Investing in China has always come with a special set of risks, but for most of modern history, investors have been able to ignore those as Chinese growth stocks have delivered.

Suddenly, those risks, which include investing in a country where American standards of rule of law and investor protections are non-existent, are back in focus. The Chinese Communist Party wiped out nearly all the value in the for-profit education sector in that country when it said that tutoring companies like New Oriental Education Group and TAL Education Group would be barred from making profits, and that they would have to register as non-profit enterprises.

As a result, a sector worth more than $100 billion earlier this year imploded, losing nearly all of its value, and Chinese stocks as a whole plunged. The iShares MSCI China ETF lost 12.6% in just three sessions as investors feared further crackdowns that could erase shareholder value overnight. 

Tensions had already been increasing after Beijing slapped a $2.8 billion fine on Alibaba (BABA -1.54%) earlier this year over anti-monopoly concerns, and blocked ridesharing giant Didi Global from listing its app on major app stores shortly after its IPO. Additionally, the U.S. has threatened to delist a number of high-profile Chinese stocks , including Alibaba, if they don't open their books to U.S. regulators.

Adding to the sell-off are reports that a number of large investors are bailing out of China. Among them is Cathie Wood, the head of ARK Invest, which runs a number of popular ETFs, including ARK Innovation ETF (ARKK 2.30%), that were big winners during the pandemic. Because of that success, investors now watch Wood's moves closely, and ARK reports its trades each day. Some investors may be following her lead on China. 

Chinese and American money with small globe.

Image source: Getty Images.

Cathie Wood's big moves

Wood had been a big believer in Chinese tech stocks, holding the likes of Alibaba, JD.comPinduoduo, and Tencent, but ARK Invest has been rapidly selling those stocks and closing out those positions entirely. On Friday, it sold off all its Tencent stock, and ARK dumped nearly 1 million shares each of Pinduoduo and on Tuesday, or about $150 million of the two combined.

Wood's thinking on the subject wasn't complicated. In a webinar with investors earlier in July, she said that there was a "valuation reset" in China and that valuations could stay down for a while. She said: "From a valuation point of view, these stocks have come down and again from a valuation point of view, probably will remain down."

Chinese stocks have long traded at a discount to their American counterparts, but the meddling from the Chinese government is leading valuations to shrink across the board as investors fear further harm to their holdings, especially as there is no real check on the Chinese government's ability to do what it wants.

Some investors even believe that the Variable Interest Entity (VIE) structure of many Chinese stocks means that the government could render them worthless, though that seems unlikely. Additionally, the U.S. has threatened to delist some Chinese stocks if they don't make their financial audits available to U.S. regulators, another source of geopolitical tensions.

Should you sell your Chinese stocks?

It's natural to think about selling your Chinese stocks at a time like this, and whether you should sell your Chinese stocks depends on a few simple questions. First, ask yourself what your risk tolerance and time horizon is. If you're a risk-averse investor or have a shorter time horizon, this may be a bad time to own Chinese stocks. The situation could certainly get worse before it gets better, and it's possible that other stocks could see nearly all of their value wiped out the way that Chinese tutoring stocks just did.

However, it's worth remembering that many of the stocks that Wood and other investors are selling are top-notch businesses. The stocks are falling not because the business fundamentals have changed, but because investor sentiment has, and that can change quickly.

Alibaba, for example, is the world's biggest e-commerce platform, with more than $1 trillion in annual gross merchandise volume and more than 800 million annual active customers. Investors also responded favorably when Alibaba received a $2.8 billion fine from the government, thinking that the regulatory risk was now finished.

In other words, if these stocks don't face any specific threat the way Chinese education stocks have and they continue to put up the kind of growth they historically have, investors could be rewarded over the long term for buying now. Alibaba, for example, is now trading at a price-to-earnings ratio of just 16 based on 2022 expected EPS, and analysts expect revenue growth above 20%. 

Alibaba and its big tech peers will have a chance to show off their results and make their case to investors. A strong performance could help make investors forget about the crackdown on the education sector.

While Chinese stocks will remain risky for the foreseeable future and the regulatory risk shouldn't be ignored, investors are clearly being compensated for that risk at current prices. If you can stomach the volatility and have a long time horizon, picking up a small position now could have a big payoff down the road.