China ETF Safety Net: Protect Against Downside Risk

Jun. 1.07 | About: iShares China (FXI)

Are you worried that the Chinese stocks have moved too far too fast? Or maybe you have missed the story and fret that it is too late to get a piece of the action. The China ETF (NYSEARCA:FXI) was one of the star performers in 2006 but this year is up only 3.44%. All the headlines about the hot China market have been about the Shanghai Composite index which includes the Shanghai and Shenzhen and their “A” shares available only to Chinese investors. Still, it is likely that a sharp pullback in the Shanghai Composite would have a spillover affect on FXI.

China has been the largest economy in the world for eighteen of the past twenty centuries and it is clearly determined to regain its role as the hegemonic power in Asia and then challenge U.S. global leadership. Will it be able to sustain its 10% economic growth rate, quell rural discontent, build a sound market-based financial system, privatize dominant state-owned enterprises and move towards openness and democracy? This is a tall order and you can put me in the skeptic column. Nevertheless, China’s raw industrial power, momentum and the palpable ambition of the Chinese people could realistically yield a huge return. I advise my clients to go ahead and invest in China but emphasize that this is a speculative investment. It is smart to protect against the considerable downside risk.

Here is a simple plan you might want to execute to capture the upside while cutting your losses if the Chinese economy hits a speed bump. First, take a broad stake in China through investing in the China iShare exchange-traded fund (FXI) that is comprised of 25 of the largest and most liquid China names. All of the 25 stocks included in the China iShare are listed on the Hong Kong Stock Exchange. Some of them are incorporated in mainland China (H shares) and some of them are incorporated in Hong Kong (red chips). The China iShare provides good exposure to three key sectors of China: energy (20%), telcom (19%) and industrial (18%). This concentration can be viewed as a plus or a minus depending on your perspective.

For example, some smart investors are placing a bigger bet on China’s consumer markets. The top five companies represent 40% of the index. The annual operating expenses of the China iShare are only 0.74% compared to 2% plus for other alternatives out there including actively managed China and greater China regional funds. Keep in mind that most of these companies are still largely controlled and owned by the Chinese government. Next, take out some insurance to protect this position by purchasing a put option on the China iShare (FXI). It sounds complicated but is actually very straightforward. An option is a right to buy (call) or sell (put) 100 shares of a security on a fixed expiration date at a set price (strike price). For this right an investor pays a fee or premium.

While you may grumble about paying the premium with cold hard cash when you might not need it, you probably have home insurance just in case disaster strikes and no doubt you have some life insurance as well. Why not protect your portfolio as well? It is especially important to consider hedging against more risky emerging markets such as China. While countries like China offer tremendous upside potential, the downside risk can be daunting and immobilize even the bravest investor. Let’s look at a couple of examples. Say you buy 100 shares of the China iShare (FXI) which is trading at $115 per share. Your total exposure is $10,500. Then purchase a put option (right to sell the China iShare) that gives you the right to sell FXI at a price of $100 on the third Friday in January 2009. I think we all can agree that a lot could happen to China, good and bad, from now until January, 2009.

If the price of the China iShare moves down toward the strike price, the value of the option will increase. This will cost you a premium of a little over $800 but limits your potential loss to 13% plus the premium. Keep a cool head when investing in emerging market countries like China. They should represent only be a small portion of your portfolio and, whenever possible, take out some insurance. I am going to take 5% of the Asian Opportunity portfolio and put some in place today.

FXI 1-yr chart

FXI

Disclosure: none