China ETFs Navigate a Unique Market

Wednesday, May 20, 2009

Many view China as the most likely sizeable country to generate long-term growth, and there are plenty of ETFs which can give investors exposure. But China is volatile, and its unique stock and currency trading practices deserve close examination. Like nearly every country, China has taken its lumps in 2008 and 2009 and has since bounced back somewhat:

The above graph shows the S&P 500 vs. two moderate cost and popular ETFs: the iShares MSCI Hong Kong ETF (NYSEArca:EWH) and SPDR China ETF (NYSEArca:GXC), with annual fees of 0.54% and 0.6% respectively. Another broad-based ETF is iShares FTSE/Xinhua China 25 ETF (NYSEArca:FXI), with annual fees of 0.74%, and iShares FTSE China (HK Listed) ETF (NasdaqGM:FCHI), annual fees of 0.74%.

Valuations appear reasonable. At the end of Q1, GXC's Price/Earnings stood at 10, for instance. Not bad compared to about 12 from Standard and Poor's.

Clearly Chinese stocks are volatile, but so, too, are US stocks. Traditionally emerging markets' volatility has been downplayed because traditionally low correlation to US stocks has reduced the more critical portfolio volatility. Unfortunately, rising correlations of global equities have weakened this argument. A glance at the above charts shows that China can deviate short-term from the US and still have substantial correlation over time. This should be no surprise since the two countries are so intertwined economically. So China is now a play on returns, pure and simple.

A surprise to many ETF investors is that China ETFs own few or no stocks on actual Chinese stock exchanges. Most of their holdings are Chinese firms listed in Hong Kong and New York or are offshore-based firms with primarily Chinese business dealings. Restrictions against foreign capital have made it impractical for ETFs which depend so thoroughly on liquidity to trade primarily on the Shanghai or Shenzhen exchanges. EWH stands out with some firms which have modest Mainland dealings, although economic ties with the Mainland will continue to grow. Although Hong Kong is a part of China now, politically it acts as an independent city-state.

Some observers charge China with keeping its best stocks for its own investors, but an eminent economist familiar with China disagrees. Burton Malkiel, author of A Random Walk Down Wall St., says China actually has a policy of sending the most professionally managed and transparent (ie., not corrupt or controlled by government bureaucrats) companies abroad so that they may attract stable foreign investment. ETFs represent investors best by staying offshore, for now.

Even China's currency has its little twists, and these should help China ETFs. The People's Republic purposely depresses its currency to help exports but also allows it to gradually appreciate against the dollar. Most observers expect China's renminbi to continue to appreciate annually in low single digits. Even though China ETFs buy most of their holdings with Hong Kong or US dollars, they represent assets on the Mainland, and we expect these to continue to rise with the renminbi once the global economy stabilizes:

For a more direct currency play there are two ETFs:

  • Van Eck Market Vectors Chinese Renminbi/USD ETN (NYSEArca:CNY), annual fees: 0.55%
  • WisdomTree Dreyfus Chinese Yuan ETF (NYSEArca:CYB), annual fees: 0.45%
  • Other more specialized plays on China include:
  • Claymore/AlphaShares China Small Cap ETF (AMEX:HAO), annual fees: 0.7%
  • PowerShares Dynamic Asia Pacific Opportunities Portfolio ETF (AMEX:PUA), annual fees: 0.8%
  • PowerShares Golden Dragon Halter USX China Portfolio ETF (AMEX:PGJ), annual fees: 0.7%

The following dual country ETF might be of interest to investors who want to play India and China in one trade: First Trust ISE Chindia ETF (NYSEArca:FNI), annual fees of 0.7%.

There is a real estate play for China in Claymore/AlphaShares China Real Estate ETF (NYSEArca:TAO), with annual fees of 0.65% .

One leveraged ETF serves the country: ProShares UltraShort FTSE/Xinhua China 25 ETF (AMEX:FXP), with annual fees of 0.95%.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.