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The Best China ETF for 2010

Editor's note: This piece was originally published on Real Money on Jan. 7. It is being republished as a bonus for readers.

Claymore/AlphaShares China Small Cap (HAO) was my favorite China ETF in 2009 and it delivered with a gain of 96.6%. The next closest China ETFs were Claymore/AlphaShares China Real Estate (TAO), up 71.9%, PowerShares Golden Dragon (PGJ), up 63.1%, and SPDR S&P China ETF (GXC), up 60.5%. The most widely held China ETF, iShares FTSE/Xinhua China 25 (FXI), advanced only 47.3% last year.

Although a lot has changed in the past year, the longer-term trends that favor small caps remain in force, in my opinion. The Chinese economy will become more consumer and healthcare focused in future, and small-cap HAO remains the best positioned broad China ETF for this trend, in my view. In my opinion, HAO has another 25% to run in 2010.

Despite difficult credit conditions for small companies in 2009, the China small-cap ETF outperformed its state-owned enterprise-heavy (SOE) competitors, such as FXI. I think we will see a repeat in 2010, as I think credit conditions will be about the same or better for smaller businesses, with the government and banks adopting targeted measures to reach out to these underserved businesses, while the large SOEs, which received much of the 2009 lending, may see credit squeezed should monetary policy tighten. With the central bank calling for "moderate loan growth", this appears likely.

In terms of sectors, HAO remains favorably weighted, with greater exposure to the technology, consumer and healthcare sectors than its peers. These sectors are likely to underpin China's growth, in my view, as it evolves into a mature consumer economy. Rival PGJ offers 50% more technology exposure (18% versus 12% in HAO), but it comes with large exposure to the SOEs that litter most China ETFs, and that's what I'm trying to avoid.

On the plus side, PGJ does have low exposure to financials, at about 8%, and it only holds U.S.-listed or ADS shares. By comparison, FXI's financial exposure is 47% and GXC holds 33%, mostly in the big state-owned banks. HAO has 12.9% of its holdings in financials, but mainly in insurance and property developers, not in banking. The recent boom in lending, coupled with the warning signs put forward in a paper by Giovanni Ferri and Li-Gang Liu , mean asset quality at the Chinese banks likely deteriorated in 2009. In general, investors should probably shy away from too much Chinese financial exposure at this point in time.
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