Round Out Your China Exposure

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Interest in emerging markets has grown exponentially over the past decade, as investors in the developed world have begun to see the benefits of shedding their "home country bias" and maintaining larger allocations in these high-growth economies with seemingly limitless potential. While a number of countries have seen significant inflows thanks to this wave of investment, arguably the most popular destination over this period has been China, now the world's second-largest economy and perhaps destined to overtake the U.S. for the top spot in the not-so-distant future.

While many emerging markets ETFs include Chinese equities, the degree of exposure is generally not commensurate with the country's importance to the global economy. Taiwan and South Korea -- two economies whose aggregate GDP is equal to less than one-third of China's -- account for about 25% of iShares MSCI Emerging Markets Index (EEM) and Vanguard Emerging Markets Stock ETF (VWO). China is the largest, single-country allocation of these popular ETFs, but still makes up just about 16% of their holdings.

Some investors utilize country-specific ETFs to step up exposure to China. Many utilize the ultra-popular iShares FTSE China 25 Index Fund (FXI), which boasts impressive liquidity, but is flawed in many ways as a means of accessing Chinese equity markets. In addition to the mega-cap focus and major concentration issues (many sectors are overlooked completely), FXI -- along with virtually every other China ETF -- ignores a major portion of the Chinese stock market.

The China A-Shares market consists of mainland China-based companies that trade on Chinese stock exchanges, such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. While this might sound similar to other types of Chinese securities, a few key differences exist. First, many share classes of Chinese stocks are quoted in U.S. dollars; not so for the A-Shares market, where every stock is priced and traded in Chinese renminbi. More important, A-shares are generally only available for purchase by mainland citizens; foreign investment is only allowed through the Qualified Foreign Institutional Investor (QFII) system. This process effectively shuts out most Westerners from the market, forcing investors seeking China exposure to buy up some of the country's largest companies that trade on exchanges around the world, such as PetroChina (PTR) or China Mobile (CHL).