Your China Exposure Could Be Better

 | Jan 13, 2012 | 1:00 PM EST
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This commentary originally appeared Jan. 13 at 9:45 a.m. EST on ETF Profits -- our pros have decades of combined investing experience to help you make the most profitable decisions when constructing your ETF portfolio. Click here to learn more.

Despite its recent struggles, few investors will argue much with the idea that China is the most important economy in the world. The powerhouse continues to expand at a blistering pace, and much of the excitement over the growth potential in China relates urbanization. Large swaths of the Chinese population are moving from rural areas to cities, taking up their first non-agricultural jobs -- and finding themselves with discretionary income for the first time. That causes a swelling of the middle class, which results in money trickling down throughout all major corners of the economy.

Though those demographic tailwinds are expected to drive growth for the foreseeable future, Chinese stocks closed 2011 on a down note as investors fretted over a surge in inflation that threatened to create resistance. But, so far in 2012, Chinese stocks have started strong, and there's reason to believe that more good times could be ahead. Chinese inflation slowed to a 15-month low in December, and producer price gains likewise lost speed.

With consumer prices rising at an annual rate of about 4%, the Chinese government now has the ability to support growth initiatives more aggressively. That development significantly lessens one of the biggest concerns about Chinese stocks, essentially clearing the way for this asset class to regain some of the ground lost in late 2011 and to continue higher. Interest in China is once again picking up, and many investors are turning to ETFs as the most efficient way to gain exposure.

There are currently about a dozen ETFs offering exposure to Chinese stocks, though the vast majority of the assets are in a single ETF: the iShares FTSE China 25 Index Fund (FXI). This is a fine product for those seeking out liquid, short-term exposure. But, for those looking to make a long-term bet on China, owning FXI is downright silly.

I've railed on FXI before for a number of different reasons, ranging from the shallow and concentrated portfolio (there are only 25 stocks in total, with 10 of these making up more than 60% of the portfolio) to the incomplete sector balance (virtually no sign of consumer, healthcare, utilities or technology stocks) and the heavy presence of state-owned firms. So, today, I'm offering some more appealing alternatives for those looking to participate in the tremendous growth potential of China.

SPDR S&P China ETF (GXC): This is, in my opinion, the best ETF option out there for investors looking to achieve exposure to Chinese stocks for the long haul. Though GXC still maintains a big allocation to energy and financial stocks, its portfolio is impressive in its depth and balance -- it holds more than 180 individual holdings, and no one name makes up more than 8% of the total. Throw in a very low expense ratio of just 0.59% -- considerably lower than that of FXI -- and you have a product with major appeal to long-term investors.

First Trust China AlphaDEX Fund (FCA): This ETF offers an alternative to the market-cap-weighting methodology that many believe is a drag on long-term returns. FCA is linked to an "enhanced" index that seeks to identify the most appealing stocks from the universe of Chinese equities. As a result of this unique methodology, FCA is one of the most balanced China ETFs on the market. Though there are only about 50 components in total, no single name makes up more than about 4% of holdings. Also, FCA avoids the huge allocation to the financials and energy sectors that is common in almost every other China ETF, and the sector balance is a huge improvement over FXI.

iShares MSCI China Small Cap Index Fund (ECNS): Whereas FXI consists almost exclusively of mega-cap companies -- essentially the two dozen largest in the Chinese market -- ECNS focuses on small-cap stocks. I view this fund as a better way to tap into the Chinese growth story. ECNS consists of smaller Chinese firms that will depend more heavily on local consumption, as opposed to FXI, which concentrates on state-owned, multinational firms. As an added bonus, ECNS avoids the single-stock concentrations that plague many China ETFs. It also offers significant exposure to the promising consumer sector, devoting about 25% of holdings to the space.



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