New Small Cap ETF Gives Investors Fresh China Angle

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Includes: FXI, GXC, HAO
by: IndexUniverse

Investors trying to catch the explosive growth in China's economy might be missing a key part of that market, warns Burton Malkiel.

Namely, that's small-cap companies. The author of A Random Walk Down Wall Street and other investing classics has a solution, however. It's a new exchange-traded fund [ETF] that focuses just on smaller Chinese names.

The Claymore/AlphaShares China Small Cap Index ETF (AMEX: HAO) launched Wednesday, joining a field of established single-country portfolios already carving up the Asian giant.

The most popular is the $5.8 billion iShares FTSE/Xinhua China 25 Index Fund (NYSE: FXI). It's mega-cap focused and concentrated with its holdings. There are also single-country iShares for Hong Kong and Singapore, where many Chinese stocks are listed. But those are also heavily large-cap oriented.

The PowerShares Dynamic Asia Pacific ETF (AMEX: PUA) had some 18% of its holdings in China entering this year. While it does invest in mid-caps, most of its assets are tied up in larger names across Asia.

The SPDR S&P China ETF (AMEX: GXC) is perhaps HAO's closest rival. But it isn't really that similar. While it's well-diversified with 300-plus names and takes an all-cap approach, GXC had around 1% of its assets in small-caps heading into January, according to Morningstar Inc. GXC has an expense ratio of 0.60%.

Claymore's HAO comes with a price tag of 0.70%. Like the others, it's float-adjusted. "But in the other ETFs available, small-cap exposure gets diluted," said Kevin Carter, chief executive of AlphaShares.

The Walnut Creek, Calif.-based provider put together the index that HAO tracks. It included about 120 different companies. "It's a traditional, market-cap weighted index," Carter said. "The only difference is that we don't allow any single name to go beyond a 5% weighting. But we don't think with the range of market-cap sizes included we'll run into that problem."

The benchmark sets a minimum market-cap size of $200 million and a maximum of $1.5 billion.

"If you want to be invested in China, it's going to be important to gain exposure to these types of companies," said Malkiel, who has traveled extensively in the country and serves as AlphaShares' chief investment officer.

While he praises FXI and others for providing exposure to an important global leader, Malkiel says such ETFs' large-cap focus raises questions.

"This new small-cap ETF is useful because if you think of the most popular ETF, XFI, it's made up of huge companies that are predominately government-owned," he said.

Banks and other key financial institutions make up a big part of most other China ETFs, Malkiel pointed out. Those huge lenders have suffered billions of dollars in write-offs from bad loans in the past.

"A big part of the non-conforming loan problem in China is that if the government's involved, loans aren't always going to be made for purely business reasons," Malkiel added.

The HAO ETF's focus on smaller-cap names brings more than just size diversification. Malkiel says that smaller companies aren't government-controlled or owned to the extent that larger ones are in China. "The nice aspect of small-cap companies in China is that they tend to be privately owned. So they're more entrepreneurial," he said.

Smaller-cap names also tend to have lower price-earnings multiples compared to their growth rates than China's bigger names, Malkiel added.

The fund's underlying index is limited to shares open to foreigners. Those include H-shares which are listed in markets outside Asian markets such as Hong Kong. The fund also includes N-shares, which are available in the U.S. as well. "I worry a lot about the A shares market," Malkiel said. "What you find is that A-shares tend to be much more richly valued than the H-shares. Typically, they'll trade at anywhere from a 50% to 100% premium."

The index will be rebalanced and reconstituted annually.

Written by Murray Coleman