Skip to main content

The Right and Wrong Way to Play China

It doesn't matter that China may be experiencing a bubble, the correct exposure at the right time is all that matters.



) -- The meme du jour is the latest missive from Jeremy Grantham, who 32 years ago co-founded Boston-based asset manager



In his letter to shareholders, there was a bit about being anti-China but pro-emerging markets. That concern was heaped on fears about the world's most populous nation. Lending has skyrocketed, fueling talk of bubble trouble. On Wednesday, the Chinese stock market dove 5%.

My initial reaction: I'm not sure how a market that's still down almost 50% from its peak can be a bubble. (Though it


up more than 80% off the low.) Trying to rationalize where there is no bubble would seem to be counter-productive and herald poor risk management.

I've been a huge believer in China as an investment destination for many years. There's no question in my mind that China is on the path to playing a much larger role in the world economic order. But you can't own it blindly or in the form of a lopsided bet that could have a ruinous effect on a portfolio and, thus, a financial plan.

What we've learned this decade is that no investment theme is impervious to panic declines, slow-moving declines or any other sort of derailment. During this bear market, the Shanghai Composite Index fell from 6,100 to 1,800, the Hang Seng Index dropped from 31,000 to 11,000 and the Hang Seng Enterprises Index declined from 20,000 to 5,600. All three have come roaring back but are still a long way from their high-water marks.

There are two action plans that arise from this. First: How much money should one have in China? I'm a believer in small exposures to many things -- countries, themes and so on. Currently, I target China at 2% to 3% for clients, and I could see increasing that to 5% to 6% if indexes fall further.

That lending is now a source of worry is interesting. I've been writing for ages that I don't want financial exposure to China, which, unfortunately, rules out using the

iShares FTSE/Xinhua 25 Index ETF

(FXI) - Get iShares China Large-Cap ETF Report

. Half of the ETF's assets are in financial firms. Even the

Scroll to Continue

TheStreet Recommends


(GXC) - Get SPDR S&P China ETF Report

is very heavy at 33%.

That leaves two other ways into China. One is through individual stocks, of which there are over 100 to choose from on the Nasdaq and New York Stock Exchange. Another is with certain specialty ETFs. For example, the

PowerShares Global Coal Portfolio


weights almost a quarter to China, the

Claymore Solar ETF

(TAN) - Get Invesco Solar ETF Report

has 30% and the

EGShares Energy Fund


has 19%. Between stocks and specialty funds, it's easy to add Chinese exposure to a portfolio and still avoid the one sector that seems to be the source of concern.

The other action point is the realization that if a lending meltdown in China causes another major decline, it will, at least initially, bring down most of the other emerging markets in sympathy. That can happen in countries that seemingly have no fundamental connection to China. Such a drop could be fast and painful for people who learn the hard way that they had too much exposure. As the chart shows, in the past five years, the

iShares Emerging Market Index Fund

(EEM) - Get iShares MSCI Emerging Markets ETF Report

has doubled, while the S&P 500 is down 10%. For U.S.-based investors benchmarked to the S&P 500, it doesn't take 30% in emerging markets to add value versus the S&P 500.

If China gets hit hard over the lending "bubble" -- or something else -- and other emerging markets go with it, which they would, something like 30% in that space would cause the entire portfolio to drop a lot more than the broad market and a lot more than what might be tolerable, resulting in a sell-off at exactly the wrong time. Having a lot of anything is great while it's working, but it also sets the stage for panic selling at the low when it isn't. That mistake is avoided by moderate exposure. Putting 5% of a portfolio in China at the worst possible time wouldn't be ruinous but 30% might be.

At the time of publication, Roger Nusbaum had no positions 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;

click here

to send him an email.