The Real Reason to Avoid Chinese Financials

Investors can only tolerate so much volatility, which is why I'm sidestepping Chinese financial shares.
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NEW YORK (TheStreet) -- A reader of my blog recently left a sarcastic comment about my avoidance of iShares FTSE Xinhua China 25 (FXI) - Get Report 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) - Get Report

. 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.

Everyone has made bad investment choices and will do so in the future -- that's OK. But taking extra risk for a slightly worse or slightly better return isn't a good choice even if it doesn't hurt the portfolio.

Another way to think about this is that we can each only withstand so much exposure to volatile assets in our portfolios. The number for you is probably different than for your friends or neighbors, but it's finite for everyone. To the extent that volatility tolerance is finite, it needs to be budgeted and not wasted on parts of the market where the potential reward doesn't justify the risk taken. For the time being, my idea of wasting the amount of volatility budgeted in a portfolio includes Chinese financials.

An investor who wants Chinese exposure through an ETF without a lot of financial stocks can look at the

PowerShares Golden Dragon Halter YSX China Portfolio

(PGJ) - Get Report

. The PowerShares fund has only 6.6% in financials. In the past couple months, it has dramatically outperformed the iShares fund due, in part, to heavier weightings in technology and energy. That the PowerShares fund has done better is all well and good, but the important thing is that it provides exposure to China without being heavy in the riskiest part of the market.

At the time of publication, Roger Nusbaum had no positons in the securities mentioned.

Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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