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The China Challenge: Guide To Investing

Huge gains in China's stock market and the need for fresh capital have prompted a surge in Chinese ADRs but market pros say mutual funds are still the best option for retail investors wanting to take part in the booming stock market in the People's Republic.

The world's fastest growing economy is widely expected to see double-digit GDP growth for at least the next five years. Trade in 2007 will probably increase 20% to more than $2 trillion. So, it's no wonder then that investors are trying to capitalize on the profits that will be generated.

The People's stock market exploded in 2006, with the benchmark Shanghai Composite Index gaining 130%. The index's 51% gain so far this year is almost as impressive given the market's resiliency following a huge one-day decline of 9% on Feb. 27.

"It's basically driven by this incredible flood of retail investors," Peter Navarro, author of "The Coming China Wars" and business professor at the University of California at Irvine told CNBC. "They have about 90 million retail investors now in China and they're adding a million a week. People are pawning their houses."

Riding the rally in Chinese stocks may seem like a no brainer, but understanding what's a very dynamic market are as important as assessing the risk-reward equation.

"You have to watch out if there's a bubble in China, if there's a problem there, that's a problem here," said Doreen Mogavero, an NYSE trader and president of Mogavero Lee.

Making A Market

Chinese authorities -- who are in the U.S. for high level economic talks May 22-23 -- are trying to both nurture a stock market to maturity as well as keep a lid on what it almost an inevitable bubble. Investor demand for stocks has been seemingly insatiable despite four interest rate hikes in the last 12 months and eight increases in mandatory bank reserves.

Securities regulators in May eased investment restrictions for Chinese investors, sending stocks listed in Hong Kong to their best daily percentage gain of the year. The popular thinking among market strategists is that it will expand the demand for stocks in Hong Kong as the valuation gap between the companies listed both in Hong Kong and the mainland converge.

"It's been a very hot market," said Uri Landesman, head of global growth and international at ING Investment Management. "They are realizing how hot their stock market is so they are giving their own investors more options."

The complexities of the Chinese stock trading system are one reason for caution and why money managers often say mutual funds are the simplest and safest entry point for small investors.

There are three classes of Chinese stocks: "A" shares in Chinese companies denominated in yuan listed on the Shanghai and Shenzhen exchanges and generally available only to Chinese residents; "B" shares in Chinese companies denominated in foreign currencies, generally available only to foreign investors; and "H" shares, which are for Chinese companies listed and traded on the Hong Kong Stock Exchange and available to foreign investors.

The ABCs of ADRs

"We're pretty bullish on Chinese GDP growth for the rest of the decade, on an average of 10% a year, but what that will mean to the Chinese stock market is difficult to know," Landesman said. "The run in the Chinese market has made it come from being the cheapest in Asia to the most expensive, so we're not as sanguine on China-listed securities as the Chinese economy."

ETFS And Mutual Funds

Individual investors with an appetite for risk, however, may find big winners among the recent flood of ADRs. Chinese stocks listed on U.S. exchanges were made up primarily of the region's "red chips," such as PetroChina , China Mobile and China Life.

Companies have been capitalizing on investor's interest in China plays and the number of initial public offerings of Chinese ADRs has exploded this year with about 10 new offerings and a dozen more on tap.

While educational services company New Oriental Education & Technology Group, solar energy firm JA Solar and home shopping company Acorn International have seen phenomenal gains, others have not fared as well.

Biotechnology company S3BIO is down 41% since its debut while Fuwei Films , a packaging firm, is seeing a similar decline.

But Landesman, also portfolio manager of ING's International Growth Opportunities Fund, says there are liquidity issues with some individual stocks, as well as the usual risks.

"You are going to be inherently taking more micro risk on the specific company. If you had a point of view on China Mobile, you'll get exposure to China and some China Mobile, but if telephone stocks underperform the rest of the market you would be at risk," he said.

"Some of the ADRs listed in the U.S. such as PetroChina and Baidu are companies that have had a relatively long trading history. I wouldn't go after a smaller-cap stock that I couldn't get info on."

ETFs or Mutual Funds?

Specialty mutual funds focusing on China saw a breakout year in 2006 and dominated the year's list of top 10 performing funds, according to Morningstar. The Dreyfus Premier Greater China Fund led the pack with a gain of 86%, closely followed by the Oberweis China Opportunities fund with a gain of 82%.

Market experts say the best way to benefit from China's rapidly rising market is through mutual funds.

"Having someone professionally manage on a day-to-day basis will limit your exposure if it does pop," said Robert Pavlik, chief investment officer at Oaktree Asset Management. "I don't see it happening but the potential is there."

Another approach recommended by money managers is to make a broad bet via exchange-traded funds such as FXI , which tracks the FTSE/Xinhua China 25 Index.

There are other advantages ETFs have over mutual funds aside from convenience, including certain restrictions subjected to mutual funds as well as higher fees required for an actively managed fund.

"ETFs are going to concentrate on owning as much of China as they can," said Pavlik. "With mutual funds, you're not always getting what you're expecting. Some funds have the ability to invest in other countries' securities so you think you're in a strictly China fund but it might have exposure to India and other parts of Asia."

Some ETFs take a different approach and try to address investor concern with overseas regulation.

The PowerShares Golden Dragonfund is an ETF which attempts to mimic the Halter USX China Index and focuses solely on Chinese ADRs traded in the United States. But that protection comes at a price: the Golden Dragon ETF rose 53% in 2006, lagging a 81% gain in the China 25 ETF during the same period.

An even broader bet U.S. investors can make is to invest in companies that do a large amount of business with China, such as Nortel Networks.

"If I'm going to do a country bet, unless I'm really up on the Chinese market it's a very difficult market to invest in," said Tom Roseen, senior research analyst at Lipper. "You're probably better off letting the big fund families do the work for you, they have people on the ground kicking the tires of the companies."

Peter Kang is a markets writer for CNBC.com. He can be reached at peter.kang@nbcuni.com.

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