Hong Kong ETF Doesn't Target China Themes

HONG KONG ( TheStreet) -- After I wrote about investing in China last week, a reader asked why there was no mention of the iShares MSCI Hong Kong Index Fund ( EWH). I probably should have included it.

The Hong Kong fund, which has been trading since 1996, has had the China space to itself for many years, even though it's a proxy for the Hang Seng Index. Hong Kong's benchmark looks a lot different than China's Shanghai Composite Index, as you can see in the chart below.

The Shanghai Composite versus the iShares Hong Kong ETF
Yahoo Finance

In the article, I expressed reservations about China ETFs that invest heavily in financial stocks. Most emerging markets have at least a couple of large banks and they tend to feature very prominently in the benchmark indices that underlie the funds.

The Hong Kong ETF is actually heavier in financials at 62% than the funds profiled last week. Six of the top 10 holdings are tied to real estate or finance, and account for 37% of the fund.

Hong Kong Exchanges & Clearing is the fund's third-largest holding with 7.85% of the fund. Its American counterpart, NYSE Euronext ( NYX), has a 0.08% weighting in the S&P 500 Index. NYSE shares have the same weighting as HCP ( HCP). Have you ever heard of HCP? I haven't.

Some of the real estate companies in the Hong Kong ETF have been wildly volatile like Sun Hung Kai Properties, the fund's largest holding at 8.7%, and Hang Lung Properties. Other holdings have tracked closely to its index.

If you're considering buying property stocks to add volatility to your portfolio, why would you want to exacerbate price swings by also adding emerging market exposure? And why would you make such a move when there are other promising stocks beyond financials in China?

As China's middle class grows and the country modernizes its infrastructure, it makes sense to allocate to areas where money must be spent. Property development in Hong Kong doesn't play into this theme. However, money must be spent on China's water problem. Duoyuan Global Water ( DGW), which cleans water, recently debuted on the NYSE.

China must also improve its roads and its railway system to encourage integration between the nation's rich cities and poorer parts of the country. Companies like Cheung Kong Infrastructure Holdings and China Railway Construction will be a part of the solution.

While China imports plenty of the resources it will need, a lot of it comes companies like Jiangxi Copper or coal producer China Shenhua Energy.

And what about solar companies, such as Yingli Green Energy Holding ( YGE) or Solarfun Power Holdings ( SOLF)? They seem like a logical bet if coal-dependent China decides to address its air-quality problems. But it's not clear to me that China views solar energy as a worthwhile investment.

Hong Kong stocks and ETFs could be a good long-term holding, but I believe you'll get a different outcome than if you were investing in mainland China, specifically. There are also industry-specific funds, such as the iShares Emerging Market Infrastructure Index Fund ( EMIF) and the PowerShares Global Coal Portfolio ( PKOL), which target some of these themes.

The Shanghai Composite is up 80% this year. While it still has a long way to go before getting to its bull market high, there is no reason it won't decline 20% to 30%. A drop wouldn't mean the theme is over but there will be big moves in both directions. Still, it makes more sense to add emerging market volatility this way than with property stocks.

-- Reported by Roger Nusbaum in in Prescott, Ariz.
At the time of publication, Nusbaum was owned shares of EMIF, although positions may change at any time.

Roger 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.