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This year hasn’t been very kind to emerging market investing, as a number of developing economies have struggled to maintain momentum thanks to fears over price increases and general risk aversion. In particular, the world’s most populous emerging market, China, has endured a particularly rocky 2011. Many investors are growing increasingly concerned over the country’s short term growth prospects as inflation remains uncomfortably high above the government’s target rate. The latest readings show the rate at 5%, which is one full percentage point above Premier Wen Jiabao’s goal.

As a result, China has begun on a reserve ratio hiking campaign attempting to stall credit growth in order to curtail inflation, while also allowing its currency to appreciate modestly against the dollar. China has already raised the reserve ratio five times so far this year, with many fearing that further measures will be taken to fight the specter of inflation from damaging the Chinese economy even more. However, these increases come at a cost to the overall economy, as some are now forecasting that the Chinese economy’s growth will "slow" to 8% this year, potentially putting further pressure on Chinese stocks.

Obviously, this sentiment over the Chinese market has had a generally negative impact on China-focused ETFs so far this year. Of the 20 ETFs in the China Equities ETFdb Category, over one-third are down for the year while another four funds have gained less than 2% since January 1. Despite these stagnant returns, some corners of the China market have been performing quite well so far this year, including the technology sector.

The two China Tech ETFs, Guggenheim’s China Technology Fund (CQQQ) and the Global X China Technology ETF (CHIB), are both up more than 10% so far this year, far outpacing the returns posted by the other segments of the country’s markets as well as broad funds targeting multiple emerging markets such as VWO or EEM. Below, we highlight some of the key reasons for these funds’ outperformance so far this year, and the key areas that will determine if they can continue to climb going forward.

First, it is probably best to highlight some of the key differences between these two products. Both funds remain relatively unpopular with investors despite solid track records, as the two combine to have less than $75 million in total assets. Additionally, expenses are a little higher than the category average but certainty are not extreme for either product, as CHIB charges investors a slightly lower fee of 65 basis points compared to a 0.72% charge for CQQQ.

In terms of holdings, both are pretty concentrated, although CQQQ is more so; the fund has more securities in total but devotes more of its assets to its top 10 holdings, suggesting that CHIB is slightly more spread out despite having fewer total securities.

Despite these differences, both funds have performed pretty well so far in 2011; CHIB has returned 16% so far in 2011 compared to an 11.6% return for CQQQ.

Inflation Immunity

A key reason that technology stocks in China have been able to weather this recent storm and prosper is the very nature of this sector: Tech companies tend to be more immune from inflationary pressures than other corners of the economy. Take for example a TV; the quality goes up over time but the prices tend to drop as more efficient means of production are devised and the product becomes more of a commodity. When this happens, costs tend to go down as well, allowing greater pricing power for technology-oriented firms that can afford to take hits to margins in ways that other industries – such as the consumer industry – are unable to do thanks to their already razor-thin margins.

Additionally, many of both of the funds' top components have seen solid years so far, thanks to impressive earnings, the exit of competition, or a a combination of these factors. Baidu.com (BIDU), often billed as the Chinese Google, has seen its share price soar by close to 40% this year thanks to a lesser presence of Google (GOOG) in the market as well as continued growth in search volume across the country. The company makes up a top four allocation in both funds, including a 12% weighting in CQQQ – the top spot in that fund.

Other top performers that make up a significant portion of both funds include online media company SINA Corp. (SINA), which has gained over 70% on the year, and Tencent Holdings (OTCPK:TCTZF), a top five component of both funds that has gained an impressive 25% on the year. Thanks to performances like these from some of the funds’ top components, it is easy to see why the China tech sector has so thoroughly outperformed the other industries of the nation so far in 2011.

Going forward, since a great deal of Chinese manufacturing is focused on low skill, labor intensive production, there is likely to be a lot of opportunity to augment the system with more technology, thereby capping labor costs, at least in the short term.

“When companies are faced with upward pressure on costs, and therefore lower margins, they can respond by raising prices — which is difficult in the current environment — or cutting costs by investing in technology,” said Richard Russell, editor of investment newsletter Dow Theory Letters, suggesting that as inflation rises in China, more firms are likely to turn to technology to keep labor costs in check and avoid raising costs for end users.

So for investors seeking exposure to the Chinese market but are increasingly worried about the issues of inflation, CHIB or CQQQ could be worth a closer look by both long-term and short-term investors alike.

Disclosure: No positions at time of writing.

Disclaimer: ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships.

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Source: Why Chinese Technology ETFs Are Crushing the Competition