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China's time is now
Sure, investing in the Asian economic giant can be a bit scary, but the rewards outweigh the risks. Here are five ways to play China safely.
Tim Middleton
China is the great investment theme of this decade, as computers were in the 1990s, radio in the 1920s and railroads in the 1870s.
But China is scary. Stocks on one of its exchanges lost nearly 10% in a single day in February -- on fairly slight news that the U.S. economy might weaken. My colleague, Jim Jubak, has issued a drumbeat of warnings about excesses in China.
But if anything, China is more appealing than its advocates claim. They point to 10% annualized growth in gross domestic product. But to understand that figure, notes Zachary Karabell, co-manager of Alger China U.S. Growth Fund (CHUSX), you have to remember that the nearly 20% growth rate of cities like Shanghai is watered down by the several hundred million rice farmers who are showing no growth. And it's the urban growth that really matters to the global economy.
China isn't nearly as scary as it seems. Mutual fund investors, in particular, don't plunge 100% into anything, and taking a modest stake in China in an otherwise diversified portfolio can push up returns substantially while barely moving the risk seismometer.
5 roads to China
Alger China is one of five funds I've identified that can help you accomplish this portfolio alchemy. It and the others -- three exchange-traded index funds and one other actively managed mutual fund -- differ markedly from each other, so you can choose among them based on how closely tailored they are to your personal requirements.
China funds' impact in diversified portfolio Fund Diversified portfolio risk* 3-year return
iShares MSCI HongKong (EWH, news, msgs)
7.94
13.37%
Alger China U.S. Growth (CHUSX)
8.35
13.68%
PowerShares Golden Dragon Halter USX China Portfolio (PGJ, news, msgs)
8.46
13.34%
iShares FTSE/Xinhua China (FXI, news, msgs)
8.47
14.45%
T. Rowe Price Emerging Markets (PRMSX)
8.68
14.44%
Notes: as of March 31, 2007. * Standard deviation. In some cases, three-year returns are based on underlying index, if fund lacks three-year record. In each case, fund represents 10% of a portfolio that has this balance of assets: 30% S&P 500 Index ($INX), 20% Russell 2000 Index ($RUT.X), 30% MSCI EAFE Index and 10% Lehman U.S. Aggregate Bond index.
Sources: MSN Money, Morningstar
Surprisingly, China's most famous offshore territory, Hong Kong, offers the least-volatile access to it. The striking difference between iShares MSCI HongKong Index (EWH, news, msgs) and a companion iShares ETF, iShares FTSE/Xinhua China Index (FXI, news, msgs), explain why.
Safe harbor
Hong Kong, unlike the mainland, is a developed market, represented by part of the MSCI EAFE Index, the broadest measure of advanced foreign economies. The ETF invests strictly in companies whose business is centered on the local, rather than the mainland, economy.
As on any rich, populous island, real estate dominates the Hong Kong economy. A third of the ETF's assets are in developers and managers like Hutchison Whampoa (HUWHY, news, msgs), which also operates port facilities. Banks make up 13% of its assets, among them Bank of China Hong Kong Holdings (BHKLY, news, msgs). More than 5% of the ETF's assets are in specialty retailers.
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Very different is iShares FTSE/Xinhua China Index. Real estate exposure is negligible, but banks like Industrial & Commercial Bank of China Asia and other financial companies account for 40% of assets. Chinese companies' access to capital markets is severely limited; most can only borrow from banks, whose fortunes mirror those of their customers.
Communications is a vast market in China, and China Mobile (CHL, news, msgs) accounts for nearly 10% of the ETF's assets. With its much more direct links to the mainland economy, the Xinhua index is more volatile than that of Hong Kong and has been more rewarding. A dollop of this fund boosts the portfolio's deviation to 8.46 and its annual returns to 14.45%.
Both of the iShares ETFs invest in companies listed on the Hong Kong Stock Exchange. PowerShares Golden Dragon Halter USX China Portfolio (PGJ, news, msgs) limits itself to Chinese companies that are listed on U.S. exchanges. Most of the highest quality mainland companies are listed here, including China Mobile and PetroChina (PTR, news, msgs), and each of these accounts for about 6% of the PowerShares portfolio.
The Halter index weights these and other Chinese companies differently than iShares, however. Xinhua gives China Mobile and PetroChina a combined 18.4% of assets, half again their weighting in the Halter index.
That is due to differences in design between the two indexes. Xinhua represents the 25 largest Chinese companies, whereas Halter includes more than 60 names intended to round out the total economy. As a result, it has substantially lower assets in big banks and correspondingly more in smaller concerns. Technology, which is absent from Xinhua, accounts for more than 10% of the weighting of Halter, according to Morningstar.
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If China's industrial development continues, global demand for commodities should grow as well. MSN Money's Jim Jubak says until China announces a policy shift -- toward rural development, for instance -- investors don't need to hedge against an economic slowdown.
But since its introduction at the end of 2004, Xinhua has greatly outperformed Halter, gaining 14.2% in 2005 and 83.2% last year. PowerShares Halter declined 3.3% in 2005 and gained 53.1% in 2006.
Indirect investments
Alger China U.S. Growth has yet another strategy. Unlike other China funds, it invests a third of its assets in American companies and an additional large fraction in non-U.S./non-Chinese companies with a big presence in the mainland economy.
Karabell argues: "China's public equity markets, or Hong Kong's, aren't really a good proxy for the China story. It manifests itself through international corporations. You need to look at China more as a growth theme than a geographic region."
This diversification lowers the fund's volatility, but also its returns.
T. Rowe Price Emerging Markets (PRMSX) follows diversification in another direction. China as a region and as a theme play a significant role in the fund's holdings, but it is only one of several. The fund has important stakes in companies from South Korea to Turkey.
Chinese companies represent 13% of this fund's portfolio, but China's influence doesn't end there. Companhia Vale do Rio Doce (RIO, news, msgs) of Brazil is an example of an indirect China play. China consumes steel voraciously, but its own iron ore is scarce and of poor quality. RIO is a world-leading producer of high-quality iron ore.
The China theme is pervasive among emerging-markets funds. The T. Rowe fund has, however, distinguished itself among its rivals and is a Morningstar Fund Analyst Pick.
In the case of each of these funds, I have analyzed them as representing 10% of a portfolio that is otherwise devoted 30% to big-cap domestic stocks, 20% to small caps, 30% to foreign developed-market stocks and 10% to U.S. bonds.
Absent China, that mix of assets has produced outstanding results: annualized three-year returns of 12.8% with a standard deviation of 7.85. Adding China, however, has boosted returns by as much as 1.6 percentage points annually, with added risk of no more than 0.8 percentage point -- a very favorable balance of risk and reward.
As a prescription for portfolio success, the story is this: Take 10% of China and see me in three years. Your net worth will be healthier.
