Chinese Small Caps: HAO Is Good, But Not Good Enough

This is one time where diversification just isn't worth it

“Hao” is a common Chinese word meaning “good,” making it a somewhat (but not entirely) appropriate ticker symbol for a popular ETF centered around Chinese small-caps and managed by Guggenheim Investments.

Guggenheim185It’s appropriate because HAO, whose full title is the Guggenheim China Small Cap Index ETF (HAO), offers investors good access to a wide range of Chinese small caps trading as ADRs in New York or on the Hong Kong Stock Exchange.

But in HAO’s case, all that good access has done little over the past year to merit attention from investors looking for good returns.

In fact, in some cases, investors could have made a lot more money by avoiding HAO and focusing on just a few of the ETF’s China small caps in online services and other profitable business sectors.

How HAO Falls Short

Investors who put money in the HAO ETF at the beginning of 2014 had earned only 2.4% as of Thursday, Dec. 4. In fact, HAO’s value fell sharply over the first five months of the year before rebounding to December levels.

True, anyone who bought into HAO ETF during a late 2011 slump for Chinese small caps would have earned 30% by late 2014. But HAO’s yield over the past five years has been around zero.

The HAO basket of more 260 small caps gives its investors a slice of almost every Chinese market pie. The portfolio includes online companies Vipshop (VIPS) and YY (YY), solar suppliers Yingli Green Energy (YGE) and JA Solar (JASO), real estate developers Soho China (SOHOF) and Beijing Capital Land (BJCLF), and heavy equipment manufacturers Zoomlion (ZLIOY) and Sany (SNYYF). Airlines, utilities, cement companies, steelmakers, miners, electronics manufacturers and software developers are in the basket, too.

The basket is so diverse that investing in HAO basically means betting on most of China’s well-known small caps in one fell swoop, based on the premise that the group’s strong performers will outweigh the weak.

That’s not a bad bet considering that although China’s economy is slowing, it’s still growing at about 7% annually. And the decline in global oil prices in recent weeks has benefited HAO small caps such as airlines and shipping companies.

But yields can be much higher for investors who take the time to survey the landscape of Chinese small caps and pick individual stocks in hot sectors, rather than relying on an ETF that’s counting on backing more winners than losers.

Consider the Internet social network-gaming-dating service YY. The company’s shares make up about 1% of the HAO ETF.

Directly investing in Nasdaq-traded YY would have yielded 37% over the past year, compared to HAO’s less than 3%. Even now, it might not be too late to make money on YY, as the company recently reported gains of more than 100% in third-quarter 2014 revenues and earnings year-on-year, and expects fourth-quarter gains of more than 70% .

In another example, shares in the electronics gear and smartphone maker ZTE (ZTCOY) are accessible through HAO, comprising about 0.8% of the portfolio. But an investor in ZTE’s over-the-counter shares, which trade in Hong Kong, would have earned 7% over the past year.

Weighing down the HAO ETF since last year have been a variety of portfolio laggards among China’s small caps hit by the country’s economic slowdown, such as real estate developers, and headwinds from poor export demand, such as solar panel makers.

Bottom Line

Investing in HAO was a good idea about three years ago, when traders were piling into stocks in China and other emerging markets. Back then, a rising tide was lifting all small-cap boats.

Today’s Chinese market, though, is like a sea with a mix of strong and weak small caps bobbing around. Plucking out the strong companies can be rewarding.

Investing in the whole fleet of small caps via an ETF can be disappointing.

As of this writing, Eric Johnson did not hold a position in any of the aforementioned securities.

More From InvestorPlace

Article printed from InvestorPlace Media,

©2020 InvestorPlace Media, LLC