By increasing exposure to emerging markets and China, investors may be focusing on return enhancement rather than volatility reduction.
China is a case study of trial and error.
The country is relying less on outsiders and more on its own internal resources as it moves from pure socialism to some form of controlled capitalism.
Still, despite such a burgeoning profile of self-reliance, many U.S. investors wonder how they can invest in an economy whose largest companies are essentially run by the Politburo.
But few can doubt the country is a growing force in the global economy. The real dilemma facing exchange-traded fund investors in coming years is going to relate to how much of China they want in their portfolios.
Should emerging markets, in general, be considered a core holding? And whether broad exposure to developing stock markets is considered as a core or noncore holding, how does China fit into the mix?
Let's start by considering choices now available to ETF investors. The market can be divided in several different ways. You can invest through H-shares traded in Hong Kong or even companies in close proximity to China that benefit from their trade with this giant.
Looking at the universe of U.S.-domiciled ETFs, let's break down funds investing in Chinese stocks into these general categories:
- Direct exposure: These include five ETFs: Claymore/AlphaShares China Real Estate ETF (NYSE: TAO); Claymore/AlphaShares China Small Cap Index (NYSE: HAO); iShares FTSE/Xinhua China (NYSE: FXI); PowerShares Golden Dragon Halter USX China (NYSE: PGJ); NETS Hang Seng China Enterprises Index (NYSE: SNO); and the SPDR S&P China (NYSE: GXC).
- BRICs exposure: These include: First Trust ISE Chindia (NYSE: FNI); Claymore BNY BRIC (NYSE: EEB); iShares MSCI BRIC (NYSE: BKF) and the SPDR S&P BRIC 40 (NYSE: BIK).
- Mixed exposure: Using an even broader mix, you can invest in China through at least five different ETFs: PowerShares FTSE RAFI Emerging Markets (NYSE: PXH); iShares MSCI Emerging Markets (NYSE: EEM); SPDR S&P Emerging Markets (NYSE: GMM); Vanguard Emerging Markets ETF (NYSE: VWO) and the WisdomTree Emerging Markets High Yielding Index (NYSE: DEM).
Of course, you can also gain even greater indirect exposure through a variety of Asia Pacific funds. More than 10 separate ETFs are focused on that part of the world and hold small doses of Chinese representation.
So how do you decide with more than two dozen choices?
One way to sort through the pack is to understand that just because it has "China" in its name doesn't mean an ETF has exposure to just China.
For example, the Claymore/AlphaShares HAO had 62% exposure to China, 37% to Hong Kong and 1% to Singapore heading into October. It's possible that many of the Hong Kong positions have underlying exposures to China, but there is some analysis needed to go through each equity position to determine just how much of the business relates to operations in or with China.
As with many new or alternative asset classes, there is a wide array of indices that can be created to represent the market. This is very true for China-related indices. For example, if you plot the three ETFs with direct large-cap exposure to China, you'll notice quite a difference in returns for the past six months:
The key point from Figure 1 is that although they generally move in the same direction, there are times when the discrepancy between any two funds can jump to as much as 10%. Just check the periods between April and May or December of this year as prime examples. (Note: The black line represents PGJ; the blue line is GXC and the gold is FXI).
Not too long ago, you just selected an asset category and picked the one fund that was available, or if there were more than one, you selected the one with the lowest fee or some other highly simplified process. There is plenty of evidence to suggest that fees aren't the greatest concern to investors with highly specialized funds.
Note that of the three ETFs plotted, FXI has an annual expense ratio of 0.74%, while both PGJ and GXC are at 0.60%. However, FXI has roughly 15 times the assets of the other two combined. This is the same story with EEM versus VWO.
FXI was first to market, although only a few months ahead of PGJ. Still, the market has clung to FXI as it has with its inverse cousin, The ProShares UltraShort FTSE/Xinhua China 25 ETF (NYSE: FXP). Here is the 12-month price chart for FXP: