Editor's note: This is the first of four articles reviewing the third quarter in mutual funds.Mutual funds that invest in Chinese stocks were one of the few bright spots in the third quarter as the impact of the U.S. subprime mortgage crisis spread far and wide. But while most domestic stocks finished the quarter much more attractively valued than they started it, valuations of Chinese stocks have reached what some would consider nosebleed territory. Mutual funds that invest in Asia excluding Japan were the single best performing category tracked by Morningstar in the third quarter, surging 22% on average. By comparison, the average world stock fund advanced just 2.8%, while the average diversified U.S. stock fund rose a measly 1.03%. China's market is actually two distinct markets: the "A share" market in mainland China and "H share" market on the Hong Kong stock exchange. While there are a number of companies that trade on both markets, their shares are not really fungible, since domestic investors can't trade outside the mainland and few foreigners are allowed to buy A shares. Both markets have been rallying for a long time. Over the past two years, the FTSE/Xingu China A50 Index, which tracks the top 50 A shares, has rocketed 530% from its November 2005 low, and is up 133% year-to-date. The Dow Jones China Broad Market Index, which tracks 95% of the Chinese A share market, has climbed 518% since the end of 2005 and 177% year-to-date. The FTSE/Xingu H Share Index of top 55 H shares, which must follow the tighter corporate governance rules of the Hong Kong exchange, hasn't had quite as meteoric a run; it's up 250% since late 2005 and 66% year-to-date. With huge run-ups in their funds over the past year, some portfolio managers are growing more concerned how to put money to work in the world's fastest-growing economy. "I wouldn't call it a bubble, but it's a market that definitely needs a correction," says Richard Gao, lead portfolio manager of ( MCHFX) Matthews China Fund (MCHFX). "Going forward the market will be very volatile." Gao says the H share market is trading at a historically high average price to earnings of 25, with some housing and financial stocks trading at 40 times earnings. In the near-term, "we are becoming very cautious," he says. In the past quarter, the fund has been trimming positions in highflying sectors such as financials, real estate and consumer goods and going overweight in the telecommunications and infrastructure sectors. However, Gao is still bullish over the long-term based on the strength of the Chinese economy and the substantial improvements that have taken place in the country's standard of living over the past two decades. Among Chinese stocks trading in the U.S., he likes Sina ( SINA - Get Report), the leading Chinese Internet provider, because it has a very strong brand and is benefitting from the strong growth in online advertising revenue. Among the fund manager's other top picks are telecom provider China Mobile ( CHL) and utility Huaneng Power International ( HNP). The Matthews China Fund rose 33.2% in the third quarter, 71.98% year-to-date and 120.1% for the past 12 months. Edmund Harriss, lead manager for the ( ICHKX) Guinness Atkinson China & Hong Kong Fund (ICHKX), is also a cautious. "Because of a scarcity factor, you have a lot of money chasing small companies," he says. "You may be able to rummage around and find pockets at a reasonable value, but Chinese shares in Hong Kong are trading at a premium and overall you'll have to exercise caution." The fund manager says financials, consumer staples and consumer discretionary stocks have all been "highly bid," but that oil, coal, materials and some industrial companies look OK. "In the short-term I think there is still further to run," says Harriss. "To the small investor I say be cautious, keep your eyes open, but don't get out. Keep investing, but don't fall asleep. Don't buy the hype. Don't go for concepts, stick with managers and companies that offer value and higher than average returns on investment." Among his top picks that trade in the U.S. are China Mobile and oil and gas company CNOOC ( CEO). He also likes HSBC ( HBC), which has taken a beating amid concerns about its exposure to the U.S. mortgage market, but is yielding around 5% and growing at a rate of 11%. Harriss adds that investing in Asian economies outside of China that produce goods for China is also a very good way to play the sector. He cites Korean steel maker Posco ( PKX - Get Report) as an example. Guinness Atkinson China & Hong Kong jumed 33.4% during the third quarter and 69.9% year-to-date. Over the past week, its 12-month return grew more than 15 percentage points to 105.6%. Not everyone is looking for a correction, however. Henry Chan, co-manager of ( OBCAX) Oppenheimer Baring China Fund (OBCAX) says that despite the market's runup, shares of Chinese companies on the Hong Kong stock exchange are reasonably valued. He notes they are trading at roughly 22 times their expected 2008 earnings. While that's not exactly cheap, he says it's not overvalued, either, considering expectations of annual earnings growth between 25% and 30%. "There could be a short-term technical correction, but I think valuations are still reasonable," the fund manager says. As of Aug. 31, the Oppenheimer Baring China fund had a big allocation to financial services stocks Hong Kong Exchanges & Clearing, China Overseas Land and Industrial and Commercial Bank of China. (None trade in the U.S.) Chan points to big discounts on closed-end Chinese stock funds as a kind of contrarian indicator for the market. Unlike open-end mutual funds, which sell as many shares as investors demand, closed-end funds issue a limited number of shares which then trade on a stock exchange. Because of this, shares of closed-end funds rise and fall as much on investor demand as on a rising net asset value, or NAV. At the end of August the five closed-end China funds tracked by Lipper traded at discounts of as much as 15% to net asset value. The best performer of the group, the ( CAF) Morgan Stanley China A Fund (CAF), jumped 24.6% in August, but still traded at a 9.1% discount at month's end. By comparison, the median discount for all closed-end funds as of August 31st was 5.7% "That's a good indication the market isn't entering maximum bullishness and complacency," Chan says. "It means there is still significant skepticism around the Chinese market." Oppenheimer Baring China leapt 35.5% during the quarter. The fund, which was launched in January, has returned 80.4% since inception. While those returns are alluring, it's risky to put too much money to work in a single country, even one with an economy as strong as China's. "Single country, emerging-market funds are not what most individual investors need," says Bill Rocco, senior analyst at Morningstar. For the international component of your portfolio, Rocco suggests investors have a core holding in a broad-based large-market international fund and a diversified emerging-market fund. Two funds are enough for most individual investors, he says, but if you want a third, a small-cap international fund should cover all the bases. "It is generally reckless to have a single-country fund as your second or third fund," says Rocco. "They are too narrow and too aggressive." Coming up next: Emerging Markets Command a Premium
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