Amid outsized returns for China stocks, investors have been flocking into funds that concentrate on the region. But anyone looking for a repeat of last year's incandescent performance is likely to be disappointed.

In 2003, funds invested in China, Hong Kong and Taiwan soared 61%, according to Lipper, a

Reuters

company. That topped the

Nasdaq Composite's

heady 50% rise and trounced the

S&P 500's

26% gain. In 2003, mutual fund investors poured nearly half-a-billion dollars into the eight funds focused on the China region, boosting total assets to $1.79 billion.

The problem for those looking to join the China party is that investors have a long, cussed history of dumping money into relatively tiny sectors -- like Internet funds -- just as they're about to sour.

"There's been a sorry track record for sector funds and single country funds," said Burt Greenwald, a Philadelphia-based mutual fund consultant. "Most people don't get in prior to the run-up. Typically, most of the money pours in after the fact."

January inflow data isn't yet available, Lipper said, but the firm reported China-oriented funds posted returns of a solid 4.3% last month. Yet starting even last year, market-watchers were already sounding the alarm that China's economy is overheating. Stocks have been bid up so much that there's little room for error, as evidenced by the pummeling in Chinese Internet names last week after the

disappointing forecast from

Sohu.com

(SOHU) - Get Report

.

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Reflecting those gains, China funds likewise "are presumably significantly less of a bargain than they were 12 months ago, and significantly closer to peaking than they were 12 months ago," said Bill Rocco, senior fund analyst at Morningstar. "It's always dangerous to chase performance."

That doesn't necessarily mean a crash is in the works but investors should expect that, at the very least, returns are likely to be more modest in the future.

Potential investors also need to consider how much volatility they can stomach, since funds that focus on one country tend to see nausea-inducing swings in performance. Back in 1999, for example, over half a dozen Japan-focused funds landed in the so-called century club reserved for those with annual returns of at least 100%. But on the heels of a blazing year, the Japan market suddenly shifted course and suffered double-digit losses for the next three years.

Moreover, Chinese stocks are subject to sizeable political risks, notably the government's majority interest in leading companies.

" I think it's quite fair to say it is capitalist

but China still doesn't call itself capitalist," noted Richard Gao, co-manager of the

(MCHFX) - Get Report

Matthews China fund. "'Socialist economy with Chinese characteristics' is the official term for the economic structure."

Other concerns include a potential revaluation of the Chinese currency and a banking system laden with bad debt.

Single-country funds are "more like stocks in terms of the risk-reward profile," said Rocco. "If things go wrong, you could lose 20% or 30% or 40% in a few months."

Indeed, China funds saw painful outflows of money after the emerging markets crisis spooked investors in the late 1990s. For the four years through 2001, the China fund sector saw cumulative outflows of nearly $400 million, according to Lipper. To put that in context, China funds claimed only $606 million in assets at the close of 2001.

A Yellow, Not Red Light

The point is certainly not that investors should shy away from the region entirely; China still offers up toothsome growth prospects. On the heels of blowout economic growth, with gross domestic product up 9.1% in 2003, investment banks are forecasting continued growth in the 8% to 9% range this year.

Nevertheless, investors interested in China should heed a couple of caveats.

First, they "need to be aware that at least in the U.S., a China region fund may or may not be investing that much in mainland China," noted Andrew Clark, senior research analyst for Lipper. He estimates that about two-thirds of China fund investments are in stocks listed on the Hong Kong Stock Exchange, which includes not only companies based on the Chinese mainland -- many list in Hong Kong because it's more liquid and has higher standards than domestic Chinese exchanges -- but also companies headquartered in Hong Kong itself, which may be slower-growing. Investors may need to do a little digging in a fund's prospectus to figure out where their money's going.

Furthermore, so-called H shares -- mainland companies that list on the Hong Kong exchange -- "need further earnings growth to support an increase in valuation," said Gao. "A year ago, most H shares were selling at single-digit P/Es. But now the average for H shares is more like 15, 16 times. We think this rerating is justified but it's a bit too fast."

Also, anyone considering plunking money into a China fund should figure out how much exposure they already have. "A typical core foreign

fund holding would have about 10% in emerging markets, and some of that is probably in China and Hong Kong," said Rocco.

For that matter, anyone who's invested in S&P 500 stocks will indirectly benefit from China's growth, given its strategic importance for U.S. blue-chips such as

Procter & Gamble

(PG) - Get Report

, which counts the country as its sixth-largest market, to

Intel

(INTC) - Get Report

, which draws 12% of sales from China.

Rocco's advice: China-oriented funds make the most sense for sophisticated investors with substantial stock portfolios. In that case, it's possible to treat a relatively volatile China fund as simply another aggressive stock holding.

He recommends investors who want to supplement a basic foreign fund steer clear of narrowly focused China funds. The real question is whether to get exposure to China through a global emerging markets fund -- which offer a more diversified play, with exposure to other big emerging markets like Brazil -- or a more concentrated fund focusing on Asia, excluding Japan.

In the latter group, two Morningstar favorites are

(MAPTX) - Get Report

Matthews Pacific Tiger and

(PRASX) - Get Report

T. Rowe Price New Asia.

Meanwhile, mutual fund outfits seem to be gearing up to exploit interest in China with more country-specific funds. Fred Alger Management, which has recently been investigated for market-timing, has been heavily promoting a China-U.S. growth fund introduced just last month.

"I think that right now any number of

China funds are on the drawing board," said Louis Harvey, president of Dalbar, a mutual fund research and consulting firm.

Perhaps more than anything, that underscores China has now arrived on the investing scene. But the sort of hype that spurs creation of new sector funds also tends to presage disappointment, or at least signals the rally is closer to the end than the beginning.