When Is The Right Time To Buy China ETFs?

by: Sam Subramanian

China's economic growth in the past decade has been phenomenal. The Chinese economy has grown 316%, dwarfing America's 43% expansion. The 2008 financial crisis has dented the economies of several nations including the U.S., but not China's. Essentially untouched by the 2008 financial crisis, China's economy has grown at close to double-digit rates in 2009, 2010 and 2011.

How have China ETFs Fared

Unfortunately, returns from China ETFs aren’t as exciting as China's economic growth.

Since the global market top in October 2007, popular China ETFs, iShares FTSE China 25 Index Fund (NYSEARCA:FXI), SPDR S&P China (NYSEARCA:GXC) and PowerShares Golden Dragon Halter USX China (NASDAQ:PGJ) are now down 48%, 41% and 44%, respectively. In comparison, the SPDR S&P 500 Index ETF (NYSEARCA:SPY) is down just 14%.

In fact, the China ETFs have lost more than ETFs that invest in troubled Europe. The Vanguard MSCI Europe ETF (NYSEARCA:VGK), for example, is down 37%.

Reasons for China ETFs’ Underperformance

There are three main reasons for the inferior performance of China ETFs.

Initial valuation. Chinese stock prices had soared nearly 150% during the 12-month period preceding October 2007. Chinese stock valuation metrics became exorbitantly high in 2007.

Corporate management. Sacrificing profitability, Chinese companies vied on gaining market share and failed to meet investors’ lofty profit growth expectations. Poor accounting practices, lax corporate governance standards, and proliferation of reverse mergers have encouraged short sellers to pile on questionable entities.

Monetary policy. China's central bank's concern over inflation, and efforts to rein it by tightening monetary policy, has been a headwind for stock prices. China's case clearly proves that one shouldn’t make investment decisions solely on the basis of growth rates or positive headlines. Purchase price and valuation matter. If they are high, performance suffers.

Right Time to Buy China ETFs

Notwithstanding the rapid growth achieved by China in the past decade, the nation ranks 95th in terms of per capita GDP among 180 nations, according to 2010 World Bank data.

However, China's economy has potential for substantial future growth. Economists predict that China will become the world's largest economy in 15 years. China ETFs are likely to perform well when the Chinese economic engine fires well on two cylinders: (a) Exports and (b) Domestic consumption.

Europe is China's largest export market. Currently, China’s exports are impacted by the European financial crisis. As for domestic consumption, Chinese monetary policymakers are divided in their efforts between taming inflation and supporting growth.

While the Chinese government is seeking to accelerate economic growth via infrastructure programs like the massive railroad construction project, China’s central bank is seeking to restrain inflation by restricting bank loans and raising reserve requirements.

Prospective investors in China ETFs should stay on the sidelines and watch Chinese inflation data as well as developments in Europe's financial crisis. Performance prospects for China ETFs should improve if Chinese inflation cools, or if the outlook for China’s exports to Europe improves.

Interim Options for China ETFs Investors

While waiting for China ETFs to turn timely, investors can look to the 'risk-off' play in Japan, where the economy is rebounding from a post-quake slump. Another alternative is Korea, where technology and construction companies are executing well. Investors can play Japan and Korea through ETFs like iShares MSCI Japan (NYSEARCA:EWJ) and iShares MSCI South Korea (NYSEARCA:EWY), respectively.

Diversified regional plays with an income bent such as WisdomTree Asia Pacific Ex-Japan (NYSEARCA:AXJL) can also work.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.