In recent weeks, there has been discussion on Seeking Alpha on the relative merits of investing in country ETFs as opposed to investing in select stocks. Roger Nusbaum covers the topic in this article.
I wanted to check this situation for myself and given the outstanding economic outcome in China, it seemed appropriate to examine the relative merits of Chinese stocks and China ETFs. For the purposes of the exercise, I analyzed NYSE listed ADRs of around 60 Chinese companies and the SPDR S&P China ETF (GXC).
I applied my usual portfolio construction methodology to Chinese ADRs for the period 1 July 2010 to the present.
The first filter was to identify ADRs that exhibited a level of consistency in outperforming the SPY over a long time frame. From that list, I identified ADRs adding consistent alpha in the current period, and then I checked historical performance to satisfy myself that these select ADRs were robust over a period of time.
In the course of this analysis, I found:
- That in the analysis period, China ADRs exhibited a high level of volatility. This may be attributed to the small number of stocks listed, or an intrinsic characteristic of China stocks or just a function of timing. Whatever the reason, volatility is an issue because the higher the volatility, the less attractive the asset.
- That because of this volatility, it was quite difficult to develop a portfolio exhibiting consistent alpha. Of the approximately 60 stocks considered, only 15 could have been considered for this portfolio, and nine were selected. In general it proved difficult to form portfolios that significantly and consistently outperformed GXC. China is a difficult market at the moment.
The ADRs forming the most consistent alpha are the following:
The Performance of the ADR portfolio and GXC relative to SPY for the period to 25 March 2011 is:
Click to enlarge charts
And to 30 Sept 2010:
I am not an ETF expert and therefore I can’t comment on issues related to ETF investing. However, from my perspective:
- The answer to the question - ADRs or ETFs ? It is, in this case, ADRs. Sector and stock selection in ETF structures significantly affect returns no matter what benefits country diversification may promise.
- The underperformance of GXC, and the difficulty in forming better performing portfolios is surprising given strong Chinese economic growth.
- Considering the difficulty in forming the above portfolio, and the modest alpha generated, I would be cautious on China investments at the moment.
Review of Ongoing Portfolio
In my previous article, I identified the following portfolio as one which exhibited consistent alpha, but which might require some hedging in a downturn. The portfolio continues to exhibit consistent alpha generation. With Q2 earnings about to be announced, I include current earnings estimates for the stocks for future reference.
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Alpha trajectory is shown below: