The Wrong Way to Invest in China

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According to Morningstar, the iShares FTSE/Xinhua China 25 Index ETF (FXI) is not only one of the 25 most popular exchange-traded funds on the market today, but also the most-traded China-focused ETF. In 2009 alone, it has taken in new investment inflows of $2 billion.

"That's great," you might think. "Investors are finally realizing that they need to invest in China." That might be true, but if so, they're going about it the wrong way.

Seriously red tape
Some investors confuse FXI with a proper way to invest in the Chinese growth story. That just isn't the case, for a variety of reasons.

By investing in FXI, you're not sufficiently tapping into the entrepreneurial spirit of the Chinese people. See, FXI tracks a FTSE/Xinhua index mainly consisting of state-owned enterprises (SOEs). In fact, all of the top 10 holdings of the exchange-traded fund are SOEs -- or are subsidiaries of SOEs, which for my purposes are one and the same.

In terms of past performance, that hasn't been so bad. Despite the recent plunge in the Chinese markets, which has sent names such as PetroChina and China Mobile down considerably, the iShares FTSE/Xinhua China 25 ETF has averaged returns of 19% per year over the past three years, versus the S&P 500 -- tethered to our own megacaps such as ConocoPhillips (NYSE: COP) and Verizon (NYSE: VZ) -- which has lost 5% a year over the same period.

But while FXI holdings such as China Life Insurance (NYSE: LFC) and China Unicom have outpaced American counterparts such as Lincoln National (NYSE: LNC) and AT&T (NYSE: T) since 2004, looking to the future, FXI isn't the right train on which to hitch your China investment dreams.

A little background
SOEs have traditionally been the dominant players in the Chinese economy. In 1958, during the days of Chairman Mao, more than 97% of the Chinese economy was under the control of the government (PRC) through the use of SOEs.

Granted, things have changed over the past 50 years, following the economic reforms of Deng Xiaoping in the late 1970s and '80s. Today there are far fewer SOEs, but they still make up a significant chunk of China's gross domestic product. They're mostly found in the energy, telecommunications, and financial sectors. The government keeps many of them alive by infusing them with capital, and one of the ways it does this is by -- wait for it -- taking them public.

The Chinese government has certainly reduced its ownership of some SOEs, but given the size of those companies, and the size of the government's remaining ownership, it could be a long time before those SOEs are fully privatized. Just imagine if the PRC decided to suddenly dump its huge stake in China Life Insurance into the public markets. It would be an utter disaster for those shares.

The bottom line is that, despite the loosening of the PRC's grip, SOEs still do not put shareholder interests first. Their motivation is still at least partly political, so you're better off looking for Chinese companies that have your interests at heart.

This one will go to the hares
While the SOEs join the free markets at a tortoise's pace, non-SOE Chinese companies such as Sohu.com (Nasdaq: SOHU), Mindray Medical (NYSE: MR), and New Oriental Education are flying by them in terms of innovation and ability to react to global economic movements.

Moreover, these Chinese companies are led by entrepreneurs who represent the Chinese growth story. These, and not the SOEs, are the types of companies that may turn out to be some of the best stocks of the next 10 years.

For this reason, the folks on the Motley Fool Global Gains team are looking beyond the realm of Chinese SOEs. That's why they just made their third trip to China in the past four years to seek out promising companies flying below Wall Street's radar. If you'd like to read their reports from the trip and take a peek at all the Global Gains recommendations, a free 30-day trial of the service is yours. Click here to get started. 

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This article was first published June 3, 2008. It has been updated.

Todd Wenning bets you he can throw a football over them mountains. He owns no shares of any company mentioned. Mindray Medical International and Sohu.com are Motley Fool Rule Breakers recommendations. The Fool owns shares of Mindray Medical International, and its disclosure policy has large talons.