The China Syndrome

Is there a mutual fund that's geared specifically toward Chinese stocks?

QUESTION: Is there a mutual fund that's geared specifically toward investments in China?

ANSWER: In a universe of more than 8,000 mutual funds, you can bet there's at least one out there that targets each corner of the investing world. When it comes to China, you've got not one but eight to choose from, according to Lipper's database.

Needless to say, this little group has had a very big year. Right now the average China Region fund is up 46.7% year-to-date (2003), according to Lipper. What's been driving that? First and foremost, the Chinese export business is booming, says Edmund Harriss, manager of the Guinness Atkinson China & Hong-Kong (ICHKX) fund. And things are improving domestically as well. "On the domestic side it's really 10 to 15 years of market and administrative reform that's finally bearing fruit," he says. That has lead to an increased standard of living and a higher level of disposable income -- which in turn has allowed Chinese companies to participate directly in the growth of the Chinese economy, Harriss says.

Moreover, Chinese stocks were punished severely during the SARS outbreak. Once the outbreak was contained, there emerged a great short-term trading opportunity for Asian investors.

The question is, can the run continue?

Fund managers we spoke with were cautious over the short-term. "We've now priced in strong earnings growth for 2004," says Mark Headley, co-manager of the Matthews China fund (MCHFX). "And we're far from having proven that. So we've gone from markets that I think were deeply discounted to markets that overall are fairly fully priced."

Over the long haul, however, the managers were decidedly bullish, pointing to the improving quality of the investment options in China. "I think there's a recognition that China is an ever-more-important part of the Asian economic sphere and increasingly the global economy," says Headley. "I think that when people talk about growth investing, China is certainly at the top of the list in terms of long-term opportunity."

But that doesn't mean a China fund belongs in your portfolio. Yes, these funds would certainly diversify a portfolio full of U.S. domestic funds. But like any single-country fund that covers an emerging market, they also come at great risk. For example, the Matthews China & Hong-Kong fund gained 21.5% during the second quarter of 2001, only to lose 27.1% during the third quarter, according to Morningstar. (By contrast, the S&P 500 gained 5.8% and lost 14.7%, respectively, during that same time period, which includes the tumultuous period surrounding the Sept. 11 terrorist attacks.)

"I think it's best to think of it as an individual stock rather than as a fund in terms of diversification and risk," says Bill Rocco, senior fund analyst at investment-research firm Morningstar. A more diversified Asian fund is probably a better choice for most investors, he says.

No matter what, when searching for an international fund (whether it's a China Region fund or a more diversified fund), be sure to keep an eye on expenses, since these funds can be quite pricey. (The two funds included in this article have relatively low fees and don't charge a load.) You also should investigate the fund family's measures to prevent short-term trading (one of the issues at the heart of the current fund scandals, since international funds are often the prey of arbitragers looking to take advantage of pricing imperfections). At Guinness Atkinson, for example, not only is there a redemption fee in place for those looking to trade within 30 days of purchase, but trades are executed at 9:30 a.m. the following day, rather than at the standard 4:00 p.m. cutoff.

Finally, if you do decide to proceed with a China Region fund, make sure you have a firm grasp on what the fund typically invests in, says Rocco. Investing in China is tricky business, and each fund is likely to slice this universe in a somewhat different way. For example, stocks listed on the two Chinese exchanges are likely to be riskier than those listed on the Hong Kong exchange. Also, some funds will focus on Hong Kong holdings that have some investment in mainland China, while others may include Taiwanese or Singaporean stocks in their portfolio. So be sure to examine the fund's prospectus and investment policy, says Andrew Clark, senior research analyst at Lipper. Otherwise, if you're looking for, say, a fund that invests in pure mainland China stocks, you could wind up buying something more diluted.

Sound tricky? Well it is. But if you aren't interested in slaying this dragon, all the more reason go with a more diversified fund instead.