China: ETFs For Investing In The Dragon by Ryan Barnes, Capital Cube

U.S. investors who have been trying to make money on Chinese stocks feel like they’ve been running a gauntlet for the past decade. One would think it should be simple enough to make money betting on an economy that has more than tripled in size since 2005 (our economy is up a much more pedestrian 34% in that time). Alas, investing in China has been anything but predictable, especially in 2014. After being one of the worst international investing spots to start the year, Chinese equities have roared back this summer, culminating in a nearly 5% rise last week in what was the best single week since February of last year.

There’s no silver-bullet reason why this is the case – instead there are a litany of smaller reasons, all part of investing in the quagmire that is China. On one hand you have an economy in the 2nd or 3rd inning of a very long game, but on the other you have a nation with only one foot in capitalism’s door (and no feet in democracy’s door). Foreign investment is strictly limited by quotas. The currency is notoriously forced down. Reporting requirements for listed stocks are muddled, and fair competition among domestic businesses is non-existent. These are big factors as to why a nation growing at 7% + per year has stock market trading at 10 times earnings, and why that multiple has been compressed by half in the past decade.

The Bull Case

Did I mention that GDP has tripled in less than 10 years? It bears repeating. Not many places on the globe talk about trying to “manage” their 7.5% – 8% GDP growth targets. Humble investors like me who try to find long-term trends can do little but drool over the demographics, the sheer numbers involved when talking about the population in China, and the markets yet untapped.

Take a company like China Mobile Ltd. (ADR) (NYSE:CHL), for instance. Yes, it is far and away the market share leader for consumer telecom in China. But China Mobile has just short of 800 million paying customers. 800 million…that’s more than twice the entire population of the United States.

So in essence, the bull case boils down to: Avoid China at Your Own Peril.

The Bear Case

As shown by the performance of Chinese equity-based indexes the past few years, investors have been concerned about China’s ability to manage its long-term growth forecasts without further deregulation of the financial industry, as well as interest rate liberalization, more free floating of the currency, and fewer limitations on current account flows.

We’re also concerned about what appears to be a solid-sized real estate bubble, recent slowdowns in manufacturing (a big no-no for the world’s largest exporter), a 5-year high in bad loans in the financial sector, and a sharp reduction in Foreign Direct Investment (FDI) coming from international investors.

Bull Or Bear?

While I’m sure there will be more volatile periods for Chinese equities, I think the bull case will win out over time. Most of my bearish data points are pretty fresh, so it’s not like investors haven’t had time to process the information. For now, China stocks are climbing the wall of worry with ease, and I think there’s just too much long-term growth potential to be out of the world’s second-largest economy. And 10x earnings starts to look even more attractive as I survey what looks like a fully valued U.S. equity market.

I’m also thrilled about the prospects for the new pilot program to be launched next month which will allow trading in local currency for investors via the Hong Kong stock exchange. Longer-term, I’m told by people who know a lot more about China than myself that the younger party leadership is eager to see more financial reforms, and wants to see China more fully integrate into the global economy.

I’m bringing you two interesting ETFs today that I think are the safest ways to currently approach baskets of Chinese equities. Investors with longer time horizons should make sure that China represents at least a proportional share of your international stock allocation. Personally, I would advise making China at least 25% of your total international equity allocation.

iShares China LargeCap ETF  – The Safest Play?

On the face of it, the iShares FTSE/Xinhua China 25 Index (ETF) (NYSEARCA:FXI) should win out for the “safest” category simply because it’s the largest by assets (at roughly $6 billion AUM), has a long performance history at over 10 years, and is managed by the largest ETF house – BlackRock, Inc. (NYSE:BLK). But there are definite red flags on this ETF for me, mainly in that there are only 25 holdings, and over 50% of holdings are in the financial sector.

iShares China LargeCap-ETF-Sectors

This is a natural outcome when you consider that the FXI will only invest in shares that trade on the Hong Kong Stock Exchange, so the pool of options is limited to the largest, most established firms in China. So far these are centered around the largest financial institutions. So there’s a basic tradeoff here at the FXI; you get more stringent listing and reporting requirements (and hopefully more transparent financial results), but you give up some diversification in the process.

Deutsche X-trackers Harvest CSI 300 China AShares Fund- Access to Home Base

Investors should start paying attention to the few – but growing – avenues to domestic Chinese A-shares. These will typically be more mid-cap firms as opposed to largecaps, but by investing in Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR) you will get much more even sector distribution, as well as a base of 300 stocks as opposed to just 25. The expense ratio is 0.82%, which is quite fair given the increased frictional costs associated with getting access to local Chinese markets.

This is a very new fund, so there isn’t a long operating history to evaluate, but so far investors have been plowing into ASHR, driving up AUM over 200% in just a few months. There’s clearly a big appetite for local A-shares, and this hasn’t gone unnoticed in China, where they are steadily increasing asset quotas and foreign access through their RFQII program.

Deutsche-X-trackers-Harvest-CSI-300 China AShares-Fund

China’s Next Decade

As to whether holding Chinese stocks is a good, consistent play in the next decade, I say this: right now China’s economy is based on the government being the lone captain of the ship; they’re the only ones steering the economy. The aggregate Chinese consumer (all 1.2 billion plus of them) are a distant second. Here in the U.S., consumer spending makes up nearly 70% of the economy. If China really pushes to reduce that ratio

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