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2 Funds for Skittish China Market

NEW YORK ( TheStreet) - Of the 35 equity fund categories tracked by Morningstar, China ranks at the top of the charts.

During the past five years, China regional funds returned 15.7% annually. Red-hot Latin American funds finished in second place, returning 11.8%, while the S&P 500 returned 2.2%. The outlook for China remains bright. The country's gross domestic product grew 9.8% in the fourth quarter of 2010, and analysts expect the boom to continue. The consensus forecast is for corporate earnings to rise 17% this year.

Still, there are grounds for caution. After years of rallying, Chinese stocks are no longer cheap. The price-earnings ratio for China funds is 16.3, compared to 14.5 for U.S. domestic funds. In recent months, the Chinese inflation rate has been climbing. To cool the economy, the central bank has raised interest rates and limited lending by banks. That has hurt stocks of banks and property companies.

During the last three months, China funds have returned 0.2%, while the S&P 500 has gained 10.9%. The Chinese markets could remain skittish as central bankers struggle to limit inflation without shutting down growth.

Should you avoid China altogether? Probably not. It pays to have a stake in the fast-growing country. To participate in the Asian boom, most investors should own diversified international funds that have holdings in China.

If you want to overweight the country, consider a China fund. But keep in mind that Chinese markets are volatile. As the financial crisis unfolded in 2008, China funds dropped 54.4%, lagging the S&P 500 by 17 percentage points. To avoid being whipsawed, start with a small stake in a China fund.

You can increase the holding by using a technique known as dollar-cost averaging. In this approach you make a series of small investments spread over months or years. The idea is to avoid buying your whole position at the top of the market.

For a relatively steady fund, consider Matthews China Investor (MCHFX), which has returned 21.5% annually during the past five years, outdoing 89% of competitors. The fund buys moderately priced stocks that can increase earnings consistently for years. "We try to find companies that are in the early stages of their growth," says portfolio manager Henry Zhang
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