Why Investors Are Fleeing China

Without a doubt, China has been an investing hot spot in recent years. As the nation expands, consuming resources and giving rise to a growing middle class, investors have clamored to get in on some of the action.

There are now more than 50 mutual funds and exchange-traded funds dedicated exclusively to investing in the Chinese market. Returns have been impressive as well, with the iShares FTSE China 25 Index Fund (NYSE: FXI  ) posting a five-year annualized return of 13.2%, compared to just 1.8% for the MSCI EAFE Index. But after such a long and successful run, China may be showing some signs of strain.

Taming the dragon
While China-based funds have seen a tremendous flood of assets in years past, recent data flows show that investors are starting to get nervous. According to ETF research firm XTF, investors yanked a net $961 million out of the iShares FTSE China 25 fund so far this year, the most of all the 140 single-country ETFs in existence. This is happening at the same time that valuations in the dragon nation have fallen to levels not seen since November 2008, the height of the financial crisis. Apparently, investors are losing some of their seemingly boundless enthusiasm for the country.

It's not hard to understand why investors are jumpy. China's central bank has been raising rates in an effort to cool down the economy and head off inflation. Rates have been raised three times already this year, as inflation has picked up to its highest level since 2008. Many are also concerned about a potential bubble developing in China's housing market, as valuations have been pushed to ever-higher levels. And with recent revelations of accounting and financial irregularities at several Chinese firms, risks have definitely intensified for investors in this market.

Spreading the risk around
So are folks right to be worried about China's future growth? At least for the immediate future, I think so. There are signs that the Chinese economy is overheating, and investors could be setting themselves up for a fall as a result. To be clear, I think China still holds tremendous long-term growth potential, and all investors should have some exposure here as a part of their broader foreign stock asset allocation. However, I think there is a distinct possibility that folks who have dedicated a lot of resources to the Chinese market will end up disappointed in the short term, even if they don't lose meaningful amounts of money.

And while China's future prospects will have worldwide implications for other developing and developed economies as well as for the investing fortunes of many, there is one reason why investors shouldn't be panicked about what lies ahead in China's future: You shouldn't be investing in funds that exclusively track the Chinese market in the first place. Single-country funds seem like a great idea when the economy in question is firing on all cylinders and producing double-digit returns year after year. But these funds can turn on a dime and take a double-digit plunge just as easily.

For example, the iShares MSCI Brazil Index ETF (NYSE: EWZ  ) has posted some truly eye-popping returns, such as its 74.8% gain in 2007 and a 121.5% gain in 2009. However, few investors likely had the willpower to sit through years like 2008 when the fund lost 54.4% or 2002 when it lost 36.3%. That means most folks will end up buying and selling at exactly the wrong times, defeating the purpose of a long-term investing approach.

Broad is best
The best way for the average investor to invest in China is through a diversified emerging markets fund or ETF. While China will probably make up the largest country allocation in any such fund, your risks will be substantially lower than if you invested in a China-only fund. For example, the iShares MSCI Emerging Markets ETF (NYSE: EEM  ) has a 17% allocation to China, which is pretty palatable.

Other good ETF choices in this space include Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) and Schwab Emerging Markets ETF (NYSE: SCHE  ) , both of which clock in with a price tag of 0.25% or less. If you're in the market for actively managed funds, T. Rowe Price Emerging Markets Stock (PRMSX) is a solid option.

The same thinking also applies for more stable, developed nations. Stay away from funds that invest in a single nation like Japan or the U.K. and stick to broad-market funds like the iShares MSCI EAFE ETF (NYSE: EFA  ) or Vanguard Total International Stock ETF (NYSE: VXUS  ) , the latter of which invests in both emerging and developed nations across the globe.

Time will tell whether China can orchestrate a soft landing from its spell of red-hot growth. Odds are good that there will be some shake-ups coming for this emerging economic superpower. But as long as investors make China just one part of a diversified investment portfolio rather than making it a centerpiece, they shouldn't fear any slowdowns or downturns that may lie ahead.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. The Motley Fool owns shares of Vanguard MSCI Emerging Markets ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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