China Conundrum: Resisting FXI's Temptation

Published October 12, 2012

| Benzinga

Give the iShares FTSE China 25 Index Fund (FXI) some credit. In the past five trading days, the largest ETF tracking the world's second-largest economy has jumped 2.9 percent. That solid run may be enough to lead some to think the $4.86 billion ETF and Chinese stocks in general are ready to snap back to life.

To be sure, there are catalysts. Several weeks ago, China pledged to spend almost $160 billion on infrastructure projects to stimulate economic growth. Then there is no getting around the fact that Chinese equities and FXI itself are cheap.

FXI trades at just 12.5 times earnings with a price-to-book ratio of 1.55. Those numbers for the iShares MSCI Emerging Markets Index Fund (EEM) are 17.3 and three. FXI was also mentioned in positive fashion by experts in the mainstream financial media earlier this week. To this point, those calls look prescient.

However, if past performance is any guide, disappointment looms. That is the case because FXI is the epitome of a big ETF rarely being better than a smaller equivalent. In fact, it has already been acknowledged that FXI is rarely the best China ETF, but because of its size and robust average daily volume, this is the China fund most so-called experts are comfortable recommending.

Obviously, being bullish on an ETF that is up almost three percent in just one week is not bad advice. At least not now, but treating FXI as the only China ETF in town is an egregious disservice to traders and longer term investors alike.

One does not even have to venture far from FXI to find an acceptable substitute because iShares offers one in the form of the iShares FTSE China (HK Listed) Index Fund (FCHI). One look at FCHI's roster shows investors will not be trading FXI's well known holdings for exotic fare. In fact, there is considerable overlap between the two ETFs.

Still, the FCHI and FXI are not identical twins and this is important. FCHI has just over $31 million in AUM and average daily turnover of less than 2,000 shares. Year-to-date, FCHI has delivered 230 more basis points of alpha than FXI. In the past year, that number grows to about 250 basis points. Since FCHI debuted in mid-2008, it is down eight percent. FXI has slid 18 percent since that time. Knowing all this, folks, professionals included still gravitate toward FXI.

The examples continue. The SPDR S&P China ETF (GXC) will turn six in March and has almost $786 million in AUM so this is not a small, obscure ETF. Yet, it is often overshadowed by FXI. Remember that China is the world's second-largest economy and FXI holds just 26 stocks. GXC holds 217 stocks. FXI has no exposure to China's Google (GOOG), Baidu (BIDU). GXC does.

Over the past five years, one year and year-to-date, GXC has obliterated FXI in terms of performance. Simply put, the numbers are not close and clients that knew of this situation would probably fire their advisors for recommending FXI over GXC.

Just a few days shy of its third birthday, the Guggenheim China All-Cap ETF (YAO) has just $51.6 million in AUM. Volume is less than 17,000 shares per day. Arguably, it is those factors that keep some traders away from this ETF.

Additionally, YAO's name implies the ETF might be heavy on Chinese mid- and small-caps. In reality, the ETF's top-10 holdings closely resemble what is found in FCHI and FXI, meaning YAO is large-cap heavy. Not to mention, YAO is home to 187 stocks and a lower P/E ratio, 9.4, than FXI. Since inception, over the past year and year-to-date, YAO has topped FXI.

Speaking of small-caps, there is no denying that low market value Chinese equities have been controversial over the past 12 to 18 months. Shady accounting practices, reverse splits and the like are fine reasons for anyone to eschew the risks and focus more on the perceived safety of Chinese large-caps.

For those willing to embrace added risk, ETFs devoted to Chinese small-caps have also shown a tendency to outperform FXI. The Guggenheim China Small-Cap ETF (HAO) has topped FXI year-to-date and since its debut in early 2008.

Reverting back to large-caps, the iShares lineup features another ETF that has trumped FXI. The iShares MSCI China Index Fund (MCHI) debuted in March 2011 and has almost $410 million in AUM, making it one of the more successful new ETFs to debut last year.

A case can be made that MCHI is FXI with a MSCI index because the two funds share plenty of similarities. However, MCHI stands out because it holds 142 stocks.

Despite strong average volume of almost 191,000 shares per day, MCHI is overshadowed by its cousin, FXI. That is odd because MCHI is up 8.2 percent year-to-date compared to a 4.5 percent gain for FXI. Neither have been great since MCHI debuted, MCHI is 270 basis points less bad.

Bottom line: FXI will continue to dominate the China ETF conversation, but if history repeats itself, and it often does in the financial markets, traders and investors will be better served with another China ETF.

For more on China ETFs, click here.

(c) 2012 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

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