China ETFs Decelerating

ETFZone

For years China was the perfect emerging market with perpetually high growth and low inflation. Now the economy is decelerating, inflation is creeping in and exporters face margin pressure.We still favor solid allocation to Chinese ETFs and even overweighting at reasonable valuations, but investors should know that just about every aspect of Chinese investment is changing, including volatility and correlation with US stocks.China continues to grow at a fast clip. The World Bank estimates solid GDP gains even after adjusting for inflation, although the US is closing the gap a bit:

USChina
20080%9.6%
2009-2.6%9.1%
20102.8%10%
2011 (est.)2.8%8.7%
2012 (est.)2.9%8.4%
China survived the Great Recession by plowing investment into much-needed infrastructure improvements such as roads and telecommunications, but also into green energy and education. The Chinese central government was applauded for fast-tracking high-profile projects such as high speed bullet trains, but in less visible projects government control often results in corruption and shoddy construction.Top line growth is rendered useless if it is gobbled up by inflation, and here, too, the outlook is not as rosy as it once was. Consumer price inflation has accelerated from mild inflation during the 2008-2010 Recession to nearly 5% inflation just as GDP is declining, says the Wold Bank. So far much of inflation has been due to agriculture commodity prices. Food accounts for almost a third of inflation measures in China, many times more than in the US. Commodity spikes in 2010 and 2011, however, have been due to weather-related events not likely to recur such as fires in Russia and floods in Australia.More troubling are tight labor and spiraling real estate prices. Potential labor demand appears vast and could drive wages higher. In centers such as Shanghai, housing prices are approaching 40 times income, among the highest ratio in the world. To contain both company expansion which drives hiring and speculative housing construction, the People's Republic has tightened lending standards. Lower economic growth we see today is thought to be a direct result.Reliance on exports is still enormous. Lending criteria has stiffened to certain export sectors to dampen this reliance, but the transition is not painless.The Yuan is undervalued according to most economists, and the Ministry of Finance seems intent on letting it appreciate about 5% per year. This both helps and hurts ETFs. On the the one hand the value of assets held in China by an ETF rise in value, and on the other hand exporters' already razor-thin margins are put under additional pressure.Valuations, meanwhile, are reasonable for such a fast-growing asset: Price/Earnings is in the 14-17 range, and Price/Book is in the 2-3 range.Historically China has correlated only moderately with US stocks and thus has offered some useful diversification. This clearly has changed as the following graph of recent performance of major China ETFs against the S&P 500 shows:

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The above graph shows the S&P 500 (SPY) vs. two popular ETFs: the iShares MSCI Hong Kong ETF (NYSEArca:EWH - News) and SPDR China ETF (NYSEArca:GXC - News), with moderate annual fees of 0.54% and 0.6% respectively. Another broad-based ETF is iShares FTSE/Xinhua China 25 ETF (NYSEArca:FXI - News), with annual fees of 0.74%. In March 2011 the new iShares MSCI China Index Fund (NYSEArca: MCHI - News), with fees of 0.61% was launched.The graph above also suggests that traditionally high volatility is dampening. China stocks appear to move only a bit more sharply than US stocks.Investors are sometimes surprised to learn that China ETFs mostly own companies on Hong Kong and New York exchanges, not Mainland exchanges. This is a good thing, according to noted economist Burton Malkiel. Tougher external accounting scrutiny forces the firms in ETFs to be better managed and more transparent than Mainland-only listed companies where government control, unreliable accounting, and wild swings in investor sentiment generate unwelcome volatility.For ETFs requiring instant liquidity, meanwhile, restrictions against foreign capital have made it impractical for ETFs to use Shanghai or Shenzhen exchanges. EWH is a bit of an exception; it contains more pure Hong Kong exposure where real estate and banking predominate.For a more direct currency play there are two ETFs:
  • Van Eck Market Vectors Chinese Renminbi/USD ETN (NYSEArca:CNY - News), annual fees: 0.55%
  • WisdomTree Dreyfus Chinese Yuan ETF (NYSEArca:CYB - News), annual fees: 0.45%
Other more specialized plays on China include:
  • iShares MSCI China Small Cap Index Fund (NYSEArca: ECNS - News), annual fees 0.65%
  • Claymore/AlphaShares China Small Cap ETF (AMEX:HAO - News), annual fees: 0.7%
  • PowerShares Golden Dragon Halter USX China Portfolio ETF (AMEX:PGJ - News), annual fees: 0.7%
The following dual country ETF might be of interest to investors who want to play India and China in one trade: First Trust ISE Chindia ETF (NYSEArca:FNI - News), annual fees of 0.7%.There is a real estate play for China in Claymore/AlphaShares China Real Estate ETF (NYSEArca:TAO - News), with annual fees of 0.65% .A leveraged ETF serving the country is ProShares UltraShort FTSE/Xinhua China 25 ETF (AMEX:FXP - News), with annual fees of 0.95%.Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.
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