Editor's note: This piece originally ran earlier today on our newest Premium service, ETF Profits . Click here for a 14-day trial to this exciting product!Interest in emerging markets has grown exponentially over the past decade, as investors in the developed world have begun to see the benefits of shedding their "home country bias" and maintaining larger allocations in these high-growth economies with seemingly limitless potential. While a number of countries have seen significant inflows thanks to this wave of investment, arguably the most popular destination over this period has been China, now the world's second-largest economy and perhaps destined to overtake the U.S. for the top spot in the not-so-distant future. While many emerging markets ETFs include Chinese equities, the degree of exposure is generally not commensurate with the country's importance to the global economy. Taiwan and South Korea -- two economies whose aggregate GDP is equal to less than one-third of China's -- account for about 25% of iShares MSCI Emerging Markets Index ( EEM) and Vanguard Emerging Markets Stock ETF ( VWO). China is the largest, single-country allocation of these popular ETFs, but still makes up just about 16% of their holdings. Some investors utilize country-specific ETFs to step up exposure to China. Many utilize the ultra-popular iShares FTSE China 25 Index Fund ( FXI), which boasts impressive liquidity, but is flawed in many ways as a means of accessing Chinese equity markets. In addition to the mega-cap focus and major concentration issues (many sectors are overlooked completely), FXI -- along with virtually every other China ETF -- ignores a major portion of the Chinese stock market. The China A-Shares market consists of mainland China-based companies that trade on Chinese stock exchanges, such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. While this might sound similar to other types of Chinese securities, a few key differences exist. First, many share classes of Chinese stocks are quoted in U.S. dollars; not so for the A-Shares market, where every stock is priced and traded in Chinese renminbi. More important, A-shares are generally only available for purchase by mainland citizens; foreign investment is only allowed through the Qualified Foreign Institutional Investor (QFII) system. This process effectively shuts out most Westerners from the market, forcing investors seeking China exposure to buy up some of the country's largest companies that trade on exchanges around the world, such as PetroChina ( PTR) or China Mobile ( CHL).
While these mega-cap firms do offer exposure to the dynamic Chinese market, it isn't the same as buying up firms that do business primarily in China and still have incredible growth potential going forward. Chinese companies listed on international exchanges tend to be more mature firms that generate revenues from global operations. The A-Shares market, on the other hand, is more likely to include younger Chinese companies that are driven by domestic consumption, and, as such, may be more of a "pure play" on the Chinese economy. Examples of companies available through the A-Share market include China's largest auto company, a popular Chinese liquor brand and the fastest-growing, insurance company in the country. Until recently, tapping into this immense market was nearly impossible for most U.S. investors, but the relatively new Market Vectors China ETF ( PEK) delivers a quick and easy way to access the China A-Shares market and develop more complete exposure to Chinese stocks. PEK seeks to track the CSI 300 Index, which is a diversified benchmark consisting of 300 A-Share stocks listed on the Shenzen or Shanghai Stock Exchange. However, thanks to QFII restrictions, PEK does not invest directly in A-Shares, but instead invests in swaps and other types of derivative instruments that have economic characteristics substantially identical to those of China A-Share stocks. These 300 companies represent roughly two-thirds of the total capitalization of the two exchanges, suggesting that it is a solid proxy for a relatively illiquid market. Admittedly, the system isn't perfect, and investors would be much better served by direct exposure to the underlying companies in the index. However, PEK remains the only game in town in terms of accessing the A-Shares class of companies. Furthermore, due to the QFII restrictions, the fund often trades at a premium to its underlying holdings, a situation which doesn't look likely to change anytime soon, unless, of course, the Chinese government opens up this market more to foreigners. The consistent presence of premiums introduces another risk factor that can work for or against investors. If the premium inflates, any positive returns would be enhanced or negative returns partially offset. But, if the premium contracts, investors would be running into the wind and could end up losing even if the underlying stocks appreciate.
Since the fund offers such a different slice of exposure to the Chinese market, investors can think of it as a complement to their current holdings in the nation, helping to round out their portfolios in what is one of the world's fastest-growing major economies. For investors seeking greater levels of China exposure without the mega-cap bias and for those tired of investing in the same two dozen or so Chinese companies, PEK may just be the fund that you have been searching for. At the time of publication, Johnston held no positions in any of the securities mentioned.