NEW YORK (TheStreet) - Of the 35 equity fund categories tracked by Morningstar, China ranks at the top of the charts.During the past five years, China regional funds returned 15.7% annually. Red-hot Latin American funds finished in second place, returning 11.8%, while the S&P 500 returned 2.2%. The outlook for China remains bright. The country's gross domestic product grew 9.8% in the fourth quarter of 2010, and analysts expect the boom to continue. The consensus forecast is for corporate earnings to rise 17% this year. Still, there are grounds for caution. After years of rallying, Chinese stocks are no longer cheap. The price-earnings ratio for China funds is 16.3, compared to 14.5 for U.S. domestic funds. In recent months, the Chinese inflation rate has been climbing. To cool the economy, the central bank has raised interest rates and limited lending by banks. That has hurt stocks of banks and property companies. During the last three months, China funds have returned 0.2%, while the S&P 500 has gained 10.9%. The Chinese markets could remain skittish as central bankers struggle to limit inflation without shutting down growth. Should you avoid China altogether? Probably not. It pays to have a stake in the fast-growing country. To participate in the Asian boom, most investors should own diversified international funds that have holdings in China. If you want to overweight the country, consider a China fund. But keep in mind that Chinese markets are volatile. As the financial crisis unfolded in 2008, China funds dropped 54.4%, lagging the S&P 500 by 17 percentage points. To avoid being whipsawed, start with a small stake in a China fund. You can increase the holding by using a technique known as dollar-cost averaging. In this approach you make a series of small investments spread over months or years. The idea is to avoid buying your whole position at the top of the market. For a relatively steady fund, consider Matthews China Investor ( MCHFX), which has returned 21.5% annually during the past five years, outdoing 89% of competitors. The fund buys moderately priced stocks that can increase earnings consistently for years. "We try to find companies that are in the early stages of their growth," says portfolio manager Henry Zhang
The fund is overweighting companies that will benefit from the growth in consumer spending. A favorite holding is New Oriental Education & Technology Group ( EDU), which provides English language training and preparation for college entrance exams. The company has been opening new schools throughout China, increasing revenues at a 56% annual rate. Another holding is Hong Kong Exchanges and Clearing, the holding company that owns the Hong Kong Stock Exchange. Trading volume has been increasing rapidly as more companies from mainland China list on the exchange. Another solid fund is Guinness Atkinson China & Hong Kong ( ICHKX) , which has returned 16.5% annually during the past five years, outdoing 57% of competitors. Portfolio manager James Weir favors high-quality stocks that are showing price improvements. Lately the fund has been overweighting energy stocks, including solar and wind power companies. "The Chinese government understands that it must spend heavily to increase energy production," says Weir. A favorite holding is JA Solar Holdings ( JASO), which makes solar cells that are used to produce electricity. Revenue has been growing at an annual rate of more than 100%. Weir also likes coal stocks. As it increases production of steel and power, China has been using more coal. With shortages mounting, the country has been forced to increase imports. Monthly imports climbed from 4.2 million tons early in 2008 to 17.3 million tons now. The growing demand is pushing up prices around the globe, boosting profits of Chinese coal companies. A top holding of the fund is Yanzhou Coal Mining ( YZC). The company has been increasing revenues at a 63% annual rate.