Party Like It's 1999

What are the chances that one of your funds will return 100 percent (or more) next year? Slim … extremely slim. Funds rarely double in a 12-month period; and when they do, one wonders: To sell or not to sell? Well, recently, just such a rarity has actually come to pass: During the 12 months ending in September, China funds surpassed that magic 100-percent figure. Winners included Aim China (AACFX: return of 143.7 percent), Dreyfus Premier Greater China (DPCAX: 141.1 percent) and Nationwide China Opportunity (GOPAX: 126.3 percent). Seeing those returns, students of the markets may grow wary, recalling the last time a large number of funds achieved 100-percent annual returns. That was in 1999, that roaring year in which 126 funds recorded triple-digit results. Soon afterwards, nearly all the winners fell off a cliff.

Despite the risks, investors have been plowing into China funds. Morningstar counts more than $14 billion invested in 26 China ETFs and conventional mutual funds. Of the total, more than $5 billion is in the biggest China ETF, the iShares FTSE/Zinhua China 25 Index (FXI). Investments in China are not limited to specialized funds. Many diversified international funds have sizable stakes in the country, and even some domestic equity funds hold Chinese shares. Marsico Focus (MFOCX), a large-cap growth portfolio, has 4.7 percent of its assets in China, while Loomis Sayles' Mid Cap Growth (LSAIX) holds 4.9 percent. “You probably have significant exposure to China — even if you don't own a country fund,” says William Rocco, a Morningstar senior fund analyst. Some observers, such as Princeton Professor Burton Malkiel, say this is the “safer” way to invest in China: in individual companies and funds domiciled domestically or in Europe with exposure to the fast-growing country.

Invest Slowly

For the truly risk adverse, should you avoid funds with big Chinese stakes? Not necessarily. While many Chinese stocks sell for price-earnings ratios of more than 30, corporate earnings in the country are soaring. Plenty of analysts expect the country's economy to grow at an annual rate of more than 10 percent for the next several years — and perhaps for the next decade. In that environment, some companies will justify their high prices.

Still, investors should proceed with caution, says Thomas S. Mench, chairman of Mench Financial, a registered investment advisory in Cincinnati, which clears trades through LPL Financial Services. In recent years, Mench has achieved big returns by holding the iShares China 25 ETF. Now he is selling some shares of the winning fund. “We don't think it's time to leave China, but we are trimming back our position,” says Mench.

To start investing in a China fund, move slowly, says Mark Headley, portfolio manager of Matthews China. Headley says that Chinese markets have long been volatile, sometimes recording downturns of more than 30 percent. “If you're excited about China's long-term prospects, try investing a bit,” he says. “Watch your investment so you get a sense of how Chinese markets work; then when there is a pullback of 20 percent or so, pick up some more shares.”

Investors who want to dip a toe in the water could try a diversified international fund with a stake in China. A sound choice is Thornburg International Value, which has 3.3 percent of its assets in China. Portfolio Manager William Fries stays diversified, maintaining a broad mix, including companies with rapidly growing earnings and unloved cyclicals that could be considered value choices. Fries owns foreign blue chips, such as Toyota Motor, as a well as a stake in the emerging markets. A favorite holding is China Telecom, which provides landline and cellular service to 325 million subscribers. “They are gaining 6 million subscribers a month, and that growth should continue as the standard of living improves in the country,” says Fries.

For a riskier taste of Asia, buy a diversified emerging markets fund that holds Chinese stocks. Pioneer Emerging Markets has 46 percent of its assets in Asia, including a stake in China. Portfolio manager Christopher Smart avoids highflyers, seeking undervalued stocks. To hold down risk, he spreads his bets, rarely putting more than 2 percent of assets in any one stock. He is bullish on the outlook for companies serving the domestic market in China, such as Industrial & Commercial Bank of China. Earnings for the bank have been increasing at an annual rate of more than 60 percent. “They have been offering a wide range of products for the emerging consumer class,” says Smart.

A Second Path

Another way to invest in China is with a fund from Morningstar's category of “Pacific/Asia ex-Japan.” These funds typically focus on the emerging markets, including China, India, Korea and Malaysia. In the volatile Asian category, a relatively stable choice is T. Rowe Price New Asia, which has 30 percent of its assets in Hong Kong, along with big positions in Taiwan and Singapore (countries that are benefiting from the growth in China). Like many T. Rowe Price funds, this one favors growth stocks that sell at moderate prices. Portfolio Manager Frances Dydasco often buys companies with improving profit margins and earnings growth of more than 20 percent. A favorite holding is Beijing Capital International Airport, a public company that has a monopoly on a key asset. “Air traffic is growing in China, and the 2008 Olympics should provide a big boost for the Beijing airport,” she says.

For a concentrated dose of Chinese stocks, try a country fund. William Rocco of Morningstar suggests that the China funds may only be appropriate for sophisticated investors with well-rounded portfolios. “If you buy a China fund, you should recognize that it has the volatility of an individual stock,” he says.

One solid option is Guinness Atkinson China & Hong Kong. Portfolio Manager Edmund Harriss favors simple businesses with high returns on investment. He avoids conglomerates and companies that depend on government edicts for their profits; a big holding is Angang New Steel. “This is a play on China's construction boom,” says Harris. “The company has a secure market and access to China's largest stock of iron ore.”

Another relatively steady country fund is Matthews China. Matthews aims to buy growth stocks at reasonable prices. These days it is easy to find growth in China, but discovering reasonable prices poses a challenge, says portfolio manager Mark Headley. Currently, the fund is sticking with mundane industrial companies such as automaker Dongfeng Motor Group. “The auto stocks have underperformed the broader markets, and you can still find shares with price-earnings ratios of under 20,” says Headley. “The stocks with modest prices should outperform if there is a hiccup in the Chinese economy, and markets turn down.”

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