Panda Power ETFs Invest in China

2007 is the Year of the Pig in China, which follows the Year of the Dog in 2006. By any scorecard, 2006 was anything but a dog of a year for the Shanghai stock index, which was up more than 130%. Investing in China used to sound as easy as shooting goldfish in an aquarium. The economy and stock market boomed for years, and growth chugged along at an average 10% clip. In late February 2007, though, a nearly 10% downturn in prices showed investors this market could do other tricks besides just going up. Hopefully, 2007 will not be the year where pigs are slaughtered in the market, at least those who gorge on China-focused securities.

One foot in
With two decades of positive economic performance behind it, there are still a number of reasons why China is a good market to invest in. Those investors seeking an ETF have two China funds to choose from. BGI launched the first China ETF in late 2004, closely followed by a PowerShares fund a couple of months later.

The two China ETFs had excellent returns last year, although one outperformed the other by 30% and both lagged the Shanghai market index by nearly 50%. The ETFs didn't match the Shanghai index performance for the simple reason that they don't track this index. The governmentally imposed restrictions on foreigners owning domestically traded shares mean these two ETFs don't have complete access to this market and cannot fully participate in its performance. Essentially, the funds have tiptoed into the market with one, rather than both, feet.

Same country, different funds
The iShares FTSE/Xinhua China 25 Index Fund (NYSE: FXI  ) is the more successful of the two China funds. FXI seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the FTSE/Xinhua China 25 Index. The other China option is the PowerShares Golden Dragon Halter USX China  (AMEX: PGJ  ) . PGJ tracks the Halter USX China Index, which is comprised of the U.S.-listed securities of companies that derive a majority of their revenue from the People's Republic of China.

Performance first, then fees
In 2006, FXI roared liked a grizzly bear with an eye-popping 83% return. In comparison, PGJ returned a miserly 53%. Longer-term, PGJ has a 20.74% return since inception, while FXI handily beats that with a 31.76 return. Both funds came to market within two months of each other, so the time span for their returns is very close.

Expense ratios are similar for each of these funds (0.71% for PGJ and 0.74% for FXI), so this shouldn't be a factor in choosing one fund over the other. Investors who keep to the mantra of high performance and low fees would clearly head toward FXI, and that's reflected in the growth of this fund to nearly $4.5 billion in assets, while PGJ has only garnered $351 million.

Portfolio differences
Both funds include China Mobile (NYSE: CHL  ) and PetroChina (NYSE: PTR  ) in their top holdings. While FXI rounds out its top five securities with several banks and an insurance company, PGJ has one aluminum company and then goes the energy route, with a coal and a solar-cell company to fill out its top positions.

The two funds are markedly different in their financial services sector weight. FXI has 43%, while PGJ has a mere 4%. In IT, the funds also have significant differences, with PGJ putting nearly 20% of its assets in this sector, while FXI has no investments. Both funds have fairly close weightings in telecom (21% and 19% for FXI and PGJ, respectively), while each fund has a roughly 18% exposure to energy. PGJ has 56 securities in its portfolio, while FXI has just about half that at 25. Most of the holdings in PGJ are companies that trade as ADRs (American Depository Receipts), while FXI has a large number of Hong Kong-listed H shares.

Economic outlook
China's gross domestic product (GDP) grew at nearly an 11% rate in 2006. The booming economy in China is not a recent phenomenon and has been widely recognized. Although the positive business climate has contributed to a thriving stock market, there are now pressures building that could derail this economy, including rising costs. China is known as a low-end manufacturer but has seen its labor costs rise and now faces competition from even cheaper labor markets like India. Some manufacturers want to move upmarket and produce goods with more value added. China's recently announced plan to construct its own commercial jets is an indication of what may be in store for the future of this country's manufacturing.

China can make toys, steel, ships, and even cars, yet some question its ability to move into a critical product like jets, where one false move can cost many lives. A somewhat similar line of reasoning made the rounds before the Japanese moved into luxury cars, with many experts saying all they could produce was low-end vehicles. It's pretty obvious how fallacious that argument was.

The Chinese market is unlikely to perform as well in 2007 as it did in 2006, simply because there's such a high hurdle to overcome, and also because balloons don't go up forever. China is a speculative market, and most of the companies that list their shares are state-owned. Corruption, embezzlement, and waste are more common in China than in the U.S., and many shares aren't tradable, so when problems are exposed, the market can be thin and volatile.

In 2008, China will host the Olympics for the first time. That means China will work hard to put on its best face, and the government has a strong incentive to keep the market positive before the games begin. Recently, volatility in Chinese stocks may have brought some rationality to this market. However, in the short term, investors might want to keep in mind the Chinese curse, "May you live in interesting times."

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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or securities mentioned in this article. The Motley Fool has a disclosure policy.


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