An Inside Look at the China Funds' New Home

Three new Morningstar categories debuted on Oct. 1. In a column announcing the changes, Russel Kinnel, Morningstar's director of mutual fund research, detailed the new groups and offered examples of funds from each. Given the interest in all things China, we thought many readers would like a deeper look at the China Region category in particular, as well as an update on the group these funds left behind.

Why China? Why Now?
The fact that Morningstar created a category solely devoted to China funds should not be interpreted as a broad endorsement of these funds or their mission. Nor are we "initiating coverage" on a large batch of China funds. All of these funds were already in our database, and a few were already receiving analyst coverage. We may add more of them to our coverage list over time, but that decision isn't tied to the introduction of the new category.

Rather, we had taken note that as the number of China-related funds proliferated over the years, they created problems for the Pacific/Asia ex-Japan category in which they resided. That group was intended for funds devoted to the broad sweep of "emerging Asia." Although, in years past, it did include a few portfolios devoted solely to Korea or other countries, such funds were tangential. However, when the number of open-end China funds exploded, growing to more than 20 in all--not to mention the many closed-end and exchange-traded funds that also target that market--their heft skewed the entire category's performance and portfolio averages in a China-heavy direction.

In addition, the returns rankings and portfolio statistics for the individual China funds themselves were of limited value when compared with category averages that reflected data from a number of much broader portfolios, as well. It was time for a change.

Similar, But Not Identical
Investors interested in China funds now have a much easier time finding them. However, the funds grouped together under the China Region label are, in many cases, quite distinct from each other. The name of the category is one tip-off. We chose the moniker "China Region" rather than "China" because not every China fund is devoted solely to the markets of mainland China.

In fact, even the funds that invest almost exclusively in mainland China's companies own some of them through shares trading in Hong Kong. In other cases, funds don't have an overly mainland-focused portfolio at all; they own plenty of companies trading in Hong Kong that are truly centered in Hong Kong rather than the mainland. Some offerings go one step further, owning a chunk of Taiwan-based companies, as well, or some China-oriented firms based elsewhere.

Aberdeen China Opportunities (GOPAX), for example, has more than two thirds of its portfolio in stocks that trade in Hong Kong. While some of those are mainland-based companies merely listed on the Hong Kong exchange, many others at the top of this portfolio, such as apparel stalwart Giordano International and conglomerate Jardine Strategic Holdings, are considered true Hong Kong-based, international firms, even if they do have extensive involvement in the mainland. By contrast, Invesco China (AACFX) has nearly all of its assets invested in "conventional" mainland China companies; the top of its portfolio is dominated by state-owned giants such as  CNOOC ,  PetroChina , and  China Life Insurance .

Of course, the line between a mainland-China company and a Hong Kong company can be blurry, so it would be wrong to put too much emphasis on those labels. But the above examples indicate that there can be real differences, and funds that lean heavily one way may perform quite unlike one tilted toward the other extreme. Then there are outliers such as GMO Taiwan III , which doesn't even invest in mainland companies. Such a fund is included in this category, though, because, while not ideal, the China Region group is a better fit than Pacific/Asia ex-Japan.

A Look Back
It would be wonderful if the exodus of the China herd had left the Pacific/Asia ex-Japan category populated solely by funds that invest all across that region. Unfortunately, the fund industry isn't that neat and clean. While the Pacific/Asia ex-Japan category is now much more homogeneous than it had been, some quirks still exist. Most notable are the seven open-end India funds in the group. (Some closed-end and exchange-traded funds target that country, as well.) That's not a large-enough number of open-end India funds to merit a separate category, and no other group would be more appropriate for them than this one, so here they remain. If that number expands much further, though, India funds might eventually get a category of their own.

So how many truly Asia-wide funds that exclude Japan are left in this category? Twenty-one mutual funds still fit that description. It's admittedly a rather compact group. But there are sound reasons to favor a portfolio that's diversified across the region rather than one targeting a single market. And this "pure" pan-Asia group offers a number of worthy options, such as the offerings from Matthews.

Bottom Line
In that spirit, it's worth reemphasizing that creating a China Region category does not mean we are trying to steer investors toward that area. In fact, given the complexities and risks involved, it's worth treading very carefully when considering China funds, as my colleague William Samuel Rocco explained earlier this year.

The intent was purely to enable better comparisons and ease the task of finding the funds you are looking for. If you do want to find either a China fund or a broader emerging-Asia portfolio, the new arrangement should make that search much easier to pursue.