Are you excited about the upside potential of China but can’t pull the
trigger because of the significant downside risk? Here is a way to
invest in China growth and still sleep at night.
China has been the largest economy in the world for eighteen of the
past twenty centuries and it is clearly determined to regain its role
as the hegemonic power in Asia and then challenge U.S. global
leadership. Will it be able to sustain its 10% economic growth rate,
quell rural discontent, build a sound market-based financial system,
privatize dominant state-owned enterprises and move towards openness
and democracy? This is a tall order and you can put me in the skeptic
column.
Nevertheless, China’s raw industrial power, momentum and the palpable
ambition of the Chinese people could realistically yield a huge return.
I advise my clients to go ahead and invest in China but emphasize that
this is a speculative investment. It is smart to protect against the
considerable downside risk.
Here is a simple plan you might want to execute to capture the upside
while cutting your losses if the Chinese economy hits a speed bump.
First, you could take a broad stake in China through investing in the
China iShare exchange-traded fund (FXI) that is comprised of 25 of the
largest and most liquid China names. All of the 25 stocks included in
the China iShare are listed on the Hong Kong Stock Exchange. Some of
them are incorporated in mainland China (H shares) and some of them are
incorporated in Hong Kong (red chips). The China iShare has been
picking up steam in the last few months and is up just over 12% so far
this year.
The China iShare provides good exposure to three key sectors of China:
energy (20%), telcom (19%) and industrial (18%). This concentration can
be viewed as a plus or a minus depending on your perspective. For
example, some smart investors are placing a bigger bet on China’s
consumer markets. The top five companies represent 40% of the index.
The annual operating expenses of the China iShare are only 0.74%
compared to 2% plus for other alternatives out there including actively
managed China and greater China regional funds. Keep in mind that most
of these companies are still largely controlled and owned by the
Chinese government.
Next, you could take out some insurance to protect this position by
purchasing a put option on the China iShare (FXI). It sounds
complicated but is actually very straightforward. An option is a right
to buy (call) or sell (put) 100 shares of a security on a fixed
expiration date at a set price (strike price). For this right an
investor pays a fee or premium.
While you may grumble about paying the premium with cold hard cash when
you might not need it, you probably have home insurance just in case
disaster strikes and no doubt you have some life insurance as well. Why
not protect your portfolio as well? It is especially important to
consider hedging against more risky emerging markets such as China.
While countries like China offer tremendous upside potential, the
downside risk can be daunting and immobilize even the bravest investor.
Let’s look at a couple of examples. Say you buy 100 shares of the China
iShare (FXI) which is trading at $62 per share. Your total exposure is
$6,200. Then purchase a put option (right to sell the China iShare)
that gives you the right to sell FXI at a price of $60 on the third
Friday in January 2008. I think we all can agree that a lot could
happen to China, good and bad, from now until January, 2008. If the
price of the China iShare moves down toward the strike price, the value
of the option will increase.
This will cost you a premium of a little over $500 but limits your
potential loss to $2 per share plus the premium. Or buy a put option at
a strike price of $50 and your premium drops to about $200 with a worst
case scenario of a loss of $12 per share plus the premium.
Here is another example. You know Latin American markets are hot and
believe the bull market will continue but are wary that there is the
potential for a sharp pullback. You could buy 100 shares of the Latin
America 40 iShare (ILF) giving you exposure to Brazil, Argentina,
Mexico and Chile at a price of $113 for a total exposure of $11,300.
Then buy a put option giving you the right to sell 100 shares at a
strike price of $100 in March 2006 for a premium of around $300. Your
worst case scenario would then be a loss of 15% with unlimited upside.
Keep a cool head when investing in emerging market countries like
China. They should represent only be a small portion of your portfolio
and, whenever possible, take out some insurance.
