view this ETF as a way to short mainland China stocks.

I'll demonstrate why FXP is not an effective way to short mainland Chinese equities.

The Shanghai market is looking expensive. It is expensive on a relative basis (relative to Hong Kong), on an absolute basis (compared to where it was just a few months ago) and on a fundamental basis (a market price-to-earnings ratio of over 25 times).

After rallying as much as 110% since its November 2008 low of 1665, the Shanghai Composite has recently shown some signs of weakness and increased volatility. The Shanghai Composite peaked at 3478 on Aug. 4, and has since fallen 16% to sub-3000 levels.

Given the volatile tendencies of the mainland market, it is not surprising then that some people are predicting a sharp reversal and looking for a way to play the downside by shorting China stocks.

The only problem is that you can't.

Many investors seem to view the ProShares UltraShort FTSE/Xinhua China as a means of shorting this year's tremendous rally in China stocks. There are two main problems with this strategy. First, FXP shorts only Hong Kong-listed shares, which trade at much lower multiples than their mainland-listed counterparts and with a surprisingly low correlation.

Second, FXP shorts only the "FTSE/Xinhua China 25 index," which as it says is only 25 stocks. It is important to note that there is absolutely no way of shorting mainland-listed shares. Investors cannot short individual shares, and there are still no traded futures that would allow investors to short the indices. As a result, there are no funds through which investors can short the China market.