Play China With This Small-Cap ETF

Editor's note: Don Dion is the president and chief investment officer of Dion Money Management and the publisher of the Fidelity Independent Adviser family of newsletters. He provides commentary on the financial markets, with a specific emphasis on exchange-traded funds and mutual funds to his clients and subscribers. He welcomes your comments at [e-mail].

China is arguably the most popular emerging market today. A tremendous bull run lifted iShares FTSE/Xinhua China 25(FXI Quote) more than 300% from 2005 to 2007, and many investors piled into all manner of Chinese stocks.

Though investors appear partial to technology stocks such as Baidu(BIDU Quote) or Suntech Power(STP Quote), these are often a small allocation in Chinese ETFs, if they are present at all. Too many ETF investors have stuck with the large-cap FXI, to the detriment of their returns.

While there are several different iterations of the broad China ETF, such as PowerShares Golden Dragon Halter USX China(PGJ Quote) and SPDR S&P China(GXC Quote), only one ETF offers investors a serious shot at outperformance -- Claymore Alpha Shares China Small Cap(HAO Quote). Rather than first point out the strengths of HAO, however, I'll explain why FXI and its close cousins are not the place to put your money.

Generally speaking, it is common knowledge that market-based economies are more efficient and produce greater wealth for the population than socialist and other economic systems. The main trend responsible for making China wealthy has been the move away from socialism and toward greater freedom in the economic life of its citizens. Socialism persists within the economy, however, in the form of state-owned enterprises.

In a December article for my monthly ETF Report, I wrote: In the long run, China's insistence on maintaining state control of certain industries should lead to equity underperformance as profits are sacrificed for market share or political and social stability (we've already seen the oil companies lose profits due to gasoline price controls).