Approach China Funds Carefully

China funds are becoming increasingly fashionable. Indeed, when JP Morgan China Region  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.

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.

These risks have led to significant volatility over time. Although these funds have bounced back from a couple of sell-offs this year, they've suffered more enduring setbacks in the past. In fact, all of the China funds that have been around at least 10 years have dropped 15% or more in at least 12 rolling three-month periods and fallen 30% or more in one such period during the past decade.

Meanwhile, investors should note that some funds compound the dangers of focusing on China by following aggressive strategies. For example, IShares FTSE/Xinhua China 25 Index is even more concentrated than most of its peers, with just 25 or so holdings, around 60% of its assets in its top 10 holdings, and exceptionally big stakes in the financials and telecom sectors. And though  Oberweis China (OBCHX) isn't particularly concentrated, it courts additional risk by focusing on fast-growing and smaller-cap names.

Anything but Cheap
These funds tend to be costlier as well as riskier than many other emerging-markets vehicles. The front-load China funds have a median expense ratio of 2.02%, which is even higher than the steep overall median of 1.88% for front-load emerging-markets offerings. The actively run no-load China vehicles have a median expense ratio of 1.59%, whereas the overall median for actively managed no-load emerging-markets funds is 1.55%. And the China ETFs have a median expense ratio of 0.65%. That's quite reasonable in absolute terms, as would be expected given that these offerings rely on index strategies, but it's higher than the overall median expense ratio of 0.54% for emerging markets ETFs.

Not So Simple
Investors should also note that China funds are more complicated than might be expected. For a variety of historical, geopolitical, and market reasons, there is a broad range of different types of Chinese stocks. That range extends from mainland companies that trade on the mainland exchanges, two kinds of mainland firms that trade in Hong Kong, and Hong Kong companies that have substantial business on the mainland to Chinese firms that are listed on various overseas markets (including the U.S.), established and other Hong Kong companies that aren't particularly dependent on the mainland, and Taiwanese firms. These different types of Chinese stocks vary significantly in their risk/reward profiles and other ways. And the China funds differ in which types of stocks they consider and emphasize.  Fidelity China Region (FHKCX) tends to focus on established Hong Kong names and Taiwanese blue chips, for example, while  Powershares Golden Dragon Halter USX China (PGJ) tracks an all-cap index of U.S. listed securities of companies that derive the bulk of their revenues from the People's Republic of China.

Conclusion
Many investors already have a significant amount of China exposure, and most of those who want more would be better off with a diversified or regional emerging-markets vehicle that pays significant attention to the Middle Kingdom. And while it is certainly true that China funds can be productive holdings for sophisticated investors who already have well-diversified portfolios of international funds and want some extra pop, even such individuals need to be careful with these funds.