The Best China ETF for 2010

Editor's note: This piece was originally published on Real Money on Jan. 7. It is being republished as a bonus for TheStreet.com readers.

Claymore/AlphaShares China Small Cap ( HAO) was my favorite China ETF in 2009 and it delivered with a gain of 96.6%. The next closest China ETFs were Claymore/AlphaShares China Real Estate ( TAO), up 71.9%, PowerShares Golden Dragon ( PGJ), up 63.1%, and SPDR S&P China ETF ( GXC), up 60.5%. The most widely held China ETF, iShares FTSE/Xinhua China 25 ( FXI), advanced only 47.3% last year.

Although a lot has changed in the past year, the longer-term trends that favor small caps remain in force, in my opinion. The Chinese economy will become more consumer and healthcare focused in future, and small-cap HAO remains the best positioned broad China ETF for this trend, in my view. In my opinion, HAO has another 25% to run in 2010.

Despite difficult credit conditions for small companies in 2009, the China small-cap ETF outperformed its state-owned enterprise-heavy (SOE) competitors, such as FXI. I think we will see a repeat in 2010, as I think credit conditions will be about the same or better for smaller businesses, with the government and banks adopting targeted measures to reach out to these underserved businesses, while the large SOEs, which received much of the 2009 lending, may see credit squeezed should monetary policy tighten. With the central bank calling for "moderate loan growth", this appears likely.

In terms of sectors, HAO remains favorably weighted, with greater exposure to the technology, consumer and healthcare sectors than its peers. These sectors are likely to underpin China's growth, in my view, as it evolves into a mature consumer economy. Rival PGJ offers 50% more technology exposure (18% versus 12% in HAO), but it comes with large exposure to the SOEs that litter most China ETFs, and that's what I'm trying to avoid.

On the plus side, PGJ does have low exposure to financials, at about 8%, and it only holds U.S.-listed or ADS shares. By comparison, FXI's financial exposure is 47% and GXC holds 33%, mostly in the big state-owned banks. HAO has 12.9% of its holdings in financials, but mainly in insurance and property developers, not in banking. The recent boom in lending, coupled with the warning signs put forward in a paper by Giovanni Ferri and Li-Gang Liu, mean asset quality at the Chinese banks likely deteriorated in 2009. In general, investors should probably shy away from too much Chinese financial exposure at this point in time.

And there is a plethora of reasons not to own SOE-heavy ETFs such as FXI. In December 2008, I wrote the following in my ETF Report:

"In the long run, China's insistence on maintaining state control of certain industries should lead to equity underperformance as profits are sacrificed for market share or political and social stability (we've already seen the oil companies lose profits due to gasoline price controls). Meanwhile, the small caps will be free to maximize profits and deliver shareholder value."

Case in point: Government reorganization of the telecom industry contributed to FXI's underperformance in 2009, due to its large exposure to the sector (16% of assets). The government created a third wireless carrier out of China Telecom ( CHA) to break up the China Mobile ( CHL)- China Unicom ( CHU) duopoly. While good for consumers, the companies have suffered losses due to lower fees and increased marketing budgets. CHU gained 9.6% and CHA added 11.5% in 2009, while CHL lost 5.6%, leaving FXI's telecom holdings as a whole flat for the year.

In summer 2009, I revisited the theme of state-owned enterprises (SOEs) from the angle of credit, in an article entitled Play China With This Small Cap ETF. In that piece, I discussed the above-mentioned paper by Ferri and Liu, which found that state-owned enterprises would have no profits if they were forced to pay market interest rates.

This issue became all the more acute in 2009 as lending ramped up fantastically for SOEs and government-favored industries, but small and medium sized enterprises (SMEs) still found loans difficult to obtain. The problem persisted through the end of the year, with the Financial and Economic Affairs Committee of the National People's Congress showing 30% of SMEs rated financing as their "top barrier to development", while others show that more than 75% of SMEs in Henan and Jiangsu province "faced financing difficulties."

Banks have moved to address the problem, though, with China Merchants Bank recently saying it would increase lending to SMEs in 2010. Many banks have set up special departments to deal with the issue, while entrepreneurs are also stepping in. Jack Ma, founder and CEO of Alibaba, a business-to-business website, has expanded partnerships with banks to help give loans to SMEs, for example.

In summary, I believe the longer-term development of the Chinese economy will favor technology, consumer and healthcare. HAO remains well positioned in those areas. Near-term, changing credit conditions are likely to hurt larger companies, while small companies may see an improvement. Most broad China ETFs have similar portfolios, heavy in state-owned banks and telecom, and both sectors looked poised for continued underperformance. For these reasons, it will pay to stick with HAO in 2010.


A special note from Don: There's no doubt in my mind that ETFs are the most exciting investment vehicles of the decade. That's why I'm thrilled to announce TheStreet ETF Action by Don Dion, TheStreet's newest premium service. You can build a profitable ETF portfolio right alongside me - click here to find out how.

At the time of publication, Dion held no positions in the ETFs or stocks mentioned.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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