China: Best Play Of The Year?

Chinese markets have taken a hit recently, but not all parts of the market have suffered equally. With ETFs, you can hone your focus.

With the Chinese Year of the Tiger having kicked off on Valentine’s Day, many global investors are asking themselves whether market conditions there will show their portfolios some renewed love later in the month. Most regional analysts say they will—but for ETF investors, making the right choice of fund may be critical to success.

The start of 2010 has been a rough time for equities globally, but nowhere more so than in
China. By last Wednesday, the Shanghai Composite Index had slumped 8 percent for the year-to-date period, while
Hong Kong’s Hang Seng had dropped 8.7 percent.

Despite the sell-off, Hong Kong-based Morgan Stanley
China strategist Jerry Lou expects 2010 to be a “goldilocks” year for the country’s equities.

“We think 2010 growth will be high, inflation will be mild and policy exit will be moderate. For equities, this means a temporary Goldilocks bullish condition before inflation eventually bites (probably in 2011)” wrote Lou in a recent research note to the bank’s clients.

Markus Rosgen, chief strategist for Citigroup in
Hong Kong, concurs with the bullish prognosis. Rosgen points out that at 13.7 times earnings and 2.2 times book value, the emerging Asian equities the bank follows—which are over 30 percent weighted with Chinese companies—are trading around the same level as most global stocks, despite ostensibly higher growth.

Two Big Choices: EWH Vs. FXI

ETF investors looking to pile into Chinese equities have a number of choices, including whether to put money into China-specific funds or to move into
Hong Kong equities as a proxy for Chinese markets.

Two of the biggest China-related ETFs split this difference, but their performance year-to-date has been remarkably different. The iShares FTSE/Xinhua China 25 Index Fund (NYSEArca: FXI) has dropped in line with the indexes, falling about 8 percent, while the iShares MSCI
Hong Kong Index Fund (NYSEArca: EWH) has managed to stem losses to just 4.2 percent.

The big performance disparities are mainly the result of FXI’s dominant focus in financials. FXI is weighted a whopping 35 percent in China Construction Bank, Industrial and Commercial Bank of China, China Life Insurance, Bank of China and China Merchants Bank.

Chinese banks took the brunt of the late-January selling after renewed concerns of monetary policy tightening and after regulators forced banks to restrict their lending in the early parts of the year.

Strategists at Morgan Stanley foresee a slowing of new loan growth to the high teens in 2010 vs. around 30 percent last year, but don’t believe that will affect equity valuations unduly. Morgan Stanley also maintains that additional capital-raising by Chinese financial institutions this year is likely to be focused among the smaller players.

If that is the case, EWH’s two financial services holdings (Bank of East Asia and Hang Seng Bank) look like more precarious targets than FXI’s broad collection of Chinese megabanks.

Naturally, FXI and EWH are not the only options for investing in
China; there are in fact more ETF choices available for the country than for any other emerging market. Some of these alternative funds are beating the two dominant China ETFs by a hefty performance margin. For example, the PowerShares Golden Dragon Halter USX China ETF (NYSEArca: PGJ) is up 65.6 percent in the last year vs. returns of 45.13 percent and 54 percent for FXI and EWH, respectively. PGJ has less than 10% of its portfolio invested in financials, which could make it the go-to play for investors concerned about the health of the Chinese banking system.

PGJ’s top holdings include such volatile names as Yanzhou Coal Mining and the Aluminum Corp. of
China. In the past year, Yanzhou has more than tripled in value, while Aluminum Corp. of
China is up nearly 70 percent.

The SPDR S&P
China (NYSEArca: GXC) is another ETF offering more diversification than FXI. With 150 holdings, it splits the difference on financials exposure between FXI and PGJ while capturing a wide spectrum of the Chinese economy. As a result, it is often able to pare its losses more in market downturns.