Is It Time to Buy iShares China Large-Cap ETF (FXI)?

Source: Jakob Monstrasio via Flickr.

When it comes to overseas growth opportunities for investors, perhaps no country looms larger or has as much appeal as China.

China's GDP growth over the past three decades has averaged a mind-numbing 10%, all while the country is quickly transforming itself into an industrialized nation that could overtake the United States in terms of annual gross domestic product within a decade.

But does China make sense as an investment?

Over the past two weeks we've taken a look at one of the most popular investment vehicles that investors have used to gain access to China's growth potential without actually having the take the time to research Chinese stocks one by one. That investment vehicle is none other than the iShares China Large-Cap ETF (FXI 1.41%).

The skinny on the iShares China Large-Cap ETF
As a quick refresher, the iShares China Large-Cap ETF is made up of 25 securities and seeks to mirror the performance of the FTSE China 25 Index as closely as possible. However, it should also be noted, per iShares, that the tracking index will expand to 50 stocks effective Sept. 19. 

Long story short, it's a pure-play investment on some of China's largest companies, and it has no regard for sector diversification. In fact, as you can see below, the iShares China Large-Cap ETF is heavily weighted toward the financial sector, with telecommunications, oil and gas, and technology also making up sizable chunks of market value.

Source: iShares. 

As of the end of July, the expense ratio of the fund -- the amount that you pay on an annual basis to cover the costs of running the ETF -- stood at 0.73%, which, based on the roughly two dozen ETFs focused on China, lands right in the middle of the 0.59%-0.85% range of most China funds.

On a trailing 12-month basis, the iShares China Large-Cap ETF has delivered earnings growth of 13.6%, placing it among the top third of China-based funds. Finally, focusing on a commonly followed value metric, its ratio of portfolio value to book value of 1.24 puts this fund right in the middle of the pack. 

The bull thesis
As we examined more closely two weeks ago, there are a number of reasons why China and this ETF could be a wise long-term investment.

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Chief among those reasons is China's superior growth rate compared to the rest of the world's industrialized nations. Its internal infrastructure build-out, the rise of its middle-class, its abundant natural resources, and the availability of cheap outsourced labor give investors reason to believe that the country can continue outgrow its peers for years, or perhaps even decades, to come.

Chinese equities are also relatively inexpensive compared to their U.S. peers. The iShares China Large-Cap ETF trades at a significantly lower trailing 12-month P/E than the benchmark S&P 500 despite a notably stronger growth rate from Chinese companies. Simply closing this gap could push this ETF markedly higher. 

The bear thesis
Of course, just like any stock, the iShares China Large-Cap ETF could also face some headwinds.

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These headwinds include the possible bursting of China's real-estate bubble, a lack of sector diversification that makes the index reliant on cyclical equities, and an overall lack of trust from investors.

If you recall, in 2010 and 2011 more than one dozen Chinese equities (mostly small-cap stocks) went belly-up after it was revealed that they were cooking the books and fudging their results. Because China has a different company oversight system in place than that of the U.S., investors' skepticism regarding Chinese equities' earnings results could wind up sending this fund lower. 

Is the iShares China Large-Cap ETF a buy?
Against that backdrop, is the iShares China Large-Cap ETF a buy today?

I'd say not. Here's why...

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China's economy is uniquely tied to its housing market. In fact, Bloomberg noted that between 16% and 20% of China's GDP is derived from real-estate investments. The problem with this is that housing is meant to reside in, not strictly to invest in. In many previous instances -- perhaps most notably in the U.S. -- where housing drove an economic boom, a reduction in home prices or home sales later caused a huge downward swing in the economy.

For China it's not this simple. If there were a downturn in the Chinese housing sector, homebuilders and real-estate developers would not be the only ones feeling the pain. Despite the Chinese government's requirement that home buyers put 30% down on new homes, many Chinese developers and banks have been lending to frankly unqualified individuals at 0% down. This sounds uncannily similar to the subprime crisis that unfolded in the U.S. a few years ago. If these homeowners default, it will send ripples throughout every facet of the Chinese economy and could even endanger some of its banks.

"Why is housing so important," you ask? Because more than half of the iShares China Large-Cap ETF is comprised of financial stocks (i.e., banks). If the year-over-year growth in housing prices continues to slow, as it has for the past few months, and real-estate development money begins to dry up, banks may discover that not only will their mortgage service revenue fall dramatically, but a number of loans they made during China's housing heyday may go uncollected. Were this to happen, the iShares China Large-Cap ETF would probably get hit hard.

There's certainly the potential for China to continue outperforming the remaining industrialized world due to its advantageous proximity to emerging markets in Southeast Asia, its inexpensive labor, and its abundant natural resources. However, what I believe could be the impending pop of China's housing bubble is more than enough to keep me squarely on the sidelines and out of this ETF.