Steadier Ways to Play the China Rally

NEW YORK ( TheStreet) -- China funds have been rallying. During the past three months, the average China fund returned 12.1%, according to Morningstar.

Investors have taken notice of the strengthening environment, putting $2 billion into iShares FTSE China 25 Index ETF ( FXI) this year.

Positive economic news has been spurring the market gains, says Morningstar analyst Patricia Oey. Retail sales in China have been climbing, growing at an annual rate of 14.5% in October. After slowing for months, industrial production growth has stabilized at a healthy annual rate of 9%.

Economists say the improving picture may be connected to a temporary increase in infrastructure spending this year. The government mandated the stimulus to strengthen the economy at a time when a new leadership team is about to take office.

Still, the data have helped to mute fears that the country could sink badly and face what economists call a "hard landing."

Bulls say the China rally can continue. After struggling in recent years, Chinese stocks sell at modest prices. The FTSE China 25 Index only has a price-earnings ratio of 8.5, compared to a figure of 14 for the S&P 500.

While the iShares fund is the largest China ETF, it presents considerable risks. The problem is the ETF has 58% of its assets in financials. Big holdings include China Construction Bank and Industrial and Commercial Bank of China. If China's banks ever sink, the fund would collapse.

Bears note that the financial sector faces substantial challenges. Many of the largest holdings in the ETF are state-owned banks. To stimulate the economy in recent years, the central government pressured banks to take on debt and assist borrowers that were not creditworthy. Now, the heavily indebted banks are faced with many loans that may never be repaid.

To obtain more diversification, consider pairing iShares FTSE China 25 with WisdomTree China Dividend ex-Financials ( CHXF). The WisdomTree fund is broadly diversified with 13% of assets in consumer staples, 24% in energy, and 15% in telecommunications. By putting half of your stake in each of the two funds, you would have 29% of the assets in financials, a reasonable allocation.

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