Go East, Young Man

The Best China Investment Strategy

Forget about it.

Illustration by Robert Neubecker. Click image to expand.

You can’t take it anymore. All this yammering about how much money everyone is making in China. (You don’t know anyone actually making money in China, but from what you read, hear, and see, you gather everyone is.) Real estate, cell phones, video games, chewing gum, cement—1.3 billion people, it seems, are in the process of striking it rich. And China is not some silly hallucination like the Internet. China is … China—the next great economic superpower, the biggest growth story in the history of the world. You can’t afford to miss it.

Note that this is probably similar to the way you felt about the Internet in the 1990s (or the way you feel about real estate now). Then review your options. Assuming you’re not up to the most labor-intensive and least risky way to cash in on the boom—moving to China, learning the language(s), buying or starting a company, and settling in for a decade or two—you’ve probably been daydreaming about the fortune to be made in China stocks.

Well, keep dreaming. Because, on the off chance that you happen to buy a China stock that appreciates 10 or a hundred-fold, you’ll probably sell too early and miss the gains, or hang on too long and end up where you started. Or, you will also buy a dozen China dogs that go to zero and, between these losses, trading commissions, taxes, lost wages, and stress-induced therapy bills, you’ll eventually conclude that you could have done better selling insurance in Toledo. Should this happen, don’t beat yourself up too much: Most casual investors who mistake the stock market for a ticket to riches have a similar experience.

But you’re not going to take my word for it, are you? You still want to know how you, Joe Laowai, can put some money to work in the latest-greatest-surefire investment scheme the world has ever seen. You’ll probably be sorry, but it can be done—with difficulty.

Most Chinese stocks aren’t available—at least not to you. China’s domestic stock markets in Shanghai and Shenzhen feature two classes of stock: “A-Shares,” which are denominated in yuan and, until recently, could be owned only by Chinese citizens, and “B-Shares,” which are denominated in dollars and can be owned by foreigners. With an account at a global brokerage firm like Merrill Lynch, you might be able to buy some “B-shares,” but, in the tradition of Groucho Marx and all clubs willing to have him as a member, you probably wouldn’t want to own any (the “B-Share” market is rumored to include the sorriest lot of public companies on the far side of the Pacific). So how do you buy “A-Shares”?

Well, if you happen to be a bank, fund, or brokerage firm with $10 billion in assets, a multiyear track record, and the willingness to commit at least $50 million, you may be able to qualify as a Qualified Foreign Institutional Investor, which will allow you to buy up to 10 percent of the outstanding stock in any listed company (provided you and other QFIIs don’t own a total of more than 20 percent—China is not about to let foreigners abscond with its crown jewels). If you’re short of $10 billion, then you may be able to strike a deal with an established QFII like UBS, in which the QFII buys the stocks you want, then sells you a “swap” that passes some of the profits and losses through to you (“some” because the QFII won’t do this out of the goodness of its heart). Of course, to make this worth the QFII’s while, you’ll still need to commit a few million.

So, forget about A-shares. Instead, turn your attention to the Hong Kong and New York stock markets. Chinese companies can sell stock in Hong Kong (known as, respectively, “H-Shares” and “Red chips,” depending on whether the companies are incorporated in China or just have assets there). Most of these companies are controlled by the Chinese government, but they tend to be, as one hedge-fund manager put it, “real companies” (as opposed to some of the horrors listed in Shanghai and Shenzhen).

If you don’t want to deal with the hassle of global brokerage trades (with every middleman taking a cut), cross-border ownership, foreign taxes, and currency conversion, issues that go with investing in Hong Kong, you can buy the American Depository Receipts or “ADRs” of Chinese companies that have listed in New York. If you go this route, though, you should be aware that what you are often buying is not the actual stock of a Chinese company, but the stock of, say, a Cayman Islands company that has a contractual relationship with a Chinese company, one that you and every other poor sod who buys the stock must pray will last longer than many contractual relationships in China (Tim Clissold and others report that, in China, contracts are often viewed as a snapshot of an ever-evolving arrangement). You should also be aware that the same Chinese companies occasionally list stock on all three markets, Shanghai, Hong Kong, and New York; that the three stocks often trade at different prices; and that arbitrageurs a thousand times more nimble than you forever exploit the difference.

If this sounds as nerve-racking as it is, your other option is to leave China stock-picking to professional investors who live in China, visit the companies, and speak Chinese (in other words, people who possess the basic advantages that, in any industry but this one, one might assume were essential to the task), and buy a mutual fund instead. This is wise. But here, too, beware. Even dime-a-dozen, U.S.-focused mutual funds often charge egregious fees, so you can imagine what most foreign funds charge. It may be true, as some argue, that China’s markets are so inefficient that fund managers can justify fat fees by delivering above-market performance (the opposite of the case in the United States, where they seldom do), but we don’t have enough history to know for sure. In any case, you’re probably best off seeking low-cost active funds, passive index funds, or exchange-traded funds (single securities designed to track an index).

The paradox of China investing right now is that even though the economy is screaming along, China’s domestic markets are sucking wind—and have been for years. To experienced investors, this is not so surprising—economic performance and stock performance often diverge—but it has left most of China’s tens of millions of retail investors feeling surly and begging for government handouts to cover their losses. Normally, this is an excellent time to buy (when everyone else thinks you’re crazy), but in the case of China’s domestic markets, the half-decade decline has only rendered stocks “expensive” instead of “outrageous.” Sadly, they’re still miles from “cheap.”

In Hong Kong and New York, China stocks may actually be cheap (it’s hard to know for sure given the uncertainties surrounding the economy, legal system, accounting system, currency, Taiwan situation, etc.) This said, a China-stock synopsis would not be complete without the caveat that there is absolutely no reason for you to buy them. Buying any stock, even an American one, is far more dangerous than the mainstream media would have you believe (low-cost, diversified funds offer a better risk/reward profile). Buying a single emerging market stock, meanwhile, is akin to playing Russian roulette. Unless you have a massive portfolio—or an unusually high appetite for risk—you can get all the China exposure you’ll ever need by owning U.S. companies that do business there, or, if you’re aggressive, small helpings of Asian or emerging-market funds.

If you simply can’t stand not having some direct China exposure, then toss a few dollars at a low-cost, diversified country fund. But make sure it’s only a few dollars. And recognize that, in addition to the possibility of posting impressive gains, you may 1) lose most of your money; and/or 2) sit tight for 20 to 30 years before you break even. Remember Japan, the last great Asian investment opportunity? Its chief stock index, the Nikkei, currently trades at approximately one-quarter of its 1989 peak.