- The Washington Times - Wednesday, November 10, 2004

With a series of open-market reforms and an economy expanding by at least 8 percent a year, China has enjoyed unprecedented international investment — and investors have enjoyed double-digit returns.

So how do mutual fund investors get in on the China phenomenon? And, what is more important, how much should they risk?

Naturally, there are mutual funds available for people who want to invest in China. According to fund watcher Lipper, 22 China region funds with assets totaling $1.94 trillion had average returns of 5.19 percent in the third quarter. Over the past year, they’ve returned 16.52 percent, with returns of 29.05 percent over two years and 18.96 percent over three years.

“The Chinese stock market is becoming much more accessible, and new sectors of the economy are being opened up,” said Philip Ehrmann, head of Pacific and emerging markets at Gartmore Funds in London. “As time has gone by, whole new companies exploiting opportunities are becoming available to investors — not only in China, but to foreign investors as well.”

It’s easy to see China as a land of investment opportunity, much like the United States was a century ago. The country continues to increase its manufacturing capabilities, and rural improvement projects make transportation and infrastructure investments very attractive as well.

Even the central government’s move last month to increase interest rates by 0.27 percentage point, raising the benchmark one-year lending rate to 5.58 percent was seen as a positive, making it more difficult for underperforming businesses to gain credit. That also serves to make more money available to stronger businesses.

China is also discussing removing some of its tight currency controls, which would make international investment even more attractive to U.S.-based mutual funds.

As a result, new China region funds have been introduced with increasing regularity, including Gartmore’s China Opportunities fund, launched in September. There’s even a new exchange-traded fund, or ETF, based on the FTSE/Xinhua China 25 index. Like most ETFs, the FTSE/Xinhua China 25 ETF, which started trading Oct. 8, can be attractive because of its low fees, since it is not actively managed. However, the index itself is often reconstituted, according to Morgan Stanley ETF analyst Paul Mazzilli, which means the fund can be more volatile than other index-based ETFs.

However, to hedge against mainland China’s risks, most mutual funds have a large percentage of their holdings in Hong Kong and Taiwanese companies rather than mainland holdings. The FTSE/Xinhua fund is particularly cautious.

“[The ETF] is also somewhat more risk-averse, since all but one of the companies on the index are in Hong Kong, rather than mainland China,” Mr. Mazzilli said. “So while it’s more secure, the returns might not be as exciting, either.”

And that’s the problem with investing in China — risk. As with any emerging market, instability in the nation’s political or economic life can have immense repercussions for investors.

“Even with the reforms, there’s still a chance for a major banking crisis in China,” said Andrew Clark, a senior research analyst at Lipper. “A chance, mind you, not a certainty. But that’s the kind of risk you’re dealing with.”

Besides the complexities of an economy in transition from central governance to free market, the political situation is also an issue. While the central government has encouraged free enterprise, it has kept very tight controls over political issues. Some analysts believe Chinese citizens who grow accustomed to freedom in their economy will soon expect that from the government as well. And China’s communist rulers are highly unlikely to cede any political control.

“Naturally, politics is a concern for investors, but right now, things appear to be very well ordered,” Mr. Ehrmann said. “Of course, many investors will question China’s rights record, and rightfully so. But the chance for political upheaval, in our view, remains slim.”

Like any mutual fund, investors should look at a China fund’s history of returns, fee structure and prospectus before investing. Furthermore, while the returns can be attractive, investors should be careful not to invest too much of their portfolios in any emerging market fund, China included.

“You would invest in any emerging market country to get that kicker on your returns for that quarter or that year, buy that’s really only a couple of percent, no more than 10 percent of your holdings,” Mr. Clark said. “Any more than that, and the exposure to risk is probably too great for the average investor.”

Finally, investors who want the increased potential for big returns — and can stomach the accompanying risk — should look carefully at any China fund’s holdings to see how much of the fund is invested in mainland China companies.


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