China Now On Sale - Via Its ETFs? What The Market-Makers Think.

Includes: FXI, FXP, HAO, PGJ
by: Peter F. Way, CFA


Controversy over China’s internal economics is driving its stock prices down.

More than two dozen ETFs offer many ways to take a diversified position.

Clouded government statistics and media speculations stimulate volatility, require intense, timely research.

Market-maker international information-gathering systems provide advantages.

ETF selectivity becomes exceptionally important.

China's conversion from an emerging, sleepy giant to a confident world power by shifting from communism to capitalism has displayed how low on that learning curve its leadership has been. Excessive overbuilding, poorly regulated resources utilization, ecology abuses, massive population shifts, and political corruption incidents (revealing that ancient art's incompetence in a new environment), are all part of the unfolding drama.

But despite the missteps, the Chinese government retains the authoritative power to remedy problems, even if not always delicately. Such changes force reflecting market moves.

Many developments in China have been obvious offerings of opportunity, capitalized on by over two dozen ETFs. Between language barriers, geographical distance, and prior political isolations, the hoped-for ETF benefits of diversification and ease of entry and exit made some, but not all, of these offerings effective. Several of the come-lately entrants have yet to prove their worth, and in a sharply-changing business environment at distance, may become dangerous capital involvements.

It's time for a fresh look at how our best-informed players now see the near term most likely price range possibilities among the ETF alternatives. We focus on the ETFs where there is adequate history of their prior forecasts to give some comfort to the present ones.

A dozen or more other ETFs have not been considered, for lack of useful data. Even among those in the above table, more than half have dimensions that would exclude them from consideration were they in competition with most other ETFs.

Market-maker hedging actions, taken when they are (frequently) required to put firm capital at risk to provide "other side of the trade" balance to a big-money-fund client's volume trade order, tell just how far the MMs think their clients are likely to push prices.

Their implied forecasts are in the two first data columns of the table, followed by the market quote at the time of the forecast, and the upside prospect between it and the top of the forecast range. Risk is compared to that potential reward by the next column's tabulations of the average maximum price drawdowns in the 3 months following all prior forecasts of the past 5 years having upside-to-downside proportions like today's.

A standard test of all such forecasts looks to find the first end of day instance of a price equal or exceeding the forecast range-top sell target. Failing that, performance is measured to the closing price at the end of a 3-month holding period time limit. That is where the rest of the table's performance data come from.

Of the five ETFs having the best (brief) past records in this table, three consist of but a handful of prior experiences (similar to what is now foreseen) among them. Collectively that is too little evidence to encourage any risking of capital. PowerShares Golden Dragon China ETF (NASDAQ:PGJ) demonstrates a better set of market-maker [MM] appraisal experiences, with profitable ones in better than 3 out of every 4 in the over 200 prior forecasts with upside-to-downside balances like today's. Its upside of +8.4% is larger than the typically experienced worst-case price drawdowns in the 3 months following those forecasts, but at their -7.2% exposures, not by much.

A better reward-to-risk comparison is present in the Guggenheim China Small Cap ETF (NYSEARCA:HAO). Its upside is the same at +8.4%, but the downside exposures experienced of -5.3% are less scary and more easily recovered from. The larger average past percentage payoffs from those forecasts (+6.5%), plus the shorter holding periods involved (37 market days) make the annual rates of gain (+54%) more attractive to a wealth-building portfolio.

In the top 5 of these ETFs there is one short-structured, leveraged (2x) issue, the ProShares UltraShort FTSE China 25 (NYSEARCA:FXP). Its skinny history of only 2 prior forecasts like today's promise a near-+11% gain against previous worst experiences of only -2% drawdowns. Before, what happened was actually +17% gains, pounced upon in only 13 days for a fantastic annual rate. But don't hold your breath until it happens again.

Here is where FXP is now in its price journey as the overall China outlook has soured. Sorry we didn't call it to your attention earlier, but we only have from now on, and there were other (domestic) opportunities of equal or better scale to take advantage of.

(Used with permission)

The vertical lines in this graph are the MMs' forecasts, made live at the date of the closing price shown by the heavy dot in the line.

While the current forecast range top may well yet be reached, the trip could be already half over, and inverse (short-structured) ETFs are notoriously unreliable. Still, it could be a hedge on commitments at this point in time in HAO or PGJ, with win-win potentials from appropriately timed closeouts.

From a quality (but not current price vs. prospects) point of view, the most liquid (and at other points in time) way to participate in China's progress is in the iShares China Large-Cap ETF (NYSEARCA:FXI), the non-evil cousin of FXP. It has a committed following of $5.5 billion of investor assets, far in excess of all the other ETFs noted above combined. Its average daily trading volume of 24+ million shares makes it extremely liquid, carrying a tiny bid-ask trade spread. For the sake of historic perspective, here is how the MMs have appraised its prospects, weekly, over the past two years:


Market-makers apparently believe there are probably still some profit potentials in the current Chinese government internal economic realignments. But no major disasters, nor Bonanzas, are envisioned. Given realistic 2-month to 4-month holding periods, selective ETF employment may provide ways at present to make money as prices move through both directions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.