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This China Play Is Too Expensive

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Many people believe that China will be the 21st century's biggest economic success story. But as investors flood the Asian superpower with investment capital, smart investors need to distinguish good ways to invest in the world's second largest economy from bad ones.

Jumping on the China bandwagon
Last week, Van Eck Global unveiled its Market Vectors China ETF (NYSE: PEK  ) . Given that the Chinese ETF market is already quite crowded, with giant iShares FTSE Xinhua China 25 (NYSE: FXI  ) commanding over $8 billion in assets, yet another Chiense ETF doesn't seem all that noteworthy at first glance.

But what sets the Market Vectors offering apart is that it claims to be the first U.S.-listed exchange-traded fund to offer access to what are known as A shares. Chinese stock markets are tightly regulated, and for the most part, only Chinese investors are allowed to own the A shares that trade on China's two main stock exchanges. Foreign investors are only allowed to own such shares if they meet the requirements of the Qualified Foreign Institutional Investor system.

Conversely, some of the Chinese companies you're likely most familiar with don't actually trade on stock exchanges within mainland China. For instance, neither Baidu (Nasdaq: BIDU  ) nor China Mobile (NYSE: CHL  ) have shares listed on Chinese exchanges; China Mobile has H shares that trade in Hong Kong, while Baidu trades only on the Nasdaq.

Van Eck's argument is simple. The stocks that most Chinese ETFs own represent only a small subset of the entire Chinese stock market. As a result, to get exposure to the entire Chinese economy, you need some vehicle to gain access to A shares. And that means buying the Market Vectors ETF.

Worth any price?
Unfortunately, investor demand has far eclipsed the ability of the new ETF to deliver that A share exposure. As of Friday, the trading price of ETF shares was more than 14% above their net asset value (NAV). That kind of situation is rare for ETFs; typically, the ability of institutional investors to create new ETF shares makes big premiums into arbitrage opportunities.

What may be causing the problem here, though, is that the Market Vectors fund doesn't actually hold A shares directly. Instead, it enters into swap derivative contracts with Credit Suisse to try to track an index of Chinese A-share companies. It will be interesting to see whether the fund will successfully minimize its tracking error.

The combination of derivative exposure and premium pricing makes the new Chinese ETF unattractive right now. Until Van Eck's ETF gains enough liquidity to see its premium disappear, buying shares carries a big risk of losses no matter what the Chinese stock market does.

An alternative
The idea behind buying A-share companies, however, is valid. With the huge exposure to state-owned enterprises PetroChina (NYSE: PTR  ) and CNOOC (NYSE: CEO  ) that traditional Chinese investment vehicles give you, you're not getting a chance at some of the best growth opportunities in the emerging market.

You can get direct exposure to A shares. The closed-end fund Morgan Stanley China A Share (NYSE: CAF  ) actually owns A shares of companies like Tsingtao Brewery and Gree Electric Appliances that could benefit from a consumer-led expansion in the country. It currently trades at a 7% premium to its NAV but has seen discounts of more than 8% in the past 12 months.

As you'd expect, the fund's performance has given investors a roller coaster ride. The fund almost doubled in 2007, lost half its value in 2008, only to gain 74% last year. It's up about 10% so far in 2010. With an annual expense ratio of 1.74%, however, it's an expensive way to buy China. But the lack of derivative exposure is an attraction for anyone who's leery of counterparty risk.

Be patient
China has a huge amount of promise, and investors are flocking to any signs of growth in a slow global economy. But paying a big premium to break into the mainland Chinese stock market isn't the right way to make money. You might get lucky, but you're more likely to see a quick loss when those premium prices go away.

Emerging-market stocks are just one area that's primed to soar. To learn about the others, just click here to get The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger believes in getting what you pay for. He doesn't own shares of the companies mentioned in this article. Baidu is a Motley Fool Rule Breakers selection. CNOOC is a Motley Fool Global Gains pick. The Fool owns shares of China Mobile. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policyworks around the world.

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