Playing the China Card

The expansion of China's economy over the past two decades has been nothing short of miraculous, but doubts persist. Were the statistics that showed off-the-charts growth in gross domestic product accurate? Did the People's Republic of China have the institutions -- government stewardship, rule of law, accounting standards -- necessary to protect investors? And, in a global downturn, would the China miracle collapse? In short, is China a place to put your retirement assets?

The answer to that last question has become clearer over the past year, and it is a resounding yes. A portfolio that neglects China ignores the most compelling economic story of the 21st century.

What slowdown? The global recession has hurt China, but much less so than other countries. "While U.S. GDP fell by 6.1% for the first quarter of this year, China posted an eerily symmetrical GDP rise of 6.1%," James Lightburn wrote in a letter to shareholders of the China Fund, the closed-end fund that he chairs. A consensus of experts in The Economist forecasts that GDP this year will fall by 2.8% in the U.S. and by 6.7% and 5.5%, respectively, in Japan and Germany, both big exporters. But in China, also a major exporter, the experts foresee positive growth of 6.5% in 2009 and 7.3% in 2010.

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The U.S. government is spending far more than it is taking in and generating a deficit that was expected to hit 13% of GDP in the fiscal year that ends in September. But China's deficit is just 4%. And, by the way, China has more than four times as many domestic consumers as the U.S.China is for real. Measured by the purchasing power of its local currency, China's GDP is now greater than that of Germany, the U.K. and France combined, and has reached half the level of the U.S. GDP.

And what about investment climate? While the market for new stock offerings in the U.S. has been largely moribund, a slew of Chinese companies are going public, including China Zhongwang, an aluminum-products manufacturer that raised $1.3 billion in April, and China Metallurgical, which is expected to raise $2.7 billion in October, topping Zhongwang as the world's largest initial public offering this year.

China, however, is still pioneer territory for most U.S. investors. Vanguard and T. Rowe Price have no mutual funds that specialize in China. Although Fidelity China Region (symbol FHKCX) has been around since 1995, it's far from a pure play on China; one-fourth of its holdings, including its biggest position, are in Taiwanese stocks.

If you want to invest in China like a native, select

Morgan Stanley China (CAF), a closed-end fund with a mandate to buy Class A shares of firms that trade on the Shanghai and Shenzhen markets. Normally, only Chinese citizens can buy such shares, but this fund has an exemption.

There are drawbacks, however. The fund was launched only three years ago and carries an expense ratio of 1.8%. Class A shares tend to be more volatile than Chinese stocks open to purchase by foreigners on the Hong Kong exchange. The Morgan Stanley fund tripled in value in 2007, fell by nearly two-thirds in 2008, and rose 59% in the first half of 2009. And, as a closed-end fund, it can trade at a discount or premium to the value of its assets. At its July 10 closing price of about $32, the fund sold at a 9% discount to the value of its assets.

Two exchange-traded funds should offer a smoother ride: iShares FTSE/Xinhua China 25 Index (FXI), which tracks a popular index of large Chinese companies, and SPDR S&P China (GXC), which, because it owns 125 stocks, contains some merely large, as opposed to huge, Chinese companies. The ETFs buy Hong Kong-listed shares, as well as American depositary receipts, which trade on U.S. exchanges. They carry reasonable expense ratios (about two-thirds of a percentage point each), and they represent the simplest and cheapest way to participate directly in China's growth.

I have also been a big fan of Matthews China (MCHFX), an actively managed no-load mutual fund, ever since I interviewed its co-manager, Richard Gao, in San Francisco in 2004. At the time, the fund was five years old and had only $88 million in assets. Today, it holds $1.6 billion, an increase that reflects growing interest in China and phenomenal performance; over the past five years through June 30, the fund returned 18% annualized -- an average of 20 percentage points per year better than the U.S. benchmark, Standard & Poor's 500-stock index.

Consumption play. Gao's top holding, Dongfeng Motor Group, illustrates the smartest way to cash in on China today: Bet on beneficiaries of burgeoning domestic consumption. Because of the global recession, exports are suffering. But China has a huge and undeveloped home market, and its government is trying to boost the economy by encouraging its consumers to save less and buy more.

The Chinese are responding. In May, they bought 1.12 million new vehicles while Americans bought only 930,000. China's auto and truck sales were up 34%; ours were down 34%. There's that symmetry again -- and, yes, China's car market is now bigger than America's.

Lei Wang, one of three portfolio managers of Thornburg International Value, a $13-billion fund that seeks promising foreign businesses at discount prices, says he's been staying away from Chinese companies that rely on exporting. Rather, he likes firms that benefit from China's internal growth. One such firm is Baidu (BIDU), a popular Web search engine (with more than three times the Chinese-language market share of Google) that sells advertising to small and midsize domestic Chinese companies.

Also among Wang's favorites are China Mobile (CHL), a provider of wireless phone services whose market value is greater than that of any U.S. telecommunications company, and China Life Insurance (LFC), an almost certain beneficiary of growing wealth among the Chinese. Like China Mobile, China Life is far bigger than the largest similar company in the U.S. Currently, Wang notes, the ratio of total life-insurance premiums to GDP in mainland China is only 2%, compared with 9% in Hong Kong and 12% in Taiwan.

Wang also likes Chinese banks, which are booming as the government encourages borrowing and consumers begin to embrace credit cards. The Industrial and Commercial Bank of China is now the world's largest bank by market capitalization. At $256 billion, the value of its stock (which doesn't trade in the U.S.) easily eclipses that of Citigroup, Bank of America and JPMorgan Chase combined.

A good way to buy domestic China plays is through the China Fund (CHN), launched in 1992 and managed since then by Martin Currie, a Scottish investment firm. The fund has performed exceptionally well, with an annualized return on its shares of 17% over the past ten years through June 30 -- better than twice that of Fidelity China Region. An investment of $10,000 in the China Fund on July 1, 1999, was worth more than $60,000 a decade later.

Although the China Fund owns several Taiwanese companies, a major attraction is that 80% of its assets are in small and midsize Chinese firms, many of them focusing on domestic customers. The fund's largest stock position is Queenbury Investments, the holding company for a Chinese retailer of home appliances, such as TVs, air conditioners and washing machines.

Be warned, however. Many Chinese stocks have had an impressive run this year. For the first six months of 2009, China's SSEA index rose 66% (in dollar terms) -- the best performance among the world's 40 most advanced nations. The S&P 500 was flat.

Still, China Life and China Mobile in July were each about 50% off their October 2007 highs, and many stocks are down for the past 12 months. There is no sense trying to time the China market; just make regular purchases of funds or stocks every quarter. Be ready for volatility, but hang on for the long term.

I would not be uncomfortable with a retirement portfolio that held as much as 15% of its stock holdings in Chinese companies. I would be leery of a portfolio that held none.

James K. Glassman is president of the World Growth Institute and former under secretary of state. He is working on a new book on investing to be published next year. He owns shares of SPDR S&P China and China fund.