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Leave the Banks, Take This China ETF

July 19, 2013 1:01 pm
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Leave the Banks, Take This China ETF

One of the most memorable lines from "The Godfather" is "Leave the gun. Take the cannoli." In the midst of what has been a dour year for ETFs tracking China, good advice would be "Leave the banks. Take the tech."

The June spike in China's interbank lending rate, the SHIBOR rate, reminded investors that ETFs, China funds or otherwise, that are heavily exposed to one sector are vulnerable when problems arise for that sector.

Year-to-date, the iShares FTSE China 25 ETF (NYSE: FXI), the iShares MSCI China ETF (NYSE: MCHI) and the SPDR S&P China ETF (NYSE: GXC) are down an average of about 12.8 percent. The average weight to the financials service sector within those ETFs is over 41 percent.

However, investors that have passed on banks in favor of heavy allocations to Chinese technology stocks have been rewarded in significant fashion. In mid-May, we highlighted the Guggenheim China Technology ETF (NYSE: CQQQ) as a pure play on Chinese tech and Internet stocks. The ETF is up nearly 3.7 percent since then while FXI is sitting on a double-digit loss.

RELATED: Last Ditch Effort to be Long China With These ETFs

Investors CQQQ is one of just three, by our count, non-leveraged China ETFs to gain at least 15 percent this year. One of the other two is the PowerShares Golden Dragon China Portfolio (NYSE: PGJ). At almost nine years old, PGJ is an elder statesman of the China ETF club, but with $197.6 million in assets under management, it would need to be multiplied by 50 to catch FXI in terms of investors' affection.

FXI is the most heavily traded China ETF and that, in part, explains its popularity. However, that proves what a terrible metric volume is in terms of evaluating an ETF's potential for delivering impressive returns. It has been noted that FXI has a legacy of underperforming other China ETFs. Some, such as MCHI, even come from the iShares family.

This year, PGJ is taking its turn thumping FXI and the reasons are clear: A 53.2 percent weight to tech and a 2.5 percent weight to financials. So PGJ is not the all-in bet on China tech and Internet stocks that CQQQ is, but consumer discretionary at 16.5 percent is the only other sector to receive a double-digit allocation in the ETF.

Seven of the ETF's top-10 holdings are tech/Internet names, including Baidu (NASDAQ: BIDU), Ctrip (NASDAQ: CTRP), Sina (NASDAQ: SINA) and Sohu.com (NASDAQ: SOHU). Increased mergers and acquisitions activity, both real deals and rumors have been a recent catalyst for Chinese Internet names.

Here is another fun fact about PGJ: It is one of the few ETFs with any noticeable exposure to Ctrip, the Priceline (NASDAQ: PCLN) of China. Priceline is up 31.6 percent in the past 90 days. Usually, 31.6 percent in 90 days is great, but it is quite mediocre compared to the 69.3 percent returned by Ctrip.

So what is the rub with PGJ? At a time when everyone and his sister is saying Chinese stocks are cheap, PGJ is not. FXI's P/E ratio is 12.7, a significant discount to the broader emerging markets universe. PGJ's P/E is nearly 26.5.

Then again, the returns show expensive has been better than cheap when it comes to China ETFs this year. The average return on equity, a critical measure of company's profitability, for PGJ's 65 holdings is 13.8 percent, according to PowerShares data. That compares nicely with the 14.8 percent ROE found on the U.S.-focused PowerShares Dynamic Technology Sector Portfolio (NYSE: PTF).

For more on ETFs, click here.

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