How to Invest in an Untrustworthy Stock Market

China is teeming with both potential and potholes. From conservative to risky, here's how to play the Chinese stock market.

Let’s start with a hard truth about Chinese economic data: It’s full of lies and deception.

china-package-185This is not just the opinion of investors and outside experts, but also the opinion within China itself. In fact, as early as 2013, we saw the National Bureau of Statistics accusing local governments of faking economic data to boost growth rates and thus win favor among power brokers in Beijing.

To make matters worse, the financial system that provides the lifeblood of the Chinese economy is characterized by “distorted incentives and poor governance structures,” in the words of the World Bank. With the government holding the reins on 95% of bank assets, the nation’s capital markets are less of a market and more of a credit free-for-all based on Beijing’s favor.

However, it’s also true that China is a powerhouse and a tremendous opportunity.

China is the No. 1 exporter in the world, and its total economy measures second only to the United States in terms of total GDP. There are 1.3 billion Chinese and counting, and while a huge share of the population lives in poverty right now, McKinsey & Company estimates that “urban-household income will at least double by 2022” and unlock tremendous consumer spending.

Given of all this, it’s fair to say most investors are intrigued by but very skeptical of China’s growth potential — particularly after the Shanghai Composite remains down about 40% from its June peak.

So what’s the best way to trade stocks in this untrustworthy and highly volatile stock market, and how can investors in China protect themselves?

Here are a few strategies:

Chinese A-Shares

The purest play — but also the riskiest — is to invest in China via so-called “A-shares.”

Chinese A-shares represent direct investment in mainland stocks, bought on the Shanghai and Shenzhen stock exchanges. They are denominated in local currency, the Chinese yuan, and thus insulated from adverse currency exchange rates. On top of the currency benefit, these China A-shares are restricted mostly to domestic investors and a select group of institutional traders. This exclusive nature means these stocks can trade for a big premium as a result.

Individual investors can get around the restrictions on A-shares by using mutual funds, closed-end funds or ETFs. A few include the Market Vectors ChinaAMC A-Share ETF (PEK) that is indexed to the Shanghai Shenzhen CSI 300 Index, or the actively managed Morgan Stanley China A Share Fund (CAF).

Of course, the fact that you are getting a direct play on a volatile market is both good and bad; PEK and CEF have both lost about 40% since June 1 thanks to their pure focus on China. And let’s not forget that Chinese markets are subject to manipulation by Beijing, as we saw this summer when the government effectively closed the stock market in a heavy-handed effort to stop equities there from cratering.

On the whole, then, I would consider direct investment via China A-shares far too risky right now for most investors. The recent “intervention” in capital markets is concerning, and the downtrend in mainland markets seems unlikely to stop anytime soon.

China Via Hong Kong

A decent alternative to A-share funds is to look at H-shares — that is, Chinese stocks that are listed on Hong Kong’s exchange and open to Western investors. Hong Kong is indeed influenced by Beijing in some ways and highly dependent on its neighbor, but has its own market standards and has a measure of autonomy.

That’s in part why the iShares China Large-Cap ETF (FXI), one of the largest China-focused funds by assets, only saw a roughly 28% decline since June 1 vs. the 40% beating we saw for A-shares.

In fact, Western investors have been flocking to Hong Kong in the last few months as a result of better governance and transparency.

For aggressive investors, there are diversified H-shares index funds like the FXI or actively managed alternatives like the Fidelity Advisor China Region Fund (FHKAX). You still face a risk of market declines, obviously, as China struggles … but at least you can have a greater degree of confidence that your investments won’t be subject to direct manipulation by power brokers in Beijing.

China ADRs

One even safer alternative, though a limited one, is to look for Chinese stocks that trade domestically as American Depositary Receipts.

These special shares are a 1-to-1 representative of shares in a foreign company, issued by a U.S. bank as the intermediary and thus subject to some level of SEC oversight. To top it off, ADRs can save you money by reducing transaction costs as you trade them via a typical brokerage account like blue-chip stocks, and avoid foreign taxes or costly administrative fees that characterize some emerging-market funds.

The universe of ADRs is more limited, of course, but some of the biggest names in China trade as ADRs — including state-run energy giant PetroChina (PTR), financial mega-cap China Life Insurance (LFC) and Internet giant Baidu (BIDU), just to name a few.

Western Stocks With a China Flavor

A similar but more watered-down approach is to buy stocks that do a great deal of business in China but are headquartered in the developed world and subject to domestic market regulations.

Think Yum Brands (YUM), which derives $1.6 billion of its $3.1 billion in sales from its China division.

Of course, research is key here because the unique challenges of an individual business as well as influences from outside of China can affect share prices. However, if you’re reluctant to make a direct play on China and prefer the relative safety of a Western company then this could be an interesting end-around. It also allows for a focus on individual areas of strength — say, China auto sales via General Motors (GM), or smartphone sales via Apple Inc. (AAPL).

The Whole World, Including China

Personally, I think geographic diversification is just as crucial in any portfolio as diversification across asset classes and sectors. While it’s fair to bias your weighting where the opportunities are, having some exposure to all global markets — from Japan to Europe to China — will ultimately provide more stable long-term returns.

As a result, I strongly believe in having some exposure to greater China as part of your long-term portfolio even given the turmoil in the region right now … so long as you are responsible, and average in as part of a broader investment strategy.

That’s what I’m doing personally right now, via the Vanguard Total International Stock Index Fund (VGTSX). The fund is ex-U.S., meaning it covers every nation in the world but America – and has only about 10% of its assets in China stocks (including investments via Hong Kong and Taiwan).

That may not sound like a lot. But remember, this is my one-stop shop way to diversify across all regions; The fund holds 5879 stocks on the whole including Europe, Japan and Latin America.

I suppose I could drive myself batty trying to find individual companies in China or elsewhere and trade them, but it’s much easier to “average in” each month to buy a little bit of everything. And with an annual expense of 0.22%, or $22 on every $10,000 invested, that wide diversification comes at a bargain price.

It’s not as sexy or fulfilling as researching individual stocks, and the returns are sure to be much sleepier. But when it comes to China or any emerging market, I only want a little bit of exposure and a lot of peace of mind.

Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he was long VGTSX.

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