Investors: Don't Give Up on Investing in China

The news from Chinese financial markets in recent months certainly has succeeded in grabbing headlines. China Evergrande (EGRNY), a domestic property giant with a towering $300 billion of liabilities, teeters on the edge of bankruptcy. A Chinese government crackdown on tech companies crushed the valuations of widely held large-capitalization growth stocks such as Alibaba (BABA) and Tencent (TCEHY). Beijing abruptly restricted the weekly hours that young people could spend playing video games and took an axe to the fast-expanding for-profit education industry, eviscerating the market value of several listed tutoring securities overnight.

It's little wonder that investors worry about the turmoil spreading to the world’s other financial markets – or about whether to invest in the humongous Chinese market at all.

But there is some good news. Despite comparisons to the bankruptcy of Lehman Brothers in 2008 (which made the firm the poster child of the subprime-mortgage crisis), financial contagion from Evergrande is unlikely to reach our shores.

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Holders of Evergrande stock will be devastated, and bondholders will take some losses, but the vast bulk of the property developer's debt is local and largely secured with real estate in China. The company was simply overleveraged, unable to increase borrowing, and it faced a liquidity squeeze, according to Jason Hsu, founder and chairman of Rayliant Global Advisors. Hsu notes that property prices continue to rise in China and says the ongoing government-led restructuring of the developer is "actually very orderly."

China's Recent Commotion is Just Business as Usual

As for the sudden raft of Chinese policy and regulatory shifts, which seemingly came out of left field, those closer to the scene are less fazed.

"Recent developments are not that out of character," says Vivian Lin Thurston, a native of China and portfolio manager of William Blair's China Growth Fund. The country's state capitalism model combines top-down direction from the government with bottom-up entrepreneurship from the private sector, she explains. The recently espoused "common prosperity" agenda is about balancing growth with sustainability, in her view, with the government seeking to distribute the fruits of growth more broadly and bring more Chinese into the middle class.

Michael Kass, portfolio manager of the Baron Emerging Markets Fund (BEXFX), a member of the Kiplinger 25 list of our favorite no-load funds, notes that cycles of regulatory and political tightening seem to arrive every several years, with the current cycle somewhat delayed by the challenges of COVID-19.

In addition, Kass thinks that the recent shift in policy focus is related to the Chinese Communist Party Congress scheduled for the fall of 2022. In the Chinese version of an election year, President Xi Jinping will seek to be nominated for a third five-year term at that convocation. One fear of the party is that rapid economic growth and "the disorderly expansion of capitalism" have sowed seeds of potential political and social instability. China statistically has one of the widest wealth gaps in the world – hence the campaign to narrow the gap, even if it results in slower economic expansion in the near term.

Despite the recent commotion, there are still compelling reasons to invest in the country's securities. "China is too big to ignore," says Andy Kapyrin, co-head of investments at Regent­Atlantic Capital. Hsu calls China and the U.S. the only two "large growth engines" in the global economy. In addition, the correlation of Chinese and U.S. stocks is relatively low, which aids portfolio diversification.

How to Invest in China

Until now, many American investors have bought American depositary receipts of Chinese stocks. This is now a risky way to invest. U.S. regulators want Chinese companies to fully comply with U.S. auditing. But Chinese regulators are unwilling to open audits to foreign inspection – plus, they want their companies to tap domestic capital sources first. As a result, Andy Kapyrin, of RegentAtlantic Capital, thinks that Chinese ADRs run the risk of being delisted from U.S. exchanges. (In fact, this is already occurring, with the delisting of China Mobile and other Chinese telecom companies earlier this year.)

The better way to invest in China these days, according to many financial advisers, is through an actively managed fund with access to Chinese "A" shares, which are stocks listed on China's domestic exchanges. (It is extremely cumbersome for individual investors to access A shares.) This opens far more of the economy – including its most vibrant sectors – to foreign investors and avoids China index funds, which hold lots of large, sluggish state-owned enterprises.

Rayliant Quantamental China Equity (RAYC) is an intriguing actively managed exchange-traded fund that invests solely in Chinese A shares. Comanager Jason Hsu, a prominent quantitative investor, combines both quantitative and qualitative techniques to analyze companies.

The "noisy" Chinese market is dominated by retail investors who can behave rather peculiarly, he says. Rayliant captures and makes use of investor behavior that "doesn't correspond to logic" in its models. It also searches for other anomalies, such as companies that underreport earnings to build capital reserves or avoid regulatory scrutiny. Hsu says about three-fourths of the portfolio is determined by fundamental factors, and the balance is driven by behavioral factors. The fund's largest holding is China Merchants Bank (CIHKY), which Hsu says operates like a private enterprise (even though it's state-owned) and has the largest wealth-management business among Chinese banks.

Another way to invest is through a diversified emerging-markets fund, such as Kiplinger 25 member Baron Emerging Markets (BEXFX), which allocates about 30% of its portfolio to China. Manager Michael Kass says a main strategy is to align holdings with the government's desire to promote growth of industries based on intellectual capital, including pharmaceuticals, robotics, semiconductors, software and electric vehicles.