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Approach China Funds Carefully

China funds are quite risky and vary widely in their makeup.

William Samuel Rocco, 05/01/2007

China funds are becoming increasingly fashionable. Indeed, when JP Morgan China Region JCHAX and SPDR S&P China GXC opened earlier this year, they became the 17th open-end mutual fund and fourth exchange-traded fund, respectively, that focus on the Middle Kingdom. There also are five closed-end funds that concentrate on China, so there are 26 such funds overall. And these 26 funds now have more than $14 billion in assets, including approximately $1.1 billion in the largest open-end fund (Matthews China MCHFX) and $4.6 billion in the biggest ETF (iShares FTSE/Xinhua China 25 Index FXI).

Those numbers dwarf those of all other types of single-country emerging-markets funds. India funds are the second most-common type of such offerings, but there are only five of them and they have a total of $4.5 billion in assets. And there are only five Korea funds, which are the third most-common type of such offering, and they have less than $3 billion in assets in aggregate (and one small open-end Korea fund is likely to be merged away later this year).

But investors should be sure that keep the growing popularity of China funds--as well as the huge gains these funds have posted recently--in perspective. Here's why.

Exposure Overlap
The first thing investors should consider is that they're probably getting a good amount of indirect China exposure through their core domestic and foreign holdings, because a wide variety of U.S. and other multinationals have sizable operations or sales in that country. And they're likely getting direct Chinese exposure from a variety of sources. There are dozens of core domestic-equity funds with decent-sized positions in one or more Chinese stocks, including Thornburg Value TVAFX (which has a 1.8% position in China Mobil) and Fidelity Magellan FMAGX (which has a 1.3% stake in China Life Insurance and smaller positions in other Chinese names).

Meanwhile, most core foreign funds have small but significant stakes in Chinese stocks and some, such as Janus Overseas JAOSX and Masters Select International MSILX, have double-digit positions in such issues. And the typical diversified emerging-markets fund devotes 9% of its assets to such issues, while the average Pacific/Asia ex-Japan offering invests around 45% of its assets to such names. Thus, many investors already have plenty of exposure to China.

Don't Count on Spectacular Gains
After they scrutinize their existing holdings, investors should take a hard look at the performance of China funds. Sure, these funds have posted terrific gains of late. Thanks to the exceptionally strong economy and improving corporate fundamentals in the Middle Kingdom, plus the enthusiasm about emerging markets in general, the average China fund has gained 36% over the past 12 months. Such returns are really impressive--and they rank among the very best one-year gains of all types of mutual funds--but they're not sustainable over the long term for valuation and other reasons.

Another reason investors need to temper their long-term expectations, despite China's exceptional nature, is that superior economic growth doesn't always translate into superior stock market performance. Though China has long enjoyed one of the fastest growing economies in the world, the long-term records of these funds don't look great relative to Pacific/Asia ex-Japan funds or diversified emerging-markets funds. The typical China fund has outpaced the average Pacific/Asia ex-Japan offering over the trailing three-year period, but the former has roughly pulled even with the latter over the trailing five-year period and lagged it by a small margin over the trailing 10-year period. And the typical China fund has lagged the average diversified emerging-markets fund over the trailing three, five- and 10-year periods. PAGEBREAK

A Bevy of Risks
Investors need to be realistic about the downside as well as the upside of China funds. These funds, in fact, are subject to a broad array of risks. For starters, China remains a communist country and the government remains heavily involved in the operations of many Chinese companies as well as in the running of the overall economy, so these funds are quite exposed to political and governmental risks. Due to the strength--and prominence--of China's export economy, these funds are vulnerable to a slowdown and protectionist measures in the U.S. and Europe. They, like most single-country emerging-markets offerings, are pretty concentrated by sector and by issue. And these funds, unlike broader emerging-markets vehicles, have nowhere to hide when there are political, economic, or other problems in China.

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