China’s Rapid Growth Doesn’t Ensure Stock Gains

Economic superlatives abound about China. It’s the world’s biggest auto market. It’s the largest producer of steel and, of course, the largest exporter. Yet there has been nothing extraordinary lately about the performance of China-focused mutual funds.

China’s Rapid Growth Doesn’t Ensure Stock Gains

As inflation and real estate prices have bubbled up in China, mutual funds that specialize in investing there have lately sputtered along like aging mopeds weaving through the throngs of Beijing. China funds lost an average of 2.2 percent in the second quarter, according to Morningstar, the fund tracker. An investor would have benefited more by holding stock mutual funds that invested in debt-addled Europe; those funds returned an average of 1.3 percent for the quarter.

Stretch the timeline to the last 12 months, and the comparisons are similar: China funds returned a healthy 23.5 percent, but those investing in slow-growing Europe fared even better, returning 36.5 percent.

The disparity between China’s economic performance — its gross domestic product has routinely grown about 10 percent a year over the last two decades — and its less-than-stellar stocks points to the perils of buying into a mutual fund that invests in a single country in the developing world. Simply put, fast growth is no guarantee of investment gains. China is annually moving millions of its people from the countryside to jobs in its growing cities. That’s been great for the Chinese economy but not necessarily for fund investors.

A study published in April by the Vanguard Group found no correlation between long-run economic growth, in real G.D.P. per capita, and long-run stock returns in emerging markets. “Investors are not compensated for investing on the basis of economic growth that is expected and therefore priced into financial markets,” the study said. China’s stock market fared especially poorly, returning almost nothing from 1993 through 2010, said Francis M. Kinniry Jr., a Vanguard principal and one of the authors.

Emerging markets tend to be more volatile than developed ones, and big declines can eat big gains. When news is good, these markets can soar, as China’s did in 2007, when the MSCI Broad China Index returned nearly 90 percent. But when the news is bad, they can plunge, as China’s market did the next year, when the index fell more than 50 percent. (If you had invested $1,000 in the index in that period, your money would have grown to $1,900, before expenses, by the end of the first year but would have shrunk to $950, before expenses, by the end of the second.)

Another reason that stock gains don’t necessarily track economic growth is that the goals of local companies can diverge, for extended periods, from those of fund investors. In China, as in many emerging markets, enterprises may plow money into projects aimed at expanding market share, regardless of the impact on their share prices. “Companies aren’t interested in rewarding minority investors,“ said Arthur R. Kroeber, managing director of GK Dragonomics in Beijing. “They’re interested in scaling up.“

On top of that, Chinese corporate governance can be lax, and accounting opaque. In searching for quality companies with good business models, said Nicholas Yeo, manager of the Aberdeen China Opportunities fund, “we do a lot of site visits to make sure the entrepreneur’s interests are aligned with the listed company.”

Investors in China funds face risks beyond poor returns. They can have difficulty even understanding what they are buying, as different funds define “China” differently. Some, like Mr. Yeo’s fund and the Guinness Atkinson China and Hong Kong fund, keep much of their shareholders’ money in companies listed in Hong Kong. Others also buy Taiwanese companies or multinationals with hefty Chinese operations. “Not all China funds are the same,” said William S. Rocco, a Morningstar fund analyst.

BESIDES understanding what you are getting with a China fund, you also should examine whether you really need one, Mr. Rocco said. “You’re not going to miss China’s growth if you have a well-balanced portfolio,” he said. Many international and emerging-markets funds include Chinese stocks, and American and European multinationals are increasingly generating profits in China, he said.

Jesper O. Madsen, manager of the Matthews China Dividend fund, counsels caution. “Anybody who looks at China needs to ask himself why he’s there,” Mr. Madsen said. Too often, retail investors pile into emerging countries after stock run-ups, losing sight of whether a particular market looks cheap or expensive based on its average price-to-earnings ratio. “If you overpay,” he added, “you won’t see good returns.”

For some people, investing isn’t just a way to increase wealth, but also a hobby. Even if they have a well-rounded portfolio, they want to make small bets on markets or sectors that they think will thrive.

If you are one of these, should recent news of Chinese inflation, which hit 5.5 percent in May, and the possibility of real estate bubbles in Beijing and Shanghai daunt you?

Several China-fund managers say the risks are real — but tolerable.

“From 2000 to 2010, when China really began to industrialize, there was surplus labor and a cycle of infrastructure investment that drove a lot of productivity growth,” said Eric A. Brock, co-manager of the ALPS Clough China fund. “Inflation over that period was shockingly low. Today is different. You still have the productivity story, but the supply of labor has tightened. It wouldn’t surprise us if inflation is 3 to 5 percent a year going forward, but that’s not a problem in the context of 8 to 10 percent annual growth.”

If inflation began to accelerate, Mr. Brock said he would worry. But so far, he said, the government has kept prices mostly in check by raising bank reserve requirements and interest rates. Last week, the central bank raised short-term rates for the third time this year. Mr. Brock and his co-manager, Francoise Vappereau, are betting that rising wages will propel the growth of China’s consumer sector. As the Chinese earn more money, opportunities arise for companies like the furniture maker Man Wah Holdings, which Mr. Brock called “the La-Z-Boy of China.” “People are hitting an income level where demand for Man Wah’s product can rise,” he said.

Frederick Jiang, manager of the Ivy Pacific Opportunities fund, said that while real estate values in Beijing and Shanghai have shot up, he was more worried about inflation than about bubbles in these markets. “If you compare prices in Shanghai and Beijing relative to the average income there, there’s a bubble,” he said. “But relative to Mumbai or Moscow, they’re still cheap.”

The Chinese government is making a big push to build affordable homes, committing to start 10 million units in 2011 alone. As a result, Mr. Jiang, who has invested about a third of his investors’ money in China, holds shares in cement suppliers like China National Building Material and China Resources Cement Holdings.

And Louis So, co-chief investment officer of Value Partners, a Hong Kong hedge fund manager, says his company is investing in private property developers like China Vanke.

“We think they’re dirt cheap at the moment,” he said. He called his company’s venture into the property sector a contrarian move, and two recent actions by ratings agencies suggest that his characterization may be correct.

Moody’s and Standard & Poor’s lowered their outlooks for Chinese developers to negative, from stable. And S.& P. predicted that Chinese real estate prices were likely to fall 10 percent over the next year, possibly by as much as 30 percent. It said government efforts to raise interest rates were likely to curb credit and reduce property sales.

The New York Times

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