3 Reasons iShares China Large-Cap ETF Shares Could Fall

View of Pudong Shanghai skyline. Source:Flickr user Oarranzli.

There's no denying that China is an economic superpower. It's on pace to become the largest country in the world by GDP within the next decade, and it has surpassed the United States in a number of other key growth categories. Its current growth rate is practically unmatched among developed nations. 

During the last global recession, China helped get the world back on its feet with its insatiable demand for goods and its ability to produce a range of cost-competitive products across a bevy of industries, pulling the global economy out of the trough little by little.

This is one reason why the iShares China Large-Cap ETF (FXI 1.82%) has been such an attractive investment for so many investors who want exposure to China's growing market but don't have the time, patience, or risk tolerance to research and invest in individual Chinese equities.

The iShares China Large-Cap ETF is comprised of 26 securities, all of which are based in China, and it seeks to mirror the movement of the FTSE China 25 Index as closely as possible. It has $5.8 billion in assets, is heavily weighted toward financials, and has a middle-of-the-road expense ratio of 0.73%, which is par for the course with a bunch of its China-region ETF peers.

But could this highly followed ETF be headed for a tumble? It's quite possible, given a number of upcoming catalysts.

Before we look at three reasons why the iShares China Large-Cap ETF could fall, I feel obligated to point out that the stock market is a two-way street, and there are two sides to every trade. More than two dozen securities make up this ETF, and plenty of economic data can swing markets up and down at the snap of a finger, so the following bearish thesis offers no guarantee that this ETF will move lower. Where the iShares China Large-Cap ETF heads next ultimately depends on you and other investors.

The China housing bubble bursts
Perhaps no single factor has been more critical to China's ongoing success than its housing boom, which has allowed middle-class citizens to taste ownership for the first time and gives China's largest cities an opportunity to expand outward, easing congestion and potentially pollution as well.

Source: See-Ming Lee via Flickr.

According to various sources (as reported by Bloomberg back in May), China gets anywhere from 16% to 20% of its GDP from real-estate investments. In other words, a swing from expansion to contraction in the housing sector, based on China's current GDP growth rate, could knock China's GDP growth to 6% or less.

Just how likely is a contraction in China's housing growth? Perhaps more likely than you realize.

As Bloomberg also noted back in June, despite Chinese regulations that require would-be homeowners to put 30% down in order to buy a home, a number of new deals have emerged from project developers in Guangzhou and Shenzhen offering people the ability to buy with no money down. Sound familiar? It should, because this is the type of mentality that led to the housing bubble in the U.S. a few years ago. By selling to unqualified people now, China's homebuilders prop up their profits, but they may be putting the Chinese economy behind the eight ball if these no-money-down loans go bad.

Through May, Chinese home sales slid more than 10% in value from the prior year. And according to China's National Bureau of Statistics, investment growth in real-estate development continues to weaken. Between the December 2013-January 2014 period and the June 2014-July 2014 period, real-estate development growth fell from 19.8% to just 13.7%. 

Source: National Bureau of Statistics of China.

The warning signs are becoming more visible, and it could be just a matter of time before China's greatest treasure becomes its biggest liability.

A lack of industry diversification
When you buy a China-based ETF, diversity may not be at the forefront of your concerns. Yet when you purchase an ETF, which grants ownership in a number of securities or investment vehicles all at once, you expect the holdings within the ETF to be somewhat diversified across a number of industries. That's not the case with the iShares China Large-Cap ETF.

As of Aug. 14, financial stocks comprised 54.5% of the market value of the iShares China Large-Cap ETF, with telecommunications comprising another 15.3%, oil and gas claiming 11.9%, and technology accounting for 10.4%.

Pie chart by author. Data source: iShares. 

There are two major implications here that should give investors pause.

First, it means this ETF is primarily made up of cyclical stocks. Financials and tech stocks tend to be at the mercy of the underlying economy in which they operate. Cyclical stocks like these tend to perform even worse in a contracting economy than broad-based stock indexes.

Furthermore, high exposure to financial stocks leaves the iShares China Large-Cap ETF particularly vulnerable in the case of a housing-industry collapse. If the number of no-money-down loans is increasing, I would assume that the quality of lending is decreasing. If China's growth slows and its middle class doesn't see the robust level of wealth creation it has witnessed over the past two decades, it's quite possible that financial institutions will bear the brunt of the impact.

Considering the aforementioned data on housing and China's projected GDP growth rate of 7%-8% (well below its three-decade average of 10%), it could be time to consider whether this lack of industry diversification poses a serious risk to the iShares China Large-Cap ETF.

A trust issue
Lastly, let's not forget that a serious trust issue still exists between global investors and Chinese companies.

Source: Alexander Baxevanis via Flickr.

On one hand, larger Chinese stocks, which are what the iShares China Large-Cap ETF focuses on, tend to be more forthcoming and transparent with information simply because they're in the public spotlight at all times. They also have some of the most robust growth prospects in the world.

But on the other hand, investors still remember being burned by more than a dozen China-based stocks that essentially cooked their books back in 2010-2011. This served as a reminder to investors, and yours truly, that the way China regulates its business differs a lot from the way the U.S. regulates its companies. This lack of trust in the financial results of China-based companies is one reason why we see China stocks regularly trade at P/E multiples that are discounts compared to those of U.S. stocks.

If any new accounting issues surface in China-based stocks, no matter how small, they could be the last straw for U.S. investors.

Tying things together
China has been an economic powerhouse for a number of decades, but it may also be on the precipice of a major slowdown precipitated by weakening investments in its housing sector and the potential for poor-quality home loans mucking up the mortgage portfolios of its large money-center banks. While that in no way ensures that the iShares China Large-Cap ETF will head lower, it certainly gives pessimists and skeptics plenty to chew on moving forward.