The Wrong Way to Invest in China

According to Morningstar, the iShares FTSE/Xinhua China 25 Index ETF (NYSE: 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.

"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. Backed by Titanic-sized companies like PetroChina (NYSE: PTR  ) and China Mobile (NYSE: CHL  ) , the iShares FTSE/Xinhua China 25 ETF has averaged returns of 22% per year over the past five years. Compare that to the S&P 500 -- tethered to our own megacaps like Pfizer (NYSE: PFE  ) and IBM (NYSE: IBM  ) -- which has eked out just 1% a year over the same period.

But while FXI holdings such as Aluminum Corp. of China have outpaced American counterparts like Alcoa this year, 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 like China Agritech (Nasdaq: CAGC  ) and China Information Security Technology (Nasdaq: CPBY  ) are flying past 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. 

Already subscribe to Global Gains? Log in here.

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

Fool analyst Todd Wenning bets you he can throw a football over them mountains. He owns no shares of any company mentioned. Pfizer is a Motley Fool Inside Value selection. The Fool owns shares of China Mobile and its disclosure policy has large talons.

Read/Post Comments (6) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 10, 2010, at 11:06 AM, EPS100Momentum wrote:

    So in other words your saying take advantage of the higher percentage moves of individual Chinese stocks.

    Here is a list of them for you to follow:

  • Report this Comment On January 10, 2010, at 11:08 AM, EPS100Momentum wrote:

    So in other words your saying take advantage of the higher percentage moves of individual Chinese stocks.

    Here is a list of them for you to follow:


  • Report this Comment On January 10, 2010, at 7:54 PM, JGalt2B wrote:

    This looks like terrible advice. Check out the chart comparing 3 months of FXI and CPBY.;r...

  • Report this Comment On January 11, 2010, at 9:45 AM, pianofritz50 wrote:

    check out PGJ which is more diversified than FXI

  • Report this Comment On January 14, 2010, at 12:32 PM, phxgator wrote:

    Yeah, very interesting, "Fool". Now click on the '6M' button on that same chart comparing FXI and CPBY.

    And today CPBY is up... 11%? Hmmmm.

  • Report this Comment On September 07, 2011, at 2:16 AM, Franky102 wrote:

    I live in China and have been for 9 years. Buying local companies is not the way to go at all. They are overpriced and the western media has no clue what is going on with them no matter how much news they read. Google and Apple are brands that are making so much money in China and even though they are American companies, they make a lot of it here. It's a great way to get a piece of the Chinese pie. Below is the best article I've found for investing in China

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