3 Reasons iShares China Large-Cap ETF Could Rise

Source: Barbara Willi via Flickr.

In a world with more than 6,500 different stocks available for purchase, the sheer number of options can be overwhelming. Thankfully, exchange-traded funds can make life a bit easier for the average investor.

Exchange-traded funds, or ETFs, enable investors to buy a basket of stocks through a single security. Today we're looking at one of those popular ETFs, the iShares China Large-Cap ETF (FXI -0.54%), and considering three reasons why it could be poised to head higher.

The skinny on the iShares China Large-Cap ETF
Let's start by covering some important ground, including the makeup of the fund, its investment goal, and its expenses relative to those of its peers.

The iShares China Large-Cap ETF is comprised of 26 securities invested solely in Chinese large-cap companies. It seeks to mirror as closely as possible the investment results of the FTSE China 25 Index and give investors the ability to own a basket of China's largest stocks. As of the end of last week, more than half of the fund was comprised of financial stocks. Another 15% was invested in telecommunications companies, 11.5% went to oil and gas stocks, and a solitary technology company alone made up more than 10% of the fund's roughly $5.4 billion in net assets, as you can see below.

Pie chart by author. Data source: iShares. 

Comparatively speaking, the iShares China Large-Cap ETF's expense ratio of 0.73% and annual turnover of 31% are more or less on par with a number of other China-focused ETFs. It also boasted a trailing 12-month yield of 1.74% as of the end of July.

Now that we have a good understanding of the makeup of the fund and its objective -- that is, to provide exposure to China's largest companies -- let's look at three catalysts that could cause this ETF to rise.

China's superior growth prospects
Without question, the premier allure of this ETF is the ability to take advantage of China's superior growth rate compared to other industrialized nations. China is smack-dab in the middle of its industrial renaissance, which is seeing success from all ends of the economy. Sectors from manufacturing down to mining are all seeing expansion as entrepreneurship grows right alongside the country's burgeoning middle class.

In U.S. dollars, China gross domestic product has more than quadrupled from $1.93 trillion in 2004 to $9.24 trillion in 2013. This works out to average GDP growth of 19% per year and suggests that China's GDP is equal to roughly 15% of global GDP. 

Graph by author. Data source: TradingEconomics. 

China is rapidly becoming an economic superpower that still has the capacity to grow independently due to its rising middle class and the need for extensive infrastructure build-outs and improvements within the country. This multidecade opportunity, as well as the nation's proximity to other rapidly growing emerging markets in Southeast Asia, makes China a common destination for investors' money. Investors simply can't find this type of growth in any other industrialized nation.

Home prices are soaring
Rising prices for newly built homes are generally a positive sign for any economy or country, but this is especially important for China.

Most importantly, rising home prices fuel investment in the housing industry and encourage consumers to buy new homes before costs rise further. This is crucial for the banking sector in China, which leans heavily on mortgage loans -- and the interest from those loans -- to boost profits.

As noted above, more than half of the iShares China Large-Cap ETF is comprised of financial stocks, meaning the health of the housing sector is paramount to the fund's success. Even though year-over-year home-price appreciation has slowed in recent months, it averaged 3.6% between 2011 and 2014, which is more than attractive enough to entice investors and home buyers to take the plunge. So long as this figure is expanding, it implies that banks are lending and profits are rising.

Graph by author. Data source: TradingEconomics.

It's notably cheaper than the U.S. alternative
As of the end of last week, the S&P 500 was trading at a trailing 12-month P/E of roughly 16.7. By comparison, the iShares China Large-Cap ETF was valued at just 14.9 times trailing 12-month earnings at the end of July. This 10%-plus discount to the S&P 500 may seem negligible on the surface, but you have to consider the catalysts mentioned above to understand why the discount could lead to a surge in this ETF.

Over the trailing 12-month period, the average earnings growth for stocks held within the iShares China Large-Cap ETF was 13.6%. This is largely due to organic product and service growth. In the U.S., blended second-quarter growth for S&P 500 companies totaled just 8.4%, according to FactSet Research -- and this comes after a near-record number of share repurchases, which artificially inflate earnings per share.

The iShares China Large-Cap ETF offers investors the opportunity to buy into a fund with faster growth and a lower trailing P/E multiple than the U.S.' broadest index. The closing of this valuation gap could present an opportunity for the iShares China Large-Cap ETF to rise notably and catch up to premium U.S. stock valuations.

Key takeaways
The iShares China Large-Cap ETF certainly offers a lot of potential for investors who are looking for region-specific investment ideas and don't have the time to research dozens of companies. Ultimately, the success of this ETF depends on the health of the housing sector and China's ability to continue to carry the global economy on its back during turbulent growth periods. Continuing to succeed in these areas won't be easy for China, but it's not impossible, either.