Investors Find Bigger Returns, Risks in China

Nov. 20, 2003 — Mutual funds that invest a significant portion of their assets in Mainland China have racked up impressive gains this year, partly reflecting the booming economy of the world’s most populous nation. According to data from FundAdvisor, the average mutual fund with significant stakes in China or Hong Kong soundly beat the developed markets as represented by the MSCI EAFE Index, as well as the S&P/IFCI Asia Index.

However, the risks of investing in China are higher than in the developed world, as reflected by the higher volatility of Chinese-themed funds. “China Funds have provided impressive returns this year once the SARS outbreak was brought under control,” noted Rosanne Pane, chief mutual fund strategist for Standard & Poor’s. “However, investing in any emerging market does involve extra volatility due to political, economic and market risks.”

Stephen Ho, senior vice president at Hansberger Global Investors, notes that China’s economy has been one of the fastest growing in the world, with an average growth rate of 7.1% for the past six years. “Unlike previous periods, China has embarked on a sustainable growth pattern due to being the ‘factory to the world,’ as well as a growing consumer. China may be one of the world’s biggest growth stories for decades.”

Guang Yang, portfolio manager of the Templeton Global Opportunities Trust/A (TEGOX), a $361-million portfolio with close to 8% invested in Hong Kong or China, views Chinese equities as a “value play” in an economy enjoying superb growth. “China ‘s GDP will grow 8% this year, and probably 9% next year,” he said. “Sectors like auto and software are seeing their sales jump by as much as 30% to 40% annually, but most Chinese stocks are trading at moderate multiples. For example, China’s national oil company, PetroChina (PTR), which Warren Buffet purchased a stake in, is trading at only 7.6 times projected earnings for 2003. The stock has doubled in price over the past year. Another major oil company, CNOOC Ltd. (CEO), has nearly tripled in price since being privatized in 2001.”

To illustrate how China’s export economy has grown, consider that in 1990 less than 3% of products imported into the U.S. came from China, versus 18% from Japan. But by 2002, China accounted for 11% of all U.S. imports, having overtaken Japan, which accounted for only 10%.

However, despite China’s explosive growth, investors looking to participate should exercise caution. For one thing, China is still a relatively small and illiquid emerging market, which means it can undergo extreme volatility. To futher complicate the situation, it remains difficult for foreigners to invest directly in Mainland shares. Typically, one either has to put money into the Hong Kong market, or otherwise negotiate the arcane rules that govern Chinese equity markets.

As a result, there are no “pure” Mainland China mutual funds. Instead, portfolios with exposure to China usually include investments in more established, neighboring Asian economies like South Korea, Hong Kong and Taiwan. For example, one of the most well-known China portfolios, the $141.9-million Matthews China Fund (MCHFX), has the bulk of its assets invested in stocks listed on the Hong Kong exchange.

Another risk with China lies in the fact that most companies there are still primarily owned by the state, resulting in a mismatch between the interests of management and shareholders. But this situation is gradually changing, according to Yang. “The private sector is increasingly participating in the market and boosting their stakes in public companies,” he said. “In fact, China’s central government has pledged to fully privatize the economy.”

While Chinese corporations have a long way to go before they adopt Western-style corporate accounting principles, “standards are rapidly improving, particularly with the larger, established companies,” Yang added. “China’s membership in the World Trade Organization will accelerate this process.”

According to China’s vice minister of commerce Wei Jianguo, the country’s foreign trade volume is likely to reach $800 billion this year; and that from January to September this year, China’s contracted foreign direct investment reached $79.2 billion, a yearly rise of 36%.