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An ETF for China's Next Act

China's reform agenda for its planned economic transition will be released next month.

Patricia Oey, 10/04/2013

It's been hard for investors to make money in China over the past few years. After a decade of 9%-10% annual gross domestic product growth, driven by exports and fixed-asset expenditures, China is facing a new normal: weaker external demand for exports and slowing infrastructure spending. Another significant concern over the past few years has been uncertainty regarding the stability of China's financial system, which includes the banking and property industries. All of these issues have weighed heavily on the performance of Chinese equities.

The Chinese government acknowledges that it needs to shift its growth away from hard asset and infrastructure spending to domestic consumption. To this end, China's new leadership is focusing on financial sector reforms, taxes, social inequality, and urbanization. More details are expected to be released following next month's meeting of senior government officials--the Third Plenary Session of the 18th Chinese Communist Party Congress (historically, new leaders have used the third plenum to unveil a major multiyear political and economic reform program). While a large-scale economic transition will be challenging and slow-going, at least China has a long-term-focused growth plan. The same can't be said for countries such as India and Brazil.

Those optimistic about China's reform program and the long-term outlook for the Chinese consumer may want to consider a small-cap exchange-traded fund such as Guggenheim China Small Cap HAO. This fund provides exposure to about 250 Chinese small-cap firms listed in either Hong Kong or New York and provides good exposure to sectors that will benefit from growth in domestic consumption. Large-cap funds, such as iShares China Large-Cap FXI and SPDR S&P China GXC, tend to be dominated by state-controlled enterprises in the financial, telecom, and energy sectors, which at times may have to put political interests ahead of profitability. These funds also tend to be relatively light in consumer names.

HAO has about 27% of its portfolio in consumer stocks (which includes auto manufacturers, retailers, and food and beverage companies) and a 9% weighting in tech companies, most of which are domestically focused Internet companies, and not global hardware supply-chain-component companies. This fund's 19% weighting in industrial firms includes airlines and airport companies, which are expected to benefit from growth trends in travel and tourism. And while HAO does hold government-controlled entities, many of its holdings are privately owned, more entrepreneurial companies.

That said, small-cap single-country ETFs tend to be very volatile and are generally suitable as satellite holdings for very risk-tolerant investors. This ETF's five-year annualized standard deviation of monthly returns (a measure of volatility) was 32.7%, higher than the MSCI China Index's 27.0% and the MSCI Emerging Markets Index's 27.5%. However, HAO's five-year Sortino ratio (which does not penalize for upside volatility) was 0.43, higher than the MSCI China Index's 0.34.

We also note that at this time, data on the Chinese consumer are mixed. July retail sales rose 13.2% year-on-year, down from 14.3% in 2012 and 17.1% in 2011, indicating slowing consumer activity. But while official retail sales data can be useful for identifying trends, one key issue with this data point is that it counts a sale from when an item is shipped rather than when it is actually sold. So it's not surprising to see that official statistics don't reflect the current woes of Chinese retailers and grocery stores, who have been reporting weak sales in 2013.

This fund tracks the AlphaShares China Small Cap Index, which uses a modified float-adjusted market-cap-weighted methodology to select stocks. The index is reconstituted annually on the third Friday of December. Securities eligible for inclusion in the index must be mainland China companies listed in either Hong Kong or in other overseas markets, with a float-adjusted market capitalization between $200 million and $1.5 billion. The fund primarily employs full replication to track its index, which includes about 250 companies.

This ETF's expense ratio is 0.75%, which we think is reasonable for such a niche strategy. In the three years to June 30, 2013, the fund's annualized returns (after fees) of negative 0.75% trailed the index's 0.12%. After the 75-basis-point expense ratio, the remaining 12 basis points of implicit costs are not significant, given the fact that this is a small-cap fund that holds less-liquid securities. Small-cap funds can also see high turnover (which can drive up costs) as companies fall below or rise above the index thresholds. This fund's average annual turnover over the past three years was 31%, which is reasonable for a small-cap emerging-markets fund.

Patricia Oey is an ETF analyst at Morningstar.

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