Are China ETFs a Good Investment?

Robert Hsu, May 04, 2006

One of the questions I get most frequently from your fellow readers -- and from investors in general: Is there a China Exchange Traded Fund (ETF) for American investors? The answer to that question is yes, but the question of whether it's a good investment is a different one entirely.

China ETFs: Missing the Real Story

The most popular China ETF for American investors is the iShares FTSE/Xinhua China 25 Index (NYSE: FXI). We've talked about it before, but based on the number of questions I've received recently, I know many of you are wondering about it.

The Barclay-sponsored FXI has actually been highly successful since its October 2004 launch, with over $2.8 billion in assets. It has the standard ETF advantages of low costs (annual expenses 0.74%), diversification (26 stocks) and simplicity.

As investors continue to look for ways to play China and the strengthening Chinese yuan, billions have piled into FXI over the past year as a quick and easy way to gain exposure to the world's fastest growing economy. International fund managers have bought Chinese stocks to the tune of $6 billion since the year began, driving up FXI's share price by 30% YTD.

That's certainly a nice start to the year, but I do not believe that kind of performance is sustainable over time because FXI has one huge drawback: All of the 26 companies in the ETF are at least partially state-owned and controlled. When investors look past the momentum to a more fundamental analysis, they'll see:

1. State-owned enterprises (SOEs) in general are in a significant decline, constituting 50% less of China's economy than just eight years ago.

2. Most SOEs are poorly run, inefficient, and susceptible to corruption and political interference.

3. It is often difficult to trust the quality of earnings or management. FXI selects its components based mainly on size, not quality, which is dangerous over the long term.

As you know, there are rare cases where state ownership in a company can be good for investors, such as when the government grants monopoly or oligopoly power and specific protections. Some of these companies are also reasonably well-managed. The few SOEs we're investing in fall into this category.

(In fact, I have a brand new recommendation in the next issue of China Strategy that falls into this category. It will be available for you on the website tomorrow, and I'll be sure to email you when it's ready.)

The largest holding in FXI right now is China Mobile (NYSE: CHL), one of our recommended companies and the biggest mobile telecom operator in the world. As we've talked about, the company is adding four million new users a month and has monopolistic pricing power in an essential service that Chinese consumers are willing to spend money on. These factors single out CHL as China's single top blue-chip stock.

But here's where I have concerns about index funds in general and FXI in particular. Does it make sense to buy all the lesser Chinese state-owned companies as well as China Mobile? And that includes problematic landline companies, questionable banks and other former government bureaucracies. Clearly not, but with FXI, you get them all -- and many other SOEs that continue to lose money and influence.

Despite FXI's strong performance so far this year, the China-based companies in our portfolio have actually outperformed it. That's because the real stories of the China Miracle are the emergence of a powerful new middle class, the globalization of businesses, the 50 million entrepreneurs being unleashed and the awesome wealth-creation opportunities these bring.

You're much better off constructing your own portfolio and filling it with quality stocks positioned to grow for the foreseeable future -- just as we're doing in China Strategy. Investing in an ETF may be simpler, but your stocks will be chosen for you. In the case of FXI, they'll be chosen by Xinhua, the Chinese government's news and propaganda arm, and based on fixed criteria (primarily size), not the analysis, research and insight necessary to truly get the most out of the China Miracle.

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