CNBC Explains

Contrarian investors still invest in China funds

Tim Mullaney, special to
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Countdown to China's open
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China contagion threat
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Cashin's worry about China selling

A funny thing is happening on the way to the Great Selloff of China—some fund investors are beginning to buy China again.

Data from Boston research firm EPFR Global shows investors having put a net of $4.3 billion into China-focused mutual funds and exchange-traded funds, even as mutual fund managers put $4.7 billion of net assets to work in Chinese companies in the week ending July 1. Along with a $635 million increase in positions the prior week, that partially reversed net outflows of $8.4 million for ETFs, and $9.2 billion for mutual fund investments in the two weeks prior.

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Chinese markets have been dropping sharply for the last month, with the Shanghai composite index down by a third over the last three weeks and dropping 5.9% today. In the States, analysts argue that Chinese stocks are still expensive, and point out that the surge preceding the recent bust was so large that more than 80 percent of long-focused ETFs focusing on China are still in the black for the year.

"I think some institutional investors believe that we are now at a good entry point, given the size of the correction and the fact the government are clearly going to do what they can to put a floor under it," EPFR research director Cameron Brandt said. "Flows from retail investors are slightly negative, and have been for months. But institutions that pulled money out began to move back in last week—a step that may or may not survive the latest selloff."

The Chinese government has rolled out an array of weapons to prop up shares in recent days. Securities regulators have warned that the selloff is irrational, the nation's central bank has made clear that it will provide liquidity to prop up markets and prevent systemic risks, and government agencies have taken a number of steps to prop up shares of battered small-capitalization stocks, in particular. At the same time, insurance regulators have loosened rules to allow insurers to buy more blue-chip shares.

But the rout continues, with as many as half of publicly held Chinese companies' shares not trading actively. The Shanghai index is down 5.9 percent Wednesday, while the Hang Seng Index in Hong Kong is down 5.8 percent today and 14 percent in the last month.

Of the top 41 China-focused ETFs, only seven funds that bet on company shares to rise are in the red for the year, according to ETF Database, based in Chicago. One China small cap ETF, the db X trackers Harvest CSI 500 China-A Shares Small CAp Fund, is still up 14 percent for the year. The CSI China Internet ETF is still up 7.7 percent since Jan. 1, while funds that short Chinese shares are down as much as 24 percent for the year notwithstanding a recent surge.

"Even after the recent sharp correction of Chinese equities, the Shanghai Composite is still up 16 percent year-to-date, and its median [enterprise value]/[earnings before interest, taxes, depreciation and amortization] is still at a whopping 27 times, double the average of the rest of the world," Bank of America Merrill Lynch analysts led by foreign-exchange strategist David Woo wrote July 6.

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Merrill's year-end target for the Shanghai composite index is 3,600, slightly above today's level of 3,507.19, Woo wrote.

Contagion from China selloff spreading
Contagion from China selloff spreading

For small investors thinking about looking for the bottom of China's market, Morningstar has direct advice: Don't.

"Small investors should do nothing; and I don't want to be glib," Morningstar senior fund analyst Bill Rocco said. "We're not big believers in small investors slicing and dicing their asset exposure.''

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Instead, investors thinking about China should focus on more general international funds and emerging markets funds, which are likely to include a lot of Chinese equities, Rocco said. But these funds are also free to pass on mediocre Chinese companies in favor of businesses elsewhere in the region that have better prospects or are less overvalued, he said.

Morningstar's top emerging-markets fund picks include American Funds New World (NEWFX), Harding Loevner Emerging Markets (HLEMX-O) and Vanguard's Emerging Markets (VEIEX). Warier investors may pick the IShares MSCI Emerging Markets Minimum Volatility fund (EEMV), which blends the lowest fees in the group with low volatility.

Morningstar cautions, however, that low volatility doesn't mean low risk, since the fund remains heavily exposed to China. The fund is down less than 1 percent for the year through yesterday, with only one of its top 10 holdings being in a mainland China-based company.

The Chinese government interferes so much in mainland markets like Shanghai and Shenzhen that they are not fully rational, Morningstar senior analyst Patricia Oey said. She speculated that some of the recent inflows may actually be bound for markets like Hong Kong that are less-volatile ways to bet on China's long-term growth.

"Think about how much China exposure you already have,'' Rocco said. "Most people are better off getting their China exposure—and they'll get plenty—through an emerging markets fund.''

—By Tim Mullaney, special to