Our Picks for China Exposure

Economic data out of China suggests that a "hard landing" scenario is now fairly unlikely. Industrial production growth rates had been trending down since 2010 but are now stabilizing at around 9%. China's electricity output rose 6.4% in October, an improvement over the low-single-digit growth rates seen in the past few months. Retail sales growth has also been trending up over the second half of 2012 to reach 14.5% in October. A number of economists now think that the third quarter's gross domestic product growth of 7.4% will mark the bottom and that China's growth will regather its prior pace in 2013.

It is probably not a coincidence that these improving data points coincided with the meeting of China's 18th Party Congress last week when new leaders for the next 10 years were selected. Improving economic figures were certainly buoyed by government-mandated infrastructure spending earlier this year (though at much lower levels relative to 2009). During the transition period before the new leaders assume power in March next year, the government will likely continue to use stimulus spending, as needed, to keep the economy humming. In the coming years, we are optimistic that this new crop of younger, more liberal-minded leaders should have a positive impact on China's economy and that we will gradually see much-needed reforms such as interest-rate liberalization, yuan appreciation, and more competition in industries dominated by state-owned firms--policies that will support stronger growth in domestic consumption.

For those less optimistic about China's outlook, we would add that current valuations for Chinese stocks are near all-time lows, which should provide downside protection. The MSCI China Index, which includes large- and mid-cap Chinese stocks listed in Hong Kong, is currently trading at 10 times trailing 12-month earnings. Foreign investor sentiment has also improved, as indicated by strong net inflows into U.S.-listed funds tracking Chinese equities over the past two months. In October, more than $3 billion in assets poured into China-focused open-end and exchange-traded funds, a three-year high.

Our Picks
An open-end fund for China exposure is a logical choice--let the experts weed out the companies with dodgy accounting or return-crippling excess capacity. Our favorite and only Gold-rated China fund is  Matthews China (MCHFX). This is a Greater China fund with a sizable (40%) exposure to Hong Kong firms, a small exposure (8%) to Taiwanese stocks, and the remainder in Hong Kong-listed Chinese firms. Even with its mid-cap tilt, this fund is less volatile than the MSCI China Index and not surprisingly has significantly lower weightings in the state-owned financials and energy names. Historically, it has outperformed during market rallies and suffered smaller-than-average losses in 2008 and 2011. The fund managers (the longest tenured has been at the helm since 1999) focus on companies that will profit from rising income levels in Asia, and, therefore, the fund has large overweightings in consumer names relative to its benchmark. This fund carries a lower-than-average expense ratio of 1.13%.

As for passive options, we are not very fond of market-cap-weighted China ETFs, as the largest firms are primarily government-owned banks and energy firms. While these companies benefit from political and financial support from the government, at times they may have to put political goals ahead of profitability and, generally speaking, are not the best way to gain access to the faster-growing areas of China's economy. We are also concerned about the large Chinese banks as they face a number of near- and medium-term headwinds--including a rise in bad loans related to 2009 stimulus spending and margin compression from interest-rate liberalization. If we had to pick one out of the handful of China ETFs available, we would recommend  SPDR S&P China (GXC) which holds both Hong Kong-listed and New York-listed Chinese securities. Thanks to its New York-listed holdings, GXC has a relatively higher (12%) exposure to technology names (a number of Chinese technology companies are only listed in New York), which are generally entrepreneurial, fast-growing companies.

Given the increasingly interdependent nature of the regional economy, companies from neighboring countries are another option for investing in the Chinese growth story. A cap-weighted fund such as  iShares MSCI Hong Kong Index (EWH) is dominated by property companies, banks, and utilities, most of which have operations locally and in China. Property firms are continuing to benefit from a boom in residential property prices in Hong Kong, partially because of an inflow of mainland money (and partly because of quantitative easing in the United States and Europe), and banks are seeing growth in renminbi business thanks to ongoing liberalizations in the yuan exchange rate and cross-border banking services. This fund is suitable for investors bullish on China's increased financial integration with the global financial community.

The Taiwanese companies in  iShares MSCI Taiwan Index (EWT) should benefit as Taiwan and China continue to liberalize certain cross-straits trade and investment restrictions. Although China is already Taiwan's largest trading partner, this increased economic interdependence will make an investment in Taiwan, which has relatively more-established equity markets and financial systems, even more of an indirect play on economic growth in China.

Finally, we highlight one global fund option. In his article "Investing in the Emerging-Market Consumer," my colleague R.J. Hottovy argues that multinational consumer firms have the infrastructure, capital, and know-how to effectively capitalize on rising living standards in the emerging markets.  IShares S&P Global Consumer Staples (KXI) holds many companies that fit this description. And while this fund isn't a China play per se, top holdings such as  Nestle (NESN),  Procter & Gamble (PG), and  Coca-Cola (KO) are investing heavily in China to capitalize on its emerging consumer class.

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