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Do Your Homework Before Buying China Funds

China funds are a very diverse and volatile lot.

David Kathman, 04/28/2010

China has seen its economy perform exceptionally well in the 2000s and currently is in the enviable position of having one of the largest and fastest-growing economies in the world. The nation's 1.3 billion people are buying a bigger--and broader--array of products and services than ever before, while many of its companies have become regional or even global leaders. Chinese stocks have posted huge gains during the global equity rally of the past 13 months, as they did from early 2006 through late 2007. 

Not surprisingly, given these auspicious conditions, the number of China funds and the amount of assets in such funds have grown significantly over the past decade. There now are 26 open-end China funds, as well as seven closed-end and 17 exchange-traded China funds. These 50 offerings have nearly $25 billion in assets in aggregate, and seven of them have asset bases of $1 billion or more.

But investors should be sure to do their homework before they even consider jumping on the China bandwagon. China funds are not nearly as straightforward--or as similar--in structure as their names imply. Their portfolios also can overlap considerably with those of a variety of other mutual funds.

More Complex Than Other Single-Country Emerging-Markets Funds
The mainland stock exchanges are fairly young and illiquid, while Hong Kong had a vibrant economy and a well-established stock market long before it reunited with China, and Taiwan has a historical connection as well as growing ties with the mainland. Thus, China funds don't simply focus on companies that are based in and trade on their target market like Brazil, Russia, India, and other single-country emerging-markets funds do.

China funds, in fact, invest in several other types of companies besides mainland firms that trade on the mainland exchanges (B shares). Those other types include mainland firms with government ties that trade in Hong Kong (red chips), companies that are incorporated on the mainland but are listed in Hong Kong (H shares), and Chinese firms that trade on U.S. or other overseas exchanges. They also include Hong Kong companies that do a lot of business on the mainland, Hong Kong firms that don't have especially close ties to the mainland, and Taiwanese companies.

China funds differ considerably in terms of which of these types of companies they invest in and emphasize. For example, Matthews China MCHFX normally ignores Taiwanese names and invests a small amount in B shares as it favors Hong Kong companies, red chips, H shares and overseas listed firms. Fidelity China Region FHKCX pays ample attention to Taiwanese blue chip as well as to Hong Kong companies, red chips, H shares, and overseas listed firms. And iShares FTSE/Xinhua China 25 Index FXI invests in nothing but red chips and H Shares.PAGEBREAK

Anything But Off the Beaten Path
Managers of China funds aren't the only ones who have discovered these stocks, however. So the first thing interested investors should do is to see how much exposure they may already have to such issues through their current holdings. Most regionwide Pacific/Asia-Japan funds invest 35% to 45% of their assets in such names, while most diversified emerging-markets offerings devote around 20% of their portfolios to such securities.

Many other international-stock skippers also pay attention to Chinese, Hong Kong, and Taiwanese stocks. Indeed, the typical foreign large-cap fund has 6% of its assets in such names, and the average foreign small/mid-cap offering has a bit more. And there are many prominent foreign funds that have opportunistically or regularly built low double-digit positions in such securities in recent years, including Janus Overseas JAOSX, Artisan International Small Cap ARTJX and Templeton Foreign Smaller Companies FINEX.

Investors may also be getting China exposure through their domestic-equity funds. Sure, most domestic-equity managers don't consider the various types of Chinese stocks. But a number of them do have such issues on their radar screens and aren't afraid to buy some. Morgan Stanley Focus Growth AMOAX, Calamos Growth CVGRX, and Heartland Value HRTVX have between 5% and 14% of their assets in such issues at present, in fact.

Packed with Perils
Once they understand the complexity of the universe of China funds, investors should review the many risks that these funds carry. First, emerging-markets equities tend to be more volatile than developed-markets issues for a variety of reasons, and Chinese stocks are no exception to that rule. Second, the geographic focus of these funds means that their managers have nowhere to go when economic problems arise in China, when relations between the mainland and Hong Kong or Taiwan worsen, or when the governments of developed nations take action--or threaten to take action--against China's trade surplus and currency policy. Third, these funds tend to be much more concentrated sectorwise than most other international-stock offerings.

Meanwhile, many China funds magnify these inherent risks with aggressive strategies. Three of the open-end funds and two of the ETFs use leverage. Several of the non-leveraged offerings take on a fair amount of company-specific risk by owing fewer than 50 names. Still others take a bold approach to stock selection by favoring smaller caps or faster growers or both.

Not surprisingly, given all these perils, China funds tend to suffer painful losses in tough conditions and considerable volatility overall. The typical non-leveraged open-end offering lost nearly two thirds of its value during the late 2007 to early 2009 global meltdown, in fact. This is no isolated incident: The average non-leveraged open-end offering lost half its value between mid-1997 and mid-1998 as the Asian currency crisis took its toll. And such funds have an average 15-year standard deviation (a statistical measure of volatility) of 27, whereas the average diversified emerging-markets offering has a 15-year standard deviation of 25 and the figure for the average foreign large-blend fund is 17.

Don't Get Carried Away
Finally, investors who can handle that level of volatility should keep their long-term returns expectations in check. The 85% gain China funds have posted over the past 13 months is not close to being sustainable. Meanwhile, these funds have stretches of middling results as well as periods of great gains and of terrible losses, and they've experienced all three during the past decade. Thus, the 11% annualized return that the average China fund has posted over the past 10 years--which is much more than the typical foreign large-blend offering has gained but only a tad more than the average diversified emerging-markets fund has returned--is a far better guide to the long-term potential of these funds than their huge gains in favorable conditions are.

David Kathman is a mutual fund analyst with Morningstar.

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