Should You Be Wary Of Chinese Small-Cap Funds?

By Aaron Levitt | October 09, 2012 AAA

For many investors, emerging market nations are playing an ever-increasing role in portfolios. With analysts predicting slow growth in the developed world for the near future, these stronger, faster-moving economies are seen as a key way to realize portfolio growth. With that said, China is certainly the 800-pound gorilla (or in this case, dragon) in the room and represents the go-to investment for many portfolios. China's rising population, expanding middle class and impressive economic growth are hallmarks of the emerging-market thesis.

Investments in China have surged over the last decade. There are now 15 China-focused exchange traded funds (ETFs) on the market and the biggest - the iShares FTSE China 25 Index Fund (ARCA:FXI) - has $4.7 billion in assets. This doesn't even take into account the various mutual funds, closed-end funds and other investment vehicles honed in on the nation.

Given the surging interest in the nation, many investors have begun to diversify away from the larger state-owned enterprises and into small-cap Chinese firms. Nonetheless, after a series of frauds and delisting announcements, it's understandable why some investors are wary of Chinese small caps. However, for those willing to take the plunge, broad-based funds that focus on the nation's smaller firms could be one of the best long-term portfolio plays around.

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Instances of Fraud
Ask any investor in A-Power or Duoyuan Global Water what they think about Chinese small caps and you're likely to get a very negative response. Both firms were found guilty of fraud and subsequently delisted from American exchanges. That fraud seems to be an issue facing many different Chinese firms. According to British magazine Money Week, 23 Chinese stocks have delisted from the market, mostly due to allocations of various financial frauds after reverse-merging onto U.S. exchanges.

Perhaps the biggest of these was Chinese timber and Canadian-based Sino Forest. Its share price, once in the mid-twenties, plummeted, as analysts exposed some of its more-than-questionable practices. Even hedge fund manager John Paulson lost almost $700 million on the investment.

Whether because of questionable accounting standards or flat-out lying, these indications of fraud have put a bad taste in many investors' mouths. This is reason enough to view Chinese stocks on the U.S. equities markets with some doubt. However, just like for every Enron or WorldCom here in the United States, there are plenty of quality firms as well; China is no different and that fact is evident in the small cap space.

SEE: Financial Fraud: Don't Let it Happen to You

The Opportunity in Broad Funds
For investors looking to capture a slice of the true Chinese growth story, small caps are more representative of the nation's domestic economy and could offer great consumer bets on China's growing middle class. However, as we've seen with the various fraud allegations, investing in Asia's Dragon is, at best, like walking through a minefield blindfolded. Add the already volatile nature of small caps to the mix and you have a much-higher risk profile than some portfolios may want.

This is where the fund structure shines. Investors can choose to tilt their portfolios toward individual small caps, such as Kongzhong (Nasdaq:KONG), but this lacks the diversification benefit of several companies and sectors in the Chinese economy. Even if 25% of Chinese small caps end up being considered fraudulent, the risk-to-rewards ratio for an investor who bought a basket of Chinese small caps would still be very profitable given the nation's growth projections and economic standing.

Both the granddaddy of small-cap Chinese ETFs, Guggenheim China Small Cap (ARCA:HAO) and the iShares MSCI China Small Cap Index (ARCA:ECNS), make ideal broad choices to play the sector. Each offers low expenses and a broad range of holdings that help protect against the potential fraud blow-ups that could occur within China's small cap space. For investors looking to add more Chinese exposure, the two ETFs could be seen as one of the only real safe ways to get small.

SEE: What Is An Emerging Market Economy?

The Bottom Line
So should investors be wary of Chinese small cap funds? The simple answer is no. Over the long term, small caps in the nation should provide plenty of upside, as they represent the real domestic Chinese economy. As for fraud protection, the broad funds diversification benefits are the only real way to play the sector.

At the time of writing, Aaron Levitt did not own any shares in the companies mentioned in this article.

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