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By Patricia Oey

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 multi-year 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 (NYSEARCA: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 (NYSEARCA:FXI) and SPDR S&P China (NYSEARCA: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.

Portfolio
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.

Fees
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.

Alternatives
IShares MSCI China Small Cap (NYSEARCA:ECNS) is a similar fund with a few minor differences. First, ECNS does not hold any U.S-listed Chinese stocks, whereas HAO does (accounting for about 10% of the portfolio). As a result, HAO and ECNS have slightly different sector weightings. ECNS has about 100 more holdings, and the average market capitalization of its holdings is around $900 million, which is lower than HAO's $2 billion. Due to its lower market cap tilt, ECNS is slightly more volatile than HAO. However, ECNS' recent outperformance relative to HAO was due to the former's greater exposure to smaller Chinese companies. ECNS is slightly cheaper, at 0.62%, but significantly less liquid. Another possibility is an A-share fund, such as Market Vectors China (NYSEARCA:PEK), which charges 0.72%. More details about the structure and risks of this particular fund are discussed here.

Our pick for large-cap China exposure is SPDR S&P China (GXC), which holds Chinese firms listed in Hong Kong and New York. GXC carries a reasonable expense ratio of 0.59%.

Those who want the experts to weed out the companies with questionable accounting or that might be operating in industries with return-crippling excess capacity can consider Matthews China (MCHFX), which has a Morningstar Analyst Rating of Silver. Even with its mid-cap tilt, this fund historically has been less volatile than the MSCI China Index, has lower weightings in the state-controlled financials and energy names, and has a relatively high degree of exposure (29% as of June 2013) to consumer names. The fund's annual fee is 1.12%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: An ETF For China's Next Act