Sorting Through China ETF Choices

December 19, 2008

 

For an inverse ETF, FXP has quite a bit of volume ... especially when you compare it with PGJ's volume in Figure 1.

Clearly, there is a long list of ETFs provided above, all with varying levels of exposures to China. The question to ask is, how would a China focused ETF fit within your portfolio?

Assuming a common asset allocation including exposures to U.S. equities, developed international markets and perhaps some broad emerging market exposure, it would be good to compare these with FXI:

 

Figure 3.

FXI Performance

(In the above graph: black represents FXI; EEM is red; EFA is blue and SPY is gold.)

 

Looks like a lot of movement in the same general direction. What about a longer, three-year chart?

 

Figure 4.  

FXI Performance (3-year)

(In this graph, the color coding and ETFs are the same as in Figure 3. The difference, of course, is that we're taking a three-year comparison.)

 

Again, you really have to wonder. From Figure 4, it would seem that a broad emerging market ETF like EEM behaves like a high-beta version of EFA.

Likewise, FXI looks to be a high-beta version of EEM.

Thus, as you "diversify" away from developed stock markets to emerging markets—and then further to China—investors may actually be anti-diversifying. In other words, by increasing their stake in emerging markets and China exposures, they may be focusing on return enhancement rather than risk (i.e., volatility) reduction. At least that's what history has shown. 

Any thought of China as a diversifier will depend highly on the "decoupling" theory of the economy from the western world and this theory further extrapolating to the capital markets.  Such a trend would be one played out in the longer-term. Thankfully, emerging market investing in general should be considered with a longer term mind frame as the drivers (like changes in demographics) assume such.

Despite this orientation and due to its inherent volatility, many investors will consider a position in a China ETF (and possibly emerging market ETFs in general) as non-core holdings and thus something to be traded tactically. I believe that the decision of whether to consider emerging markets as core or non-core holdings will be one many investors will have very soon. 

In these times of defensive-oriented thinking, it's important to consider the right balance between the focus on return enhancement versus risk reduction. For many investors who think we are closer to the bottom, perhaps getting back into the market is the priority, and even further, with high-beta exposures to those that have been hit hardest, like many areas of the emerging markets.

However, as any long-term investor likely realizes, moving away from the classic theory of diversification based on a mix of relatively uncorrelated positions results in having all your eggs in one basket.

After what we've all seen in the past year, even diversification has had limited use for us. This is true not only for asset classes such as emerging markets equities and commodities, but also strategies such as hedge funds.

Thus, investors are left to consider how best to think about these asset classes and strategies and determine for themselves if a different approach is required.


Richard Kang is chief investment officer and research director at Emerging Global Advisors. He welcomes comments and suggestions for future columns at: [email protected].

 

 

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