9 ETFs To Invest In To Play The Rising Chinese Yuan

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Includes: CNY, EIDO, EPHE, EWM, EWT, EWY, FXI, THD, VNM
by: Erik Gholtoghian

So now that most of the world finally understands the major theme of the currency markets going on, how can investors benefit?

Obviously if one can exchange their U.S. dollars into Chinese Yuan, it would be ideal, but due to tight regulations imposed by the Chinese, this is essentially impossible to do without Chinese citizenship. The closest thing there is to a direct investment in the Yuan available is exchange traded notes (ECNs) such as the (NYSEARCA:CNY) fund. The problem with these kinds of funds though is there is a management fee imposed which eats up a significant amount of the arbitrage profits available. Additionally there is a large amount of decay underlying the instruments being used by the CNY fund managers, so the true return is generally near zero unless the moves in the Yuan are larger than expected. With the People's Bank of China consistently raising the value of the Yuan versus the dollar by only four percent per year, using an exchange traded note fund doesn't make much sense.

Chinese stock funds such as (NYSEARCA:FXI) are another way to change dollars into Yuan, but the downside is that it is converting dollars into Chinese equities which are denominated in Yuan. Meaning, even if the currency effects of the investment did result in four percent per year, the added risk of a Chinese economic slowdown could easily wipe out more than 10% on the investment because Chinese equities are very vulnerable once the Yuan rises.

Ideally one would buy Chinese government bonds, which would rise in value as Chinese equities fell in value with the rising Yuan. As of yet, I have seen none traded in U.S. markets. It is surprising I haven't seen Chinese corporate bonds being traded, as I am sure the demand would be astronomical. In other words, a multinational company who could issue bonds in Yuan would be able to raise much more money than a multinational who issued corporate bonds in dollars.

Solution:

Since there are so many closed doors when trying to profit on this situation, one must look fairly deeply at the financial market currency effects to follow the money so to speak. As the Yuan rises further and further, three effects will result. U.S. exports will rise, U.S. imports will likely slow down, and countries which can produce even more cheaply than China will see their exports boom.

The portfolio which makes the most sense for the short term for this opportunity heavily allocates into frontier markets surrounding China. Namely, Vietnam, South Korea, Malaysia, the Philippines, Indonesia, Burma, Taiwan, Laos, Bangladesh, Cambodia, and possibly even India.

These countries are going to continue growing heavily due to their new large neighbor no longer stealing all of the sales to the U.S. (the largest consumer in the world). In other words, you will see in your daily lives more and more frequently that items you buy in U.S. stores will no longer be made in China, and instead they will be made in Thailand, Malaysia, Vietnam, and the other frontier markets. You will see more products made in America as well, but the effect on American product production will be more gradual and long term in nature.

The best way to reduce risk significantly on an overall portfolio would be to allocate to each of these markets, but to also short some of the Chinese market to smooth out risk versus return.

The charts below show the unemployment rate of some of the frontier markets I have mentioned. One glaring example is Thailand, which has the lowest unemployment rate in the world. Recently, China became the largest buyer of Thai products in the world, overtaking the US. This is a result of Yuan appreciation. China's role will likely morph from the manufacturer of the world to the middleman or broker of Asia.

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Conclusion:

For the next year, for investors who wish to have limited global economic growth risk yet still benefit from the rising Chinese Yuan, I recommend creating an investment composed of 15% in each of the following ETFs: Thailand (NYSEARCA:THD), Malaysia (NYSEARCA:EWM), the Philippines (NYSEARCA:EPHE), Vietnam (NYSEARCA:VNM), South Korea (NYSEARCA:EWY), Indonesia (NYSEARCA:EIDO), and Taiwan (NYSEARCA:EWT).

I also recommend putting 15-20% of your portfolio in a short position in Chinese equities by way of the (FXI) fund. Cumulatively, this combination of investments will result in a high risk adjusted return with an overall market beta of below 1. I would short FXI by way of buying in-the-money long term puts.

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