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China's Influence Felt Far and Wide

Funds need not be Asia-focused to have felt the impact this year.

Gregg Wolper, 10/25/2011

Concerns about China have hit that stock market hard in 2011.

A potential slowdown in that country's economy has frightened investors, even if China's growth rate would still hit levels most developed markets would envy. In addition, questions about the thoroughness and accuracy of the accounting of Chinese companies--concerns that aren't new but tended to be brushed aside when enthusiasm ran high--have come to the fore, particularly with Chinese firms listed in the United States and Canada.

The impact on funds has been widespread. It can even be felt in some areas most might not expect.

Hurting at Home
Funds in the China Region category have felt the impact most directly. It has suffered the worst average performance of Morningstar's 14 international-fund categories for the year to date through Oct. 21, with a loss of 24.4%. In a year that's been tough for many areas of the investment markets, that's the worst showing of any category, whether equity, bond, or alternative, domestic, or foreign.

Although, as noted above, there are good reasons why doubts have arisen about China, it's still a bit surprising the China Region category is sitting at the absolute bottom of the rankings in 2011. After all, it wasn't China that suffered a devastating earthquake, tsunami, and nuclear crisis. Nor is China at the forefront of the most serious ongoing financial crisis this year: the Greek debt fiasco and its real and potential impact on European banks and governments.

Perhaps China stocks, having recently been viewed as such a trendy play, were simply in position to suffer a greater fall. It's worth noting as well that China's dismal category ranking derives partly from fund-creation trends. Had fund companies not created so many China portfolios when that country's market was riding high, there wouldn't be a China Region category available to sit in last place. Conversely, it's safe to say that if enough suitable funds existed to create a Greece category, it would be doing worse than China Region. In any case, China funds have suffered even though most of them aren't limited to the Mainland. They can also invest in Hong Kong and, in some cases, Taiwan. But unfortunately for the funds, these markets have tumbled about as far as China's have this year. Indonesia, Malaysia, and Thailand have held up much better, but they're off-limits to this crowd.

Other Emerging-Markets Funds Also Feeling the Pain
That said, the effects of China's rough year have not been limited to China funds. Concerns about slowing growth in China also help explain certain other categories' travails so far this year. The second worst group, with a loss of 21.7%, is Latin America stock. Latin America fund portfolios are dominated by Brazil, and Brazil's market is heavily influenced by resource giants whose most influential customer is China. (There are also several Brazil-only funds in the category.)

Needless to say, the other Asia-focused categories have also been affected, but most interesting is how some funds have been hurt far more than others. Dreyfus Emerging Asia DEAAX, for example, is the worst performer in the Pacific/Asia ex-Japan category, with a staggering loss of 38.1%. A key reason: It has about one third of its assets in China versus just 14% for the category average. It's also overweighted in Taiwan. Meanwhile, that fund has much less invested than most peers have in South Korea, whose market has been much healthier than China's this year.

Broad-Based Funds Not Immune
Even funds in the more diversified categories have been stung by China this year. Artio International Equity BJBIX is one of the biggest funds in the foreign large-blend category while Davis International DILAX is among the smallest. Both, however, sit near the bottom of the group's year-to-date return chart, and in both cases, China bears much of the blame.

Davis International had about 20% of assets in Chinese stocks as of its July 31 portfolio, compared with a category average of 3%. Causing special pain: Earlier this year, China's Sino-Forest--which later crashed after fraud allegations--was one of the fund's top holdings. Meanwhile, though the Artio fund has a bit less than half Davis International's stake in China, its 9% stake (which owes to the managers' conviction in the country's long-term potential) is still a substantial overweighting. It has been a key contributor to Artio International Equity's stumble this year.

Templeton Global Bond TPINX does not have the direct exposure to China that the Dreyfus, Davis, and Artio funds do. But as Morningstar analyst Miriam Sjoblom explained in a recent column, much of manager Michael Hasenstab's portfolio is constructed to take advantage of a healthy Chinese economy, including hefty exposure of bonds and currencies from China's main regional trading partners. While his interest-rate stance has also taken a toll, the China play is one reason why the fund sits in the world-bond category's 96th percentile year to date.

Appreciating the China Factor
It's not news that China's economy has become so immense and influential that a sharp slowdown there would reverberate around the world. Probably less well-known, though, are the ways in which perceptions of that country's prospects can affect mutual fund performance. That's true even without a serious economic downturn there, and even if funds aren't in an Asia category or even own many Chinese securities.

The examples above (and many others could have been chosen) show the strength and breadth of China's influence in the fund world. The intention isn't merely to highlight the risks, though. China also can exert a positive impact on performance, as it has in the past. Rather, the message is that investors who understand as well as possible the exposure funds have to that powerful country's influence will be best placed to appreciate the risks and opportunities they run in that realm. They will also be in a better position to understand and put into context their funds' performance, not only this year but for years to come.

Gregg Wolper is an editorial director and senior mutual-fund analyst at Morningstar.
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