Sorting Through China ETF Choices

December 19, 2008

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:

 

Figure 1.

PGJ Performance

 

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:

 

Figure 2.

FXP Performance

 

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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