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The Right and Wrong Ways to Invest in China ETFs

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Make no mistake about it, China is back on track.

The nation suffered through weak stretch in 2012, but the economic outlook appears brighter for this year and beyond. Growth is expected to be at 8% for the calendar year as exports pick up thanks to a solid U.S. market, and a much more stable situation in China’s biggest trading partner, the EU.

This trend has once again rekindled American investor interest in the world’s second biggest economy, causing many to tilt portfolios to stocks, or funds, that have high levels of exposure to the nation.

How to Buy China

Investors can access China directly via a few companies already. Some Chinese mega caps are already listed on American exchanges such as China Mobile (CHL - Free Report) or China Petroleum & Chemical (SNP - Free Report) .

Meanwhile, plenty of American firms are largely driven by their Chinese growth prospects, so these could be considered ‘tangential’ plays on the Chinese economy, such as Yum Brands (YUM) or Coach (COH). But, in my opinion, both of these strategies pale in comparison to an ETF approach for the China market (see China ETF Investing 101).

That is because an ETF allows investors to buy up shares in a variety of Chinese companies in a single ticker, many of which wouldn’t be investable by Americans outside of the fund world. These funds also help to reduce on the risk of a single blowup in the Chinese market, as the diversification benefits inherent in ETFs helps to cut down on the pain from company specific issues.

Furthermore, ETFs usually offer up decent liquidity, something that may not be there with some Chinese ADRs. This can be very important in the fast-moving Chinese market, as the country can still see large bouts of volatility in short time periods.

China ETFs

Usually, when investors think of ‘China ETFs’ the one that comes to mind is the iShares FTSE China 25 Index Fund (FXI - Free Report) . This product is easily the most popular and well-known in the space, as it sees average volume of about 17 million shares a day with assets of over $9 billion.

The fund is by far the oldest China ETF on the market, having made its debut in 2004. However, while the product might have impressive volume levels and widespread investor interest, it makes many ETF analysts like myself cringe.

Why FXI is a Weak Choice

While the product has done a great service in opening up China, and getting the nation into many investor portfolios, it has outlived its usefulness. There are plenty of better choices out there for most investors, and for a variety of reasons (see The Key to International ETF Investing).

First, investors should note that despite having an enormous asset base, FXI is actually one of the more expensive China ETFs on the market today. The product charges 72 basis points a year in fees even though it holds large cap stocks, the same fee that PEK charges although this China fund focuses on harder-to-obtain local A-Shares and swaps for its exposure.

If that wasn’t enough, the product is heavily concentrated into a few sectors, namely financials and energy. In fact, of the limited 25 stock portfolio, over 50% goes to financials, while another 20% goes to the oil and gas sector (read Do ETFs Suggest that the China Panic is Over?).

Telecom, basic materials, and real estate round out the rest of the fund, meaning that a number of key sectors receive no weight at all in the product. Think about that for a second. FXI offers nothing to either consumer sector, health care, utilities, or industrials, putting a full 95% of assets into large cap stocks.

While this strategy certainly promotes safety, one can easily argue that it misses out on what many investors believe will be the more dynamic corners of the Chinese economy going forward. It also zeroes in on China’s biggest state-owned firms which probably don’t have a whole lot of growth left anyway, meaning that investors may not tap into the real China growth story with FXI.

Plenty of Better Choices

Fortunately, the explosion of ETFs over the past few years has given investors a number of other options to use in the China ETF world. Many of these products address the severe issues in FXI highlighted above, and thus could be better picks for China ETF investors, including the following three funds:

SPDR S&P China ETF (GXC - Free Report)

This ETF is the second most popular China fund on the market today with over $1.2 billion in AUM. The product has solid volume of about 200,000 shares a day so liquidity should be ample in this product.

GXC is also a bit cheaper than FXI, charging investors just 59 basis points a year in fees. This makes it one of the lowest-cost choices in the space, while still having great liquidity (read Three Excellent Dividend ETFs for Safety and Income).

Its portfolio consists of a robust 200 stocks, stretching across all the industries. Financials and energy do make up the top two in this product, but technology (12%) and industrials (9%) round out the top four spots.

Guggenheim China Small Cap ETF (HAO - Free Report)

For a focus on smaller firms in China, HAO could be the ticket. This product tracks the AlphaShares China Small Cap Index, which charges investors 70 basis points a year in fees.

Assets under management for this product are approaching $400 million, while the average daily volume is a solid 200,000 shares a day as well. This suggests that despite the focus on small caps, the fund should see high levels of liquidity for most investors.

The ETF holds over 240 firms and it doesn’t put more than 2% in any single security, so company specific risk is pretty much non-existent. The sector exposure is pretty solid as well, as energy and financials account for just 5% of total assets.

Instead, industrials, consumer cyclical, and basic materials make up half of the fund, giving this product a very different tilt. Investors should note, however, that the mid and small cap focus of HAO does make it a bit volatile, so risk averse investors should be cautious with this product (See 4 Best ETF Strategies For 2013).

Global X China Consumer ETF (CHIQ - Free Report)

For those seeking a pretty big departure from what is in FXI, this Global X fund could be an interesting alternative. The product only buys Chinese consumer stocks, making it a great pairing for an FXI investment, or a targeted play on one of China’s key growth segments.

This is done by focusing on the S-BOX China Consumer Index, a benchmark that has about 40 stocks in its basket. It is tilted towards cyclical consumer stocks (48%), while mid caps dominate from a cap perspective.

In terms of sectors, food products take up roughly 18%, while automotive, and specialty retail account for the rest of the top three. Assets are relatively well spread out, as no one company makes up more than 6.5% of assets, although automotive and food firms do dominate much of the top ten holdings.  

The approach has been relatively popular with investors, as the ETF has over $200 million in assets and average volume above 130,000 shares a day. The total cost is pretty competitive too, coming in at 65 basis points a year, which is surprising given the targeted exposure in the fund (read Is It Time to Buy China ETFs?).

The Bottom Line

Why anyone is still holding FXI is beyond me. The product is overly concentrated, expensive, and has no holdings in some of the country’s key growth sectors. The only saving grace of the ETF is that it is very liquid, so maybe it can be argued to be a good pick for short-term traders.

Anyone else though would be better off looking at some of the aforementioned ETFs instead. Not only are they cheaper, but their exposure seems poised to make them better picks for most investors over the long haul, which is probably what you should be focused on when investing in China ETFs anyway.

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