Newcomers to investing in China have learned the hard way that a country doesn't automatically generate big investment returns just because it's an economic juggernaut.
The Chinese economy has expanded at an annual rate of about 9 per cent in 2005, which is spectacular by any standard and consistent with the growth pattern of the past few years. Yet recent returns from many China-focused mutual funds, exchange-traded funds and closed-end funds have been mediocre at best and quite often disappointing.
China is still a buy, whether you jump in directly or take the approach of investing in funds that focus on a mix of emerging economies. But the experience of the past few years shows you'll need to be a patient long-term investor to get decent results.
Expectations about China's potential for investors were stoked by the huge returns generated in 2003. The largest China mutual fund available to Canadian investors, the $123-million AGF China Focus Class, made 63.4 per cent that year, while the smaller Talvest China Plus made 40.5 per cent.
Buying into an investment niche after a huge year is almost always an error, and China funds have been no exception. Globefund.com shows that five of eight funds with significant China exposure are down this year, and that each of the four funds that were around for all of 2004 lost money.
Mark Mobius, an expert on emerging markets who manages mutual funds for Franklin Templeton Investments, said the problems are with China's stock market and not with the country or its economy. "There's no question that China is booming and that there's a lot of investment still going in," he said in an interview by telephone while passing through Shanghai.
One issue weighing on the market is a rush of initial public offerings of major Chinese corporations, Mr. Mobius said. The pace of IPOs this year is expected to be double or triple last year's level and investors have been selling some of their existing Chinese holdings to participate.
Another issue flows directly from efforts by the Chinese government to liberalize the country's stock markets. To follow what's going on here, you need to understand the various types of Chinese stocks. There are A and B shares listed on Shenzhen and Shanghai exchanges -- the A shares are denominated in yuan and reserved for Chinese citizens plus a few foreign institutional investors, while the B shares are available to foreigners and denominated in U.S. dollars. There are also H shares listed on the Hong Kong exchange.
All these venues for trading Chinese stocks suggest a wide-open market, but that hasn't been the case. In fact, something like two-thirds of the shares of Chinese companies were government controlled and non-tradeable until earlier this year, when a plan was announced to sell off these shares gradually. "The government wants to invigorate the A-share market, which has been a disaster for a number of years now," Mr. Mobius said.
The selloff of state-controlled shares has caused some volatility for Chinese stocks as investors consider the implications for various individual companies. But the feeling of many observers is that is part of a process of market reform that will eventually create a more solid and attractive market for investors. "Long term," Mr. Mobius said, "the outlook for China is good and the outlook for its capital markets is good."
So the case for investing in China remains intact, even if the euphoria is gone. The question now becomes how best to tap into the country's growth.
Chinese stocks often turn up in the portfolios of emerging markets funds, but only as a small component. In the Templeton Emerging Markets Fund, managed by Mr. Mobius, China accounts for about 15 per cent of the holdings. An alternative would be to look at a small niche of funds that invest in all or part of the so-called BRIC group of powerhouse emerging economies -- Brazil, Russia, India and China.
There's a diversification argument for these sort of funds, but if you're keen on China itself then you'll want a more direct investing vehicle. China mutual funds are an option, although they're not quite as focused on the Chinese market as you might think.
Most of these funds invest in the shares of companies based in China, while also holding companies that stand to benefit from China's economic growth. That's a pretty vague mandate. Another issue is that some China funds consider it part of their mandate to invest in Taiwan, Hong Kong and, in at least one case, other Far East countries.
This lack of precision is a major reason why finance professor Eric Kirzner thinks the best pure China investment on the market today is an ETF listed on the New York Stock Exchange called the iShares FTSE/Xinhua China 25 Index Fund. "If you want to be in China, then you want the most direct way to do it," said Prof. Kirzner, who teaches at the University of Toronto's Rotman School of Management and writes for the MoneyLetter, an investing newsletter. "This is the closest thing that I've found."
The index on which this ETF is based comprises 25 of the largest, most liquid Chinese companies, including China Mobile, PetroChina and China National Offshore Oil Corp., the energy company that made an unsuccessful attempt recently to buy California-based Unocal Corp.
The FTSE/Xinhua China fund was launched a little over a year ago and the returns so far look good when compared with competing vehicles. The units had a year-to-date gain of about 4.5 per cent as of midweek, and that reflects an October pullback of 7 per cent.
The main rival to the FTSE/Xinhua China fund is an ETF that trades on the American Stock Exchange called the PowerShares Golden Dragon Halter USX China Portfolio. The underlying index in this case is made up of 49 U.S.-listed companies that derive most of their revenue from the Chinese market, which in practical terms means it invests to a large extent in Chinese companies listed on U.S. exchanges.
The Golden Dragon Fund was launched in early December and so far in 2005 is down about 8 per cent. However, back testing of the underlying index shows that a $10,000 investment made at the beginning of 2000 would have grown to $24,599 as of the end of last year, compared to $9,179 for the S&P 500 stock index.
Daily trading volumes for the FTSE/Xinhua China fund are about 10 times those of the USX China fund, which says that the former ETF has earned greater market acceptance. Even so, Prof. Kirzner says investors must exercise caution on two fronts.
First, there has to be recognition that, given China's status as an emerging market, an investment in 25 of the largest companies in the country cannot be equated with putting money into U.S. or Canadian blue chips. Second, don't buy into this or any other China fund looking for the kind of quick score that you sometimes get from investments in emerging markets.
"If your horizon is a year or two, that's not long enough," he said. "This is really a 10-year investment."
Advice to invest for the long term may sound like pure boilerplate, but in this case it has a practical application because the maturation of China's stock markets is happening at a slower rate than its economy is growing.
"China is obviously going to be one of the dominant economies, if not the dominant one," Prof. Kirzner said. "But it doesn't matter how many good companies you have, if they're not traded in a liquid, accessible market."
The China conundrum
China is one of the worlds fastest-growing economies, but the rewards from investing in its stock markets lately have been puny. Here's a selection of funds that investors can use to get exposure to China, along with their recent and longer-term returns.
MUTUAL FUNDS As of Sept. 30, 2005
| FUND | MER | MINIUM INVESTMENT | YEAR-TO-DATE | 1-YEAR | 3-YEARS | 5-YEARS |
| AGF China Focus Class | 2.99% | $1,000 | + 1.69% | + 10.57% | +18.69% | +12.65% |
| BMO Greater China Class | N/A | 500 | Ð 8.85 | Ð | Ð | Ð |
| Dynamic Greater China | 3.74 | 500 | Ð 4.87 | + 1.56 | Ð | Ð |
| Excel China | 5.72 | 500 | Ð 11.83 | Ð 5.39 | Ð | Ð |
| Excel India China RSP | 2.90 | 500 | Ð 0.04 | Ð | Ð | Ð |
| HSBC Chinese Equity-I | 2.74 | 500 | + 1.21 | + 11.19 | Ð | Ð |
| MIX China Opportunities Class | 2.88 | 500 | + 1.31 | + 13.12 | Ð | Ð |
| Talvest China Plus | 3.21 | 500 | Ð 9.27 | + 2.68 | +8.36 | -1.29 |
| Templeton BRIC Corp. Class | 2.79 | 500 | Ð | Ð | Ð | Ð |
EXCHANGE-TRADED FUNDS As of Oct. 26, 2005
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| --------------------RETURNS-------------- | ||||||
| FUND | STOCK SYMBOL | MER | YESTERDAY'S CLOSE | MONTH | YEAR-TO-DATE | 1-YEAR |
| ishares FTSE/Xinhua China 25 Fund | FXI (NYSE) $U.S. | 0.74% | $57.13 | -8.4% | +3.0% | +12.9% |
| Power Shares Golden Dragon Halter USX China Portfolio | PGJ (ASE) $U.S. | 0.60 | 12.96 | -8.0 | -10.7 |
© The Globe and Mail
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