3 Ways to Invest in China's Powerhouse Economy
Katy Marquardt

It's poised to become the world's largest economy, but there are factors to consider before jumping in

With the latest forecast that China could take the reins as the world's largest economy as soon as 2030, experts are debating how its growth should be measured and if it will indeed outmuscle the United States. But regardless of when (and if) China will reach that milestone, the country's powerful and growing influence on the world economy cannot be ignored.

Should you reserve a spot in your portfolio for this emerging superpower? Investors would be wise to consider the country's big economic picture, which isn't as black and white as the numbers. That picture is full of contrasts. Factors fueling China's incredible growth include an influx of foreign capital, a boom in productivity, growth in foreign trade, the creation of a middle class, and economic reforms. But concerns remain over China's currency policy, heavy dependence on exports, its regulatory environment, and the deterioration of its actual environment -- to name a few.

"It's more complicated than saying 'I'm going to pick the biggest, most fast-growing country,'" says Bill Rocco, Morningstar's lead analyst on China funds. "There's going to be ups and downs -- political events along the way, trade issues ... and there's a debate about whether superior economic growth translates to superior stock market performance. There's certainly research that shows no correlation."

As is the case with other emerging markets, Chinese investments are notoriously volatile. Consider the performance of China-region mutual funds over the past few years. Virtually all stripes of mutual funds took a deep dive in 2008, but China funds particularly fell hard. During that year, the average fund focusing on this region lost more than half of its value, making China-region funds the second-worst performing category behind Latin America, according to Lipper. China funds made a big comeback in 2009, rocketing nearly 70 percent, but they're down about 1.5 percent so far this year (still less than the average world equity fund). Look at historical calender-year returns and you'll see similar swings in performance. Given the singular focus of these funds, investors should be "risk-seeking and risk-tolerant," says Lipper senior research analyst Tom Roseen.

Although China funds haven't offered a smooth ride, the category has rewarded investors with an average gain of 14.3 percent per year over the past five years through August 19. Over that time period, the average domestic stock fund lost an annualized 0.3 percent. "It's a big, growing, burgeoning country with just a slew of opportunities and obviously a very large population to work with if they can get rolling and free up things -- by that I mean the free-enterprise concept -- there are great opportunities for China going forward," says Roseen.

Another factor to consider before jumping into China:

You may already have it in your portfolio, Rocco points out. Vanguard Total International Stock Index, for example, holds a quarter of its assets in emerging markets, including a 5 percent stake in Chinese stocks. And T. Rowe Price's actively managed Emerging Markets Fund has nearly 20 percent of its assets in China, but investors also get exposure to countries including Brazil, South Korea, India, and Russia. Even domestic funds can provide China exposure, as many U.S.-based companies are big beneficiaries of the country's growth. Caterpillar is an indirect play on China, says Rocco, where the maker of construction and mining equipment is rapidly expanding its operations.

"To make a bet on a particular market is not a good idea for most investors," says Rocco. "Who it does make sense for is people who already have a well-balanced portfolio and understand that they may already have a significant amount in China. It's more akin to buying a stock than fund -- high-risk and high-reward for people with a long time horizon who understand what they're doing."

Here are three China funds for such investors:

1.Matthews China Fund.

The San-Francisco-based fund family invests exclusively in Asia, seeking companies with long-term growth prospects, strong business models, quality management teams, and reasonable valuations. The managers of the firm's China Fund -- U.S. News's top-ranked fund among those that invest in Pacific/Asia stocks with the exception of Japan -- look to capitalize on long-term growth trends with investments in companies like Digital China, a play on the country's demand for IT services. The duo invest heavily in the consumer sector, in stocks like China Mobile and Golden Eagle Retail Group, given the population's growth in income and spending. From the fund's inception in February 1998 through the end of June, it gained an annualized 13 percent, besting the MSCI China Index by an average of 10 percentage points per year. "Matthews does Asia very well and they do China well," says Rocco. Pluses include management's proven expertise, solid research (the team visits companies it invests in), and reasonable expenses, he adds. Annual fees for the fund are 1.21 percent.

2.Guinness Atkinson China and Hong Kong Fund.

The London-based Guinness Atkinson team follows the same basic strategy in all six of its mutual funds. Management sizes up companies by comparing their past and projected returns on investment (ROI), measuring valuation, analyzing earnings trends, and considering their relative performance over three, six, and 12 months. Edmund Harriss and James Weir employ this methodology to weed through the universe of companies traded on Hong Kong and Chinese exchanges. The fund's top three holdings were recently Weichai Power Co., Dongfang Electric Corp, and Yanzhou Coal Mining Co. The fund's 10 percent annualized return ranks it in the top 10 percent of its category over the past 15 years.

3.SPDR S&P China ETF.

Looking for China exposure on the cheap? This exchange-traded fund (symbol GXC), which holds about 130 stocks, charges 0.59 percent in annual fees (compared with 1.21 percent for Matthews China and 1.58 for Guinness Atkinson China & Hong Kong). The fund mirrors the market-capitalization weighted S&P China BMI Index, which measures the universe of publicly traded companies domiciled in China that are legally available to foreign investors. Holdings are spread throughout a handful of sectors, with a third of the fund's assets recently in financial stocks, followed by telecommunications (20 percent), and energy (16 percent). Market giants dominate the portfolio; Recently, its top three holdings were China Mobile, Industrial and Commercial Bank of China, and China Life Insurance.

Available at Amazon.com:

The Seven Deadly Sins of Investing: How to Conquer Your Worst Impulses and Save Your Financial Future