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The Risks of Investing in China

Don't fall foul of fraudsters when investing in the Dragon Economy - like Fidelity manager Anthony Bolton did in his Special Sits fund - and beware currency risk

Hortense Bioy, CFA 31 July, 2013 | 2:45PM

China is an emerging market, and as such investing in Chinese stocks could involve a greater risk of loss than investing in developed markets due to, among other factors, greater political, tax, economic, foreign exchange, liquidity and regulatory risks.

Investors are advised to understand the fundamentals of the Chinese equity markets before investing.

When transacting in ETFs listed outside the Asia-Pacific region, say in Europe and the US, investors should exercise caution when analysing these funds’ “premiums/discounts” due to the difference in the trading hours between the ETFs and their underlying portfolio securities.

The listing location of an ETF has a number of important implications, including but not limited to trading hours, liquidity and tax treatment. Trading hours may be a more important consideration for retail investors, given that they will most likely execute trades on local exchanges.

In our view, for long term investors considering two otherwise identical ETFs trading on different exchanges, choosing between the two will hinge on the relative cost of transacting in their shares, while accounting for differences in trading rules and regulations.

Investors should also keep a close eye on bid-offer spreads, which will tend to be wider for those ETFs whose underlying securities are not being actively traded concurrently with the ETF shares.

Currency Dangers

A-Shares are denominated in Renminbi (RMB). And while offshore Chinese stocks are quoted in Hong Kong dollars or other currencies, given that the underlying businesses are in China, the prices of these firms’ shares are still fundamentally exposed to fluctuations in the RMB.

For investors with a positive view on the RMB, hedging their RMB exposure will be counterproductive.

The Chinese Equity ETFs currently available in the marketplace are mostly unhedged. Investors wishing to hedge their RMB exposure could consider utilising derivatives such as the USD/CNH futures available through the HKEx.

As a general note of caution, investors should understand how these instruments work before making any investment decisions.

This is an excerpt from Morningstar's Guide to Investing in Chinese Equities via ETFs, co-authored by Morningstar analysts Jackie Choy, Ben Johnson, Hortense Bioy, Patricia Oey and John Gabriel.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Hortense Bioy, CFA

Hortense Bioy, CFA  is director of passive fund research in Europe.