As the Chinese economy has surged over the last decade, investors unafraid to reach beyond their borders and embrace international equity investments have been handsomely rewarded. As a result of easing economic barriers and sound economic policies, China has now passed Germany for the number three spot on the list of the world’s largest economies. And many believe that it is only a matter of time before China passes Japan and the U.S. as well. Yet the portfolios of many U.S. investors maintain little exposure to the Chinese markets. “If you read the paper, you know that China is at least the second most important economy in the world today,” notes Kevin Carter, CEO and Chief Investment Strategist of AlphaShares. “Yet the average investor has less than 2% of their money in China and most have none.”
Bright Spot Under a Dark Economic Cloud
Despite a global downturn, China continues to expand, with the Institution for International Finance, a coalition of 370 of the world’s largest commercial and investment banks, projecting GDP growth of 7.5% in 2009 (Beijing’s official forecast calls for 8% growth this year). While these projections certainly represent a drop from double digit growth rates turned in earlier this decade, they are remarkable in an environment where most national economies are projecting year-over-year declines. China’s banks are relatively healthy, unemployment remains reasonable, and Chinese companies and investors have been among the most opportunistic buyers in the best “buyer’s market” in a generation. Carter notes, “when you consider that China is at least 5% of global GDP and is likely to represent 100% of global GDP growth this year, investors really need to ask themselves – do I own enough China? The answer is almost certainly ‘no.’
Going Beyond FXI
With the development of the ETF market, gaining well-diversified exposure to the Chinese markets in a cost-efficient manner has never been easier. But U.S. investors have been slow to embrace the wide variety of China ETFs on the market. A significant portion of ETF investments in China have been made through FXI, which tracks the FTSE/Xinhua 25 Index. Despite its popularity, the Xinhua 25 Index has some major drawbacks. First, the index is narrow, holding only 25 stocks at any given time. Second, its industry allocations are unbalanced, with no exposure to consumer discretionary or technology companies and significant overexposure to banks and the oil industry. For investors looking beyond FXI, there are several ETFs offering unique exposures to China:
- Claymore/AlphaShares China Real Estate ETF (TAO): This ETF tracks the performance of an investable universe of publicly-traded REITs deriving a majority of their revenue from China (including Hong Kong and Macau). TAO, which is the only ETF currently offering exposure to the Chinese real estate market, is essentially flat since its launch in July 2008. By comparison VNQ, which tracks the broad U.S. real estate market, is down more than 35% over the same period.
- iShares FTSE China (HK Listed) Index Fund (FCHI): This ETF seeks to replicate the performance of large- and mid-cap Chinese companies trading on the Hong Kong Stock Exchange. With more than 85 individual holdings, FCHI offers relatively broad exposure, although a single company (China Mobile Ltd.) accounts for nearly 15% of total assets. FCHI is up more than 33% so far in 2009.
- Claymore/AlphaShares China Small Cap Index ETF (HAO): With more than 135 individual holdings, HAO offers exposure to a broad, well-diversified basket of small-cap Chinese equities (those with a market capitalization between $200 million and $1.5 billion). Since its launch in July 2008, HAO is up more than 10%. IJR, which tracks the S&P SmallCap 600 Index, is down more than 20% over the same period.
- PowerShares Golden Dragon Halter USX China Portfolio ETF (PGJ): For investors wary of investing directly in Chinese equities, PGJ offers an alternative way to gain exposure to China. This ETF tracks the Halter USX China Index, which is comprised of U.S.-listed companies that derive a majority of their revenues from China. According to its prospectus, this allows the fund to “provide access to the unique opportunities of China while still providing investors with the transparency offered with U.S.-listed securities.”
A Compelling Case
The recent downturn has shown that despite reduced global barriers and an increased amount of cross-border investment, the correlation between the U.S. and Chinese markets is moderate at best, with China equities outperforming U.S. stocks in 2009. Despite numerous options and attractive returns, however, many investors have been hesitant to invest in China ETFs, opting for more traditional and developed markets in a period of market turmoil.
There is no guarantee that China will continue its rapid economic expansion into the next decade. The tremendous returns generated year-to-date obviously cannot continue indefinitely. And exposure to the Chinese markets certainly comes with its fair share of risks. But the arguments for inclusion of China funds in a well-diversified portfolio are compelling, particularly in our current economic environment.