New ETF is a way into smaller China

The latest fund includes a broad swatch of the country's companies, including its smaller businesses.

By Scott Cendrowski, reporter

NEW YORK (Fortune) -- If Burton Malkiel, author of the famous "A Random Walk Down Wall Street" and Princeton University economist, is right, the majority of U.S. investors aren't profiting enough from China's rapid growth.

China's main index, the Shanghai Composite, has gained 52% this decade. Yet Americans are estimated to have only 2% to 20% foreign stock exposure. That means Chinese stocks represent at most a low single-digit percentage in the average portfolio.

Malkiel believes the problem is worse: even if U.S. investors do hold China stocks, they're missing the rapid rise of China's smaller businesses. For example, iShares FTSE (FXI), the first and most popular China ETF, with $9 billion in assets, holds mainland China's 25 biggest companies.

"You don't get any of the smaller-cap companies," explains Malkiel, who points out that financial, energy, and technology stocks make up more than 80% of iShares FTSE.

To give U.S. investors broad exposure and diversification in China, Malkiel and Claymore Securities last month launched a new China ETF with small-, mid-, and large-cap companies. Called the Claymore/AlphaShares China All-Cap ETF (YAO), the "all-stock market" fund tracks a 100-stock index composed by AlphaShares, where Malkiel is chief investment officer, and Standard & Poor's.

YAO is different than other China ETFs in several ways, some good and some bad.

First, many of the nine existing China ETFs do not include Chinese companies listed on the New York Stock Exchange, such as Baidu (BIDU), the Internet search company, which has returned 228% this year. YAO holds Baidu and other technology stocks like business-to-business site (ALBCF), up 238% in 2009, and instant messenger service Tencent (TCEHY), up 183%.

Second, many other China funds are heavily weighted to mega-cap companies. (The average market capitalization in iShares FTSE is $65 billion.) As Malkiel points out, the Chinese government controls many of those companies. "They may have the company do things that you as a private investor might prefer not be done," he says.

The AlphaShares YAO fund guards against holding too great a percentage of large caps by using a "modified market-cap weighted" system. Stocks cannot constitute more than 5% of the fund when it rebalances each year. If a stock rises during the year to constitute more than 10% of the fund, it's cut back. This prevents China Mobile, for example, from constituting 20% of the holdings.

"By limiting the weight of the China Mobiles," he says, "we're increasing the weight vis-à-vis cap-weighting of all of the smaller companies."

Indeed, as China's growth extends to its rural villages and its potential 500-million-person middle-class buys more domestic products such as tennis shoes and dairy products, more small- and mid-cap companies look to profit.

YAO charges a 0.70% annual management fee, which is slightly higher than some competitors' fees. SPDR S&P China (GXC), for example, holds 129 stocks, including small- and mid-cap ones. Its management fee is 0.54%.

And low trading volume could lead to high bid-ask spreads for YAO, which would increase the cost of buying shares. The iShares FTSE trades 21 million shares a day on average; YAO's average is 179,000 shares.

Morningstar ETF strategist Patricia Oey says YAO and other China ETFs are much riskier than U.S. investments. A three-year measure of volatility for China ETFs is more than double that of the S&P 500. "We remind investors to carefully monitor their investments in the region, as it can be a bumpy ride," she wrote in a recent report. Oey notes that the Shanghai Composite Index's 60% rise in 2009 included a more than 20% decline in August.

Still, Malkiel remains bullish on China for the long-term. Its 9% to 10% annualized GDP growth rate in the past two and a half decades, he says, is "unprecedented in world history." He expects growth to continue as 500 million educated and unemployed Chinese spur greater domestic spending and production.

Says Malkiel, "It's probably one of the few places in the world where I suspect you're going to get double-digit returns" for years. To top of page

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