Top 10 ETFs for a Rising China

It might seem inevitable that a nation with 20% of the world's population would be an economic powerhouse. Yet for several centuries now China has been both the world's most populous nation and one of its poorest.

From the end of the Ming dynasty in 1644 to the death of Mao, the West eclipsed the Middle Kingdom in every imaginable metric of human progress.

By the middle of the 20th century China was a nation wracked by civil war and starvation, and in the following decades its Communist government pursued Stalinist economic policies that further impoverished and isolated the nation's population.

At the height of the Cultural Revolution in 1968, the world's most populous nation had precisely three embassies: in Havana, Moscow, and Pyongyang.

In the late 1970s China under the leadership of Deng Xiaoping finally began to reverse its economic decline by embracing free market capitalism and opening up to global trade. Since 1980, Chinese GDP growth has averaged 7.7% a year, outpacing both the world as a whole and other emerging markets.

This spectacular growth has lifted China from an insignificant economic player to the second largest economy in the world, and has delivered hundreds of millions of its citizens out of abject poverty.

Even after that extraordinary period of growth, China's overall GDP per capita is still only 1/4 that of the OECD average. The Middle Kingdom's now inexorable rise is far from over, and its economy's strongest days are still ahead of it.

Although its export sector has been hit hard by the financial crisis, China's overall rate of growth has hardly fallen below trend with a forecast for 6.5% this year and 7.5% in 2010. Chinese shares have risen dramatically in anticipation of this continued growth, with the benchmark SSE Composite Index up 52% ytd. Investors cannot trade those Shanghai listed A shares because they are limited to a few "qualified foreign investors". Most Americans and most index funds thus must invest in Hong Kong " H" shares or US listed ADRs.

It is important not to overstate the rise of China, however. In the medium term there are still the small yet distinct possibilities of political turmoil on the mainland or conflict with Taiwan.

In the very long term the nation faces a severe demographic crisis that will begin to shrink its population in a few decades' time. By the middle of the 21st century China will look a lot like Japan does now, a prosperous but aging nation with its best economic days behind it.

But within this half of the century China's economy will almost certainly become the largest in the world, its companies and their shares will dominate market capitalization tables, and the skyline of Shanghai will be as recognized as that of New York, San Francisco, or Sydney. The following ten ETFs will help you make money along the way:

10. WisdomTree Dreyfus Chinese Yuan Fund (CYB) +2.56% ytd and .04 vol

The value of the Chinese Yuan is currently held below its fair value, within a tight trading range specified by the Chinese government. The authorities have slowly allowed the currency to rise over the past few years, but China still keeps it lower than market value in an attempt to subsidize its export sector. The costs of this policy are extraordinarily high - China must load itself with dollar denominated debt in order to maintain its loose peg - and will certainly be abandoned in the future. When it does, the Yuan will skyrocket.

9. iShares MSCI Australia Index Fund (EWA) +20.26% ytd and 4.17 vol

The Australian economy is the ying to China's yang. While China is rich in labour and capital, Australia has the natural resources China needs to fuel its boom. The EWA invests in 74 Australian listed companies and is heavily weighted towards the materials sector with metals giant BHP Billiton (ASX:BHP) alone currently making up 16 percent of the fund. Its large exposure to financials such as Westpac (ASX:WBC) and ANZ (ASX:ANZ) isn't as worrying as it would be in other nations: Aussie banks have performed admirably in the crisis.

8. Claymore/AlphaShares China Real Estate (TAO) +59.03% ytd and .06 vol

Real estate is a notoriously volatile and bubble-pone asset class. But over the long run, the economics of scarcity mean its price must rise. The TAO invests in 40 real estate developers and REITs that are mostly Hong Kong based and to varying degrees do business on the mainland. Up handsomely so far this year, it should be a great long term investment if its liquidity concerns are assuaged by higher volume.

7. iShares MSCI Taiwan Index (EWT) +41.24% ytd and 20.28 vol

Although the political status of Taiwan is disputed, no one can deny that Taiwan is economically part of China. Although the mainland only makes up a quarter of its exports, many of Taiwan's shipments to richer economies are really just the final end of a value chain that begins across the Straits. Although Taiwan's export driven economy has been hit hard this year and is expected to contract, its long run growth potential is intact as its tech sector continues to dominate low cost manufacturing in computing. Almost 60% tech by market cap, the 123 stocks of the EWT are poised to benefit.

6. PowerShares DB Base Metals Fund (DBB) +28.03% ytd and .54 vol

China's thirst for raw inputs increases the price of Earth's most basic materials. The DBB invests equally in three principal base metals: aluminum, zinc, and copper, all of which China imports in massive quantities to sustain its construction and manufacturing boom. With raw materials -especially copper- facing shortages within this century, owning the metals themselves is a good bet for the long term.

5. iShares MSCI Chile Index Fund (ECH) +50.90% ytd and .12 vol

The Chilean stock market is entirely a play on copper, which is the most sensitive of the base metals to soaring Chinese demand. Copper is used in manufacturing electronics, roofing, piping, and heavy machinery - all things in strong demand in China. Chinese demand for the metal alone makes it Chile's largest trading partner, and the value of the Santiago Stock Exchange rises and falls with the price of the metal. The ECH invests in 36 of the the companies listed on that exchange, with a strong weighting towards the copper producers.

4. United States 12 Month Oil Fund (USL) +26.39% ytd and .15 vol

The most precious commodity around is oil. Demand from emerging markets such as China are driving up demand, just as the supply of easily recoverable conventional oil is plateauing. Oil won't run out for the foreseeable future, but the rise of emerging economies means that it will become lastingly more expensive. Investors should be careful to avoid the USO, whose returns are stolen by backwardization and contango. USL is specifically structured to avoid these problems by purchasing oil futures contracts of different maturities.

3. iShares MSCI Hong Kong Index Fund (EWH) +40.78% ytd and 6.68 vol

Hong Kong has for centuries benefited from its status as China's gateway to the West. As the mainland itself opens up, some of Hong Kong's thunder will be stolen by Shanghai and other nascent financial centers. But Hong Kong's political stability, knowledge of English, and financial sophistication mean that it will remain one of China's premier economic centers. The EWH tracks an index of 123 companies that derive a majority of their revenue from the city-state itself, and is extremely weighted towards financials, which is less concerning than it would be on the mainland as banks like HSBC's Hang Seng Bank (HKG:0011) are well-regulated and in private hands.

2. Powershares Golden Dragon Halter USX China Portfolio (PGJ) +49.69% ytd and .34 vol

The basis of any China play should be a broad market fund with exposure across sectors and market capitalizations. The PGJ is the best ETF for this purpose because it avoids a pure capitalization formula which overweights the financial sector. Its 101 holdings represent mostly stocks from the energy, tech, and industrial sectors that trade in the US . Unlike its inferior competitors the GXC and FXI, the PGJ is underweight financials, which make up only 5% of PGJ and almost 50% of the FXI. Financial shares in China have performed well in the past, but are a risky proposition as the state owned banks are often used for government purposes and have experienced severe finanical distress in the recent past.

1. Claymore/AlphaShares China Small Cap Index (HAO) +63.67% ytd and .14 vol

There is good evidence that small cap stocks outperform large cap over time. But even without the "small firm effect", the HAO would still be the best China ETF available to US investors. The fund has its biggest exposure to the industrials and tech sectors, with a decent mix of materials and energy names as well. Its financials exposure is around 15%, about half that of the GXC and 1/3 that of the FXI. Its broad sector base, wide holdings (137) and uniqueness in focusing on China's small caps make it the best way to play China's rise, and its impressive outperformance year to date speaks volumes.

Disclosure: None

Comments

[User 422955:]

eucephi wrote "so far, China could not do a thing to Russia." How about forcing the Soviet Union to keep a large part of its armed forces on the Chinese border? This used up resources, making life easier for NATO.

Jun 09 09:20 PM

[Debra J. Di...:]

Nice idea but buying ETF's for Australia and Chile and base metals ETF's are not going to do for you what you think they will. There are too many other issues (political, currency, other companies within the ETF that are part of that countries economy buy not related to Chinese business) that will influence performance of these ETF's. You are going to get yourself into trouble by stretching this hypothesis. Stick to basics.

Jun 09 10:19 PM

[ETF Grind:]

I wouldn't recommend them if the other factors weren't kosher as well. Australia and Chile are both politically stable with sound macroeconomic fundamentals.

Every sector is linked to one another. Australian mining wages, for example, support consumer discretionary and retail.

Its indisputable that China drives both of those economies, and so long as China grows they have significant opportunity to benefit.

I'd rather own Australian miners, for example, than an all China ETF that's 50% state-owned and operated financials! Just because something says "China" on the label doesn't mean its a buy.

The real risk is not thinking outside the box in your investment strategy...


On Jun 09 10:19 PM Debra J. Diamond wrote:

> Nice idea but buying ETF's for Australia and Chile and base metals
> ETF's are not going to do for you what you think they will. There
> are too many other issues (political, currency, other companies within
> the ETF that are part of that countries economy buy not related to
> Chinese business) that will influence performance of these ETF's.
> You are going to get yourself into trouble by stretching this hypothesis.
> Stick to basics.

Jun 09 10:41 PM

[The Kansan:]

"Financial shares in China have performed well in the past, but are a risky proposition as the state owned banks are often used for government purposes and have experienced severe finanical distress in the recent past."

Middle kingdom, United Kingdom, United... forget it. But seriously, why even mention trading volume when you care so little about it?

Jun 09 10:59 PM

[ETF Grind:]

I figure some people might care. My own view is that outperformance matters more than volume, but some people feel cheated by illiquidity.


On Jun 09 10:59 PM The Kansan wrote:

>
> "Financial shares in China have performed well in the past, but are
> a risky proposition as the state owned banks are often used for government
> purposes and have experienced severe finanical distress in the recent
> past."
>
> Middle kingdom, United Kingdom, United... forget it. But seriously,
> why even mention trading volume when you care so little about it?

Jun 09 11:04 PM

[Fruffing:]

Don't rule out investing in the FXI. Transparency is rotten all around, at least your SRE holdings are backed by the Peoples Liberation Army.

Jun 09 11:17 PM

[Think-About-It:]

Thanks for a good article with a number of investable ideas for anyone that's a long-term bull on China.

Question:
Was there any reason you did not mention an agriculture ETF or Brazil via EWZ to go along with your theme?

Jun 10 01:00 AM

[JPChile:]

There is a misundersting with the ECH.

In the Chilean Stock market there is not a single mining company in the IPSA index, there are pulp companies, potasium companies, a lot of banks, an airline but not a cooper company.

So if you want to invest in cooper buy JJC.

Jun 10 09:08 AM

[ETF Grind:]

The ECH doesnt' follow the IPSA, it follows the MSCI. THe MSCI's has several mining and mining services companies.

More importantly the value of copper exports drives the ENTIRE economy. Same as Australia.


On Jun 10 09:08 AM JPChile wrote:

> There is a misundersting with the ECH.
>
> In the Chilean Stock market there is not a single mining company
> in the IPSA index, there are pulp companies, potasium companies,
> a lot of banks, an airline but not a cooper company.
>
> So if you want to invest in cooper buy JJC.

Jun 10 09:21 AM

[ETF Grind:]

I'm very bullish on agriculture, but yes I think agriculture is more of a global story while base metals are a Chinese story.

Also, the agriculture ETFs in the US are limited to certain crops. China's biggest demand is for Brazillian soy, which we can't buy in the US through ETFs.


On Jun 10 01:00 AM Think-About-It wrote:

> Thanks for a good article with a number of investable ideas for anyone
> that's a long-term bull on China.
>
> Question:
> Was there any reason you did not mention an agriculture ETF or Brazil
> via EWZ to go along with your theme?
>

Jun 10 09:23 AM

[chleoku:]

good insights. Investing in China makes sense as they are Already in the BULL cycle:

www.wealthalchemist.co.../

Jun 10 09:32 AM

[mbkelly75:]

Great article - thank you for some good insights and feedback. Well done!

Jun 10 11:41 AM

[Life of Luxury:]

I agree with your assessment. China is in such a rapidly growing economic state, that even a slow-down for them is leaps and bounds better than most countries in the world.

They seem to be kicking in high-gear and many sectors are participating in their overall growth. They may be late to the prom, but may very well be crowned "King of the Ball" when it's all said and done.

An example is their strong demand for wine:
www.thelifeofluxury.co...

... for luxury products:
www.thelifeofluxury.co...

... and real estate
www.thelifeofluxury.co...

Jun 10 05:40 PM

[thetrystero:]

@ETF Grind: These stocks have all rallied anywhere from 20% to 60+% YTD. From a purely technical stance, doesn't that make a pullback likely in the near term? or are they somehow exempt due to factors I'm not seeing?

Jun 11 12:55 AM

[thetrystero:]

on a related note, how do you value the "cheapness" of an ETF? Same as a stock (i.e. look at earnings yield if you're a magic formula guy for example)?

Jun 11 01:00 AM

[ETF Grind:]

My guides are meant for long term fundamental investing. These funds may pull back in the short term, but its hard to argue that China's gonna be worth less in 10 years.


On Jun 11 12:55 AM thetrystero wrote:

> @ETF Grind: These stocks have all rallied anywhere from 20% to 60+%
> YTD. From a purely technical stance, doesn't that make a pullback
> likely in the near term? or are they somehow exempt due to factors
> I'm not seeing?

Jun 11 04:31 AM

[ETF Grind:]

When I use the word "cheap" above its just in reference to the expense ratio of the fund.


On Jun 11 01:00 AM thetrystero wrote:

> on a related note, how do you value the "cheapness" of an ETF? Same
> as a stock (i.e. look at earnings yield if you're a magic formula
> guy for example)?

Jun 11 04:32 AM

[jimboy:]

On point 4 OIL, it's hard to argue the long term case for some massive oil price appreciation with China a big driver but I don't think the main ETFs are delivering.
The oil price has gone up 50% this year and USL only 26% so it's not tracking the price that well and has not beaten USO by much.

Jun 11 05:22 PM

[thetrystero:]

@ETF Grind: can you suggest a few agriculture funds?

why do you feel that ags are not bullish enough to have made the top 10?

Jun 12 03:29 AM

[thetrystero:]

whoops, just saw your comment to a similar question above.


On Jun 12 03:29 AM thetrystero wrote:

> @ETF Grind: can you suggest a few agriculture funds?
>
> why do you feel that ags are not bullish enough to have made the
> top 10?

Jun 12 12:27 PM