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."

CONTINUED : ETFS And Mutual Funds

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