Commentary

Positive economic data continues to drive Chinese stocks, and for the year to date, the benchmark Shanghai Composite Index is up more than 60%. China's GDP appears on track to grow 8% in 2009, thanks to strong stimulus spending and bank lending in the first half of the year and a recovery in industrial production and exports in the second half of the year. Price/earnings ratios for China ETFs are at year-to-date highs, at around 18 times trailing 12-month earnings, but still below highs of around 28 times, reached in 2007.

Before considering adding exposure to China to a portfolio, it is important to carefully evaluate the risks of this investment category. First of all, the three-year standard deviation for China ETFs that have been in existence over that time period is more than double that of the S&P 500. It is also important to note that China accounts for almost 20% of the portfolio of popular emerging-markets funds such as iShares MSCI Emerging Markets Index and Vanguard Emerging Markets Stock ETF, so investors should check to make sure they are not unintentionally overweight in China. In the near term, a weaker U.S. dollar and a slower than expected global economic recovery will weigh on China's exports, which account for about a third of GDP. There are also concerns of a real estate and stock market bubble in China, thanks to a surge in new bank loans of more than $1 trillion during the first six months of 2009, 2.3 times the amount of loans issued during the corresponding period in 2008. Finally, we highlight that rising oil prices could also weigh on China's near-term growth.

U.S. investors generally have a choice of one or two ETFs per country, but there are currently nine China-related ETFs and a handful in registration that are expected to be launched soon. The ones we feel are worth noting are described below.

The first China ETF to launch was iShares FTSE/Xinhua China 25 Index, which started trading in late 2004. Relative to other China ETFs, this fund is currently the most liquid, with a three-month average daily trading volume of 22 million shares, and the most expensive, with a management fee of 0.74%. Almost all of the other China ETFs trade less than half a million shares per day. FXI holds the largest 25 Mainland Chinese firms available to international investors, and many of these companies rival their global peers in size, enjoy significant economies of scale, and have rich profit margins. However, financials-sector companies comprise about half of this fund, and sectors such as consumer and high tech, which are better exposed to rising income levels, are not represented at all in this fund. One near-term risk to the China financials sector is the recent surge in loan growth, which could result in a rising tide of bad loans. A correction in the lofty stock market and real estate market would also weigh on the profitability of the financials sector. This fund also has fairly concentrated sector weightings in telecoms (16%) and energy companies (12%).

A broader fund, SPDR S&P China, holds 129 firms but still has heavy weightings in financials (32%), energy (19%), and telecoms (13%). As a result, GXC's performance is fairly correlated to that of FXI, but GXC might be a more attractive option given its lower management fee of 0.54% and exposure to mid- and small-cap stocks. GXC invests in Mainland Chinese firms listed in Hong Kong or New York, whereas FXI only holds firms listed in Hong Kong.

PowerShares Golden Dragon Halter USX China is an attractive option for investors who prefer to invest in companies that are listed in the U.S. and are therefore regulated under U.S. securities laws. Unlike FXI and GXC, PGJ only invests in American Depository Receipts of companies operating in China. None of the big four banks is listed in the U.S., so the financials sector weighting in PGJ is only 6%. This fund also has a much larger exposure to the high-tech sector (which includes Internet and online gaming companies), with a 22% weighting--FXI has no holdings in the high-tech sector, and GXC has a 10% weighting. New companies continue to be added to PGJ, partly due to IPOs, and as a result, the number of PGJ's holdings has more than doubled over the last two years. The list of component stocks is adjusted every quarter. While PGJ's performance has been fairly correlated to that of FXI over the last few years, we expect this correlation to weaken as PGJ continues to broaden its holdings.

Small-cap emerging-markets funds are usually the vehicle of choice to play the expanding and rising domestic consumer sector, and for Chinese equities, there is one small-cap fund-- Claymore/AlphaShares China Small Cap. This fund has fairly balanced sector weightings, with the four largest being industrials (which accounts for 23% of the fund), IT (19%), consumer discretionary (15%), and financials (15%). This fund is up more than 80% for the year to date and has outperformed FXI, GXC, and PGJ. But it is also important to note that volatility can be quite high given this fund's investments in less-liquid small-cap stocks. HAO carries a slightly higher expense ratio of 0.70%.

New to the market this week is Claymore/AlphaShares China All Cap, whose sector weightings and main holdings are fairly similar to those of GXC. YAO holds about 100 names and charges a management fee of 0.70%. If given the choice, we would prefer to purchase the lower-priced GXC, whose expense ratio is 0.59%.

We also want to point out that investing in a Taiwan- or Hong Kong-focused ETF can also provide exposure to China, with slightly less risk, given their fairly developed financial systems and equity markets. Taiwan and China are in the process of liberalizing cross-straits trade and investment restrictions for financial services, high tech, and a handful of other industries. China is already Taiwan's largest trading partner, and this growing economic interdependence will make an investment in Taiwan even more of an indirect play on China. In particular, Taiwan's numerous high-tech firms are well positioned to benefit from a growth in consumption of consumer electronics in China. At this time, there is only one Taiwan-focused ETF-- iShares MSCI Taiwan Index.

Hong Kong, as a Special Economic Region of China, is even more economically integrated with Mainland China. Most of the companies included in the iShares MSCI Hong Kong Index have operations and investments in China, but it is important to note that this fund has a significant 60% weighting in financial services and property companies, which could underperform if the credit environment starts to tighten in 2010.

We believe China has a bright future in the long run, and its stock market's low correlation to the U.S. market makes it a good diversification tool. However, we remind investors to carefully monitor their investments in the region, as it can be a bumpy ride. Within the Shanghai Composite Index's year-to-date 60% appreciation, there was a 20%-plus decline in the month of August.

Patricia Oey does not own shares in any of the securities mentioned above.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.