China ETF Safety Net: Protect Against Downside Risk

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 (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

Disclosure: none

Comments

[MaverickBian:]

A great piece on the hedging advice.

However, if you dig into much deeper, you may need to answer the following tough questions in the first place:

1. You mentioned although China A-share was up by 50%+ so far, FXI was only up by 3.44%. My question is in the event that China A-share were to shed by 50%+, yet FXI only shed by 3.44%, what would happen to your abovementioned hedging strategy? Hedging is supposed to cut the downside risk/max drawdown magnitude when the overall market goes against your portfolio holdings. Yet, in this extreme situation, it seems to me that you lost almost all your premium while protecting for almost nothing. Most importantly, based on the correlation analysis, this FXI has much less correlation with those market risk factors/benchmarks we wish to hedge out, then why should we use this as a hedge? If so, it would be a huge mismatch for your hedging proposal. Then, what’s the probability that this situation will occur? If very large, then your proposed hedge strategy using FXI may not be practical at all.

2. In terms of generating alpha, you may think adding shorts will add the greatest alpha based on a lot of researches, yet in China's case, almost all funds' alpha in magnitude can not even on a par with its beta at least during the past two years of bullish run. Last year, the overall Chinese market was up by around 140%, yet you couldn't find any fund that can deliver an annualized alpha at 140% in 2006, which means if you change directional bet strategy on China's overall market to pair trading or other alpha strategies, your loss in beta far exceeded your gain in alpha, perhaps making your investment unjustifiable. I know a couple of hedge funds using relative value and absolute return while keeping a zero beta in China last year, they only delivered a return at 15% around while most others who were betting on the directional rise of the overall stock market delivered a very spectacular return at 100% neighborhood. My point is if you cut down your beta exposure to China, then your portfolio's major diver will also be cut down significantly and even disappear.

3. Back to the mismatch in hedging portfolio against huge distresses/corrections... if my portfolio is built on small caps, say 2.0 in beta, yet I use 0.2 shorting instruments like FXI, then your hedging strategy was a waste of money because it didn't solve the problem, or only marginally. If you're holding a 0.2 beta portfolio like FXI but you wish to hedge it use a 3 beta vehicle, then this kind of overhedge will both cost a lot more and cut your upside potential dramatically. Personally, I think if you're pursue a 30% annualized return over the next 5 years, you can keep a small beta below 0.5 while managing a 15% alpha, which is the very optimal solution based on my research. Unfortunately, most funds have little or no alpha at all, and adding short does add some alpha, but it's a double-bladed sword: just don't let it hurt you more while you benefit less.

4. What’s the put option liquidity on FXI is also my concern. If I’m a hedge fund manager and operating half a billion, can I hedge my portfolio using FXI puts? If yes, use put at what strike price, short-dated or long-dated? If you closely look at these issues seriously, I would say you may want to resort to other solutions. To my knowledge, most talented short managers only use S&P 500 or the like because of the liquidity constraint. If you’re only a retail investor managing a small amount of money, that may not become a big issue.

There’re too many topics in the hedging strategy, but all in all, all hedging will lead to a cost, sometimes very expensive and even fruitless. As long as the benefits can justify the hedging costs, you can consider doing it. Although hedging can make you long live, it can also make you below average most of time after deducting the expensive hedging costs. And you can also build a beta-neutral, gamma-neutral portfolio, but based on my research, most neutrality and relative strategy only deliver a so-so or below average return among all strategies, which may explain why Taxes Teachers Pension System would like to propose a 15% emerging market exposure UNHEGED.

Just my 2 cents.

Maverick500

2007 Jun 01 01:00 PM