The Real Reason to Avoid Chinese Financials

NEW YORK (TheStreet) -- A reader of my blog recently left a sarcastic comment about my avoidance of iShares FTSE Xinhua China 25(FXI Quote) because of its financial exposure. The exchange traded fund has risen 33% this year; I missed the boat, he said. That brings up an important concept about allocating volatility within a diversified portfolio.

For a long time, I've been saying I don't want financial exposure in China. IShares FTSE Xinhua China 25 has 47% of its assets in financials. I have addressed that point often but maybe not clearly enough.

In the big picture, a lot of angst can be sidestepped by simply avoiding something, something that turns out to be the wrong thing. For example, any time a sector grows larger than 20% (30% is a real danger) of the S&P 500, it's time to trim. Another example of successful avoidance has been Japan for the past 20 years.

The thing here is recognizing risk. I'm convinced the risk in Chinese financial stocks (specifically banks, brokerages and insurers) far exceeds other parts of the Chinese market. It's possible that the consequence of this extra risk will never be observed in the price of these stocks and, even if it is, it may only be for a short time. We can't know whether Chinese financial stocks will implode or not, but we can know they are on shakier ground than other parts of the market.

As for the ETF's 33% increase, that's great but it lags the iShares Emerging Market Index Fund(EEM Quote). Given that Shanghai is up 80%, I'd say the iShares fund isn't a good proxy. I would also say that taking extra risk with a narrower fund, but not getting any extra reward, made the iShares fund a bad choice. Now that last comment has the benefit of hindsight because if iShares FTSE Xinhua China 25 had gone up 50% versus 35% for iShares Emerging Market Index Fund, maybe it would have been a good choice but the commenter appears not to understand why it turned out to be a bad choice.