China ETFs: A Red Flag for U.S. Equities?

China ETFs: A Red Flag for U.S. Equities?

We've seen it before: China's markets fall ill, and not long after U.S. investors are sick.

Edited by: Ron Day

If we were to play a game of “market calamity bingo,” in which a bingo card fills with things that tend to occur around major market declines, we’d find squares with titles like “high stock valuations,” “consumer optimism,” and “geopolitical risk.” Those conditions exist today.  

There’s one square investors may be surprised to find: “China.”  

When blue chip stocks of China-based companies underperform their U.S. counterparts by historically wide margins, it is usually not long until the S&P 500 SPDR Trust (SPY) gives way. 

Investment advisors and self-directed investors may want a look at the strange goings-on between the iShares China Large-Cap ETF (FXI) and SPY. FXI is a $4.1 billion ETF that is in its 20th year, and it contains all the “usual suspects” within the China market, the biggest stocks that in different cases are suppliers or competitors to the U.S. economy.  

FXI’s 58 holdings haven’t provided much of a diversification benefit to its price, or versus that of SPY lately. In the 12 months ended Monday, SPY is up 24% while FXI is down 33%—the same amount the Nasdaq 100 fell in 2022.  

China and U.S.: a Brief History of SPY vs FXI

More significantly, FXI suffered similar underperformance to SPY in the 12 months ended in early 2022, and in the autumn of 2008. Those were the precipice of two of the worst periods in SPY’s recent history.  

Bingo players take notice: When the U.S. market trounces the China market over a 12-month period, risk levels are rising, red lights are flashing.  

Ironically, in China the color red symbolizes luck, joy and happiness, and is the dominant color on the Chinese flag. But this shade of red (ink) is not something ETF investors who kept the faith in China amid the past few years’ economic concerns are feeling much joy about. 

For those curious about whether they can try to profit from a continue collapse in the Chinese stock market, there are levered ways to pursue that. However, for those who prefer not to use leverage and the wild price swings it potentially invites, the small but mighty ProShares Short FTSE China 50 ETF (YXI) might be worth a look. 

To those of us who scour the ETF marketplace looking for potential hidden gems, the fact that this ETF has been around since 2010, yet has only $8.4 million in assets, is one of two things: astounding or as expected, the latter case being that it reflects investors’ preference for those levered versions of equity hedging. How well has this inverse China ETF done, albeit with few noticing? Over the past three years, it has averaged 19.7% a year. That’s nearly twice the 32% cumulative total return of SPY over that period.  

Investing in China Stocks Through ETFs 

China’s issues are well known to global investors and are not limited to earnings and GDP figures. There has long been a concern that the world’s second largest economy overbuilt on a massive scale and is facing a long-term decline in population due to a generation of its “one-child” policy.  

This might be another instance of the U.S. being the nicest house in a rough neighborhood, or a true separation of the fate of two nations which are still closely tied in so many ways. ETF investors have a front row seat to what happens next, and they can pursue profits on the long and short side of both markets.  

Rob Isbitts' Wall Street career spans 5 decades and multiple roles, all dedicated to providing clarity to investors by busting classic myths and providing uncommon perspective. He did so as a fiduciary investment advisor, Chief Investment Officer and fund manager for 27 years before selling his practice in 2020. His efforts now focus exclusively on investment research, education and multimedia. He started ETFYourself and SungardenInvestment to provide straightforward commentary and access to his investment intellectual property for portfolio construction, stocks and ETFs. Originally from New Jersey, Rob and his wife Dana have 3 adult children and have lived in Weston, Florida for more than 25 years.