Chinese stock mutual funds have jumped this summer despite earlier worries

Surprise: One of the summer's hottest investments was also one of the most anxiety-inducing a few months earlier.

Dollars are pouring into China again despite worries about the country's slowing economic growth. Chinese stock mutual funds have returned an average of 12.5 percent over the last three months, making them the second-best fund category of the 105 that Morningstar tracks.

Mutual fund managers say they still see opportunities in Chinese stocks, even though the recent gains mean they're no longer as cheap as they were. But investors hoping to take advantage should be mindful that Chinese stocks have a long history of jagged swings, one that has made even steadfast buy-and-hold investors nervous. China's economy also still has its doubters, as do broad swaths of its stock market.

"These are the times I love investing in a country, when the market is overly pessimistic," says James Oberweis, co-manager of the Oberweis China Opportunities fund (OBCHX), the top-performing Chinese stock fund over the last five years.


Much of the worry centers on how well China can navigate a slowdown in its economic growth. Even through the global financial crisis, China's growth blew past the rest of the world. In the decade from 2002 through 2011, growth never dipped below 9 percent annually and got as high as 14.2 percent.

But this year, China's growth will slow to 7.4 percent, according to estimates from the International Monetary Fund. Next year, the IMF says the pace will fall to 7.1 percent. The Chinese government is in the midst of attempting to reshape the economy. It wants to focus more on consumer spending driven by its growing middle class than on trade and investment, hoping for a more sustainable rate of growth.

Many investors question how successful it will be revamping the world's second-largest economy. Those doubts come on top of longstanding concerns about the political risk of investing in China and the quality of accounting there.

Such concerns led to an essentially flat year for the MSCI China index in 2013. Many China-focused mutual funds use the index as a benchmark. The performance fell way short of the economies of developed markets. The Standard & Poor's 500 index shot up 29.6 percent in 2013.


The struggles for Chinese stocks came even as profits for many of those companies continued to rise. That meant price-earnings ratios for Chinese stocks fell, and many investors use the ratio to measure how cheap a stock is. Chinese stocks traditionally carry lower price-earnings ratios than U.S. stocks, but the Chinese market also looks attractive relative to its own history, fund managers say.

"It definitely remains one of the world's cheapest markets," Oberweis says

In recent months, investors have grown more comfortable with China following encouraging reports on manufacturing and other areas of the economy. Economists credit "mini-stimulus" efforts by the Chinese government, which helped economic growth strengthen in the second quarter.

Many economists still question whether the improvements are ephemeral or lasting, but optimism has risen enough that Chinese stock funds pulled in more than $1.4 billion during the last week of July. That's the largest one-week amount in over six years, according to fund-tracker EPFR Global.


One of the big traps in Chinese investing is looking solely at the economic growth rate, says Tom Leventhorpe, a client portfolio manager who helps oversee the JPMorgan Emerging Markets Equity fund (JFAMX).

"Just because something is fast growing doesn't necessarily mean it's a good place to invest," he says. Investors instead should focus on where the earnings of a Chinese company are heading.

Leventhorpe is generally avoiding large Chinese banks and natural-resource companies, even though they're among the biggest stocks in the market and look very cheap relative to their earnings. Instead, he prefers companies that focus more on selling to Chinese consumers, such as social media companies and food packagers. These stocks aren't as cheap due to all the excitement around China's rising middle class. But they have better earnings growth prospects, and Leventhorpe says their management teams tend to put shareholder interests higher than the state-run companies.


China's volatility means investors need to be prepared to commit to the market for a long time, says Robert Horrocks. He is chief investment officer of Matthews Asia, which runs several Asia-focused mutual funds and manages $27 billion.

Over the last five years, the MSCI China index has posted a monthly loss of more than 3 percent, 15 times. For comparison, the S&P 500 had that happen nine times.

The volatility is a result of sharp swings in investor enthusiasm for Chinese stocks. That's why Horrocks says investors should put money in Chinese stock funds only if they're optimistic about the next three to five years rather than just the next 12 months.

"I still think it's a place to look forward to for the next 10, 20 years to see growth in earnings, valuations and corporate-governance improvements," Horrocks says. "It's too big to ignore."