Investing in China via Hong Kong – Riding the Dragon with Less Risk

Shanghai stocks jumped 4.7% on January 15th, their biggest one-day rise in more than a year. This followed a $3.6 billion initial public offering (IPO) by the insurance company, China Life, the shares of which doubled in the first day of trading. Such developments are characteristic of the current high volatility of China’s mainland equity markets, Shanghai and Shenzhen, capping a year of exceptional gains. Is this the time to book those profits or are the Chinese markets likely to continue to be strong performers in 2007?

China’s markets certainly have become more frothy after their steep upward climb in the second half of 2006. They are likely to continue to be quite volatile (risky). Indeed, there are signs that a bubble may be developing in the shares that are sold only to domestic investors. Rightly concerned about possible overheating, the Chinese Regulatory Commission is said to be delaying approval of new domestic mutual funds. Such measured efforts to temper these markets’ exuberance should help avoid more serious market adjustments later on.

In contrast to the well established Hong Kong market, the Shanghai and Shenzhen equity markets are still very much emerging market exchanges. They are less liquid than more developed markets and are still in the process of bringing their regulations and practices up to international standards.

Cumberland continues to maintain overweight positions for China in our International and Emerging Market Portfolios. The reasons why we believe this strategy should add value are discussed in the remainder of this Commentary.

The Chinese economy is growing at a rate that outpaces the other major economies; that is why their stock market outlook for 2007 is bullish. The OECD estimates that China’s GDP growth will be 10.3% in 2007, following a 10.6 % advance last year. The economy is projected to accelerate to a 10.7% pace in 2008. Domestic demand is advancing at about the same pace, with strong growth in residential construction and household durable goods. Profits are said by the OECD to be “extraordinarily strong”.

In short, the Chinese economic boom shows no signs of faltering. One potential cause of a slow-down, a sharp easing in the US economy, is now looking increasingly unlikely. Non-economic shocks are, of course, possible, such as a bird flu pandemic. Last week’s unexpected and disturbing anti-satellite missile test illustrates how geopolitical developments always have the possibility of throwing well founded forecasts off-track. Investment managers need to monitor markets closely and be ready to react to unexpected developments

Cumberland’s investment strategy for China is also determined by the instruments we employ to invest “in China”. There is no available Exchange Traded Fund (ETF) that invests directly in the two mainland China exchanges in Shanghai and Shenzhen. Instead, the main ETF we use, the iShares FTSE/Xinhua China 25 Index Fund (ticker FXI), invests in the 25 largest Chinese firms that are listed on the Hong Kong Stock Exchange. To be listed on the Hong Kong Stock Exchange firms must meet that Exchange’s international standard listing requirements. This market is very well developed with world-class regulators.

These differences between the Hong Kong and mainland China markets are important from the perspective of risk management. Shares of Chinese firms that are listed in both Hong Kong and Shanghai are not fungible. This is due to exchange controls and other regulatory barriers. Significant price differentials can and do develop between the two markets. Currently there are 37 Chinese firms with dual listings and all are trading at premiums in the less liquid and more volatile Shanghai market.

Major Chinese companies in FXI include China Mobile, PetroChina, Industrial and Commercial Bank of China Asia and the Bank of China. China Life was added to the index after its IPO. This ETF’s limitation to just the top Chinese firms that can meet Hong Kong’s standards doesn’t seem to be hurting performance. The total return provided by the FXI ETF in 2006 was a remarkable 83.19%.

The other available ETF for China is the PowerShares Golden dragon Halter USX China fund (ticker PGJ). This ETF invests in companies listed in the US markets that derive a majority of their revenue from China. The US listing requirement is a higher standard because it includes the obligation to file quarterly reports with the SEC. Some of the same Chinese firms listed in Hong Kong and held FXI are also listed in the US and held in PGJ. China Mobile and PetroChina are two examples. The overall sector mix between PGJ and FXI is quite different. Financials account for 44% of FXI but less than 5% of PGJ. This is one of the reasons why FXI’s stellar out performance (83%) exceeded PGJ’s terrific result (53%) in 2006.

Adding PGJ to FXI provides more diversified exposure to the Chinese economy. Of course, the firms held in these two ETFs operate mainly in an emerging market economy. Investing in such economies involves a higher degree of risk than investing in the advanced market economies of the US and Europe.

These two ETF limit their holdings to firms that meet international listing standards and are traded in well regulated markets. That should shield portfolios from some of the risks inherent in investing directly in the China mainland markets. We estimate that the risk/reward ratio of such a strategy continues to be attractive.