Investing in China? Go by Way of Hong Kong

A recent decision by the U.S. Securities and Exchange Commission will help open up China’s stock markets to American mutual funds.

But many portfolio managers who like the investment appeal of the world’s most populous nation say they will continue to use the back door through Hong Kong.

The SEC in late April said it won’t take action against open- or closed-end portfolios wanting to buy Chinese shares directly. Most fund managers had shied away from direct investment because of uncertainty over whether China’s two stock markets offered custodian arrangements acceptable to the SEC.

“It’s not that the SEC said you couldn’t invest in China, but it hadn’t said you could either,” says James B. Hawkes, president of the Eaton Vance Greater China Growth Fund, a Boston-based portfolio that has been investing directly since late last year.

“We were quite comfortable that our custodians fully met the requirements,” he says. “Now we’re 100% sure.”

Despite the green light for China, Hong Kong will remain the investment avenue of choice in the foreseeable future for China-oriented funds. Most large Hong Kong companies already have some type of economic connection with China, making them a good substitute for direct ownership.

Besides, the colony’s stock market is better regulated, much bigger and more cheaply priced at the moment, offering a safer investment path.

“Everybody’s interested in China because the prospects are great,” says Mark Mobius, managing director of the Hong Kong-based investment arm of the Templeton fund group, headquartered in St. Petersburg, Fla.

“But we think the best way to get in will continue to be through Hong Kong, where the valuations are better and the (accounting) numbers can be trusted,” Mobius says.

Besides, Chinese laws permitting foreign ownership of property aren’t yet sufficiently developed to satisfy some fund companies. “I expect major changes (conducive to foreign ownership) within the next 18 months, but we will continue to use Hong Kong as a proxy for China for probably three to five years,” says Tim Tuttle, managing director of Newport Pacific Management of San Francisco.

The company’s Newport Tiger Fund has 50% of its assets in Hong Kong stocks but no direct mainland investments.

Even the Eaton Vance portfolio has only a 6% direct China stake, compared to 40% in Hong Kong and the balance in other Asian nations.

Another factor favoring Hong Kong is that the colony’s currency is pegged to the U.S. dollar, which minimizes exchange rate fluctuations.

But perhaps the most important edge for Hong Kong is that China’s two stock markets are too small to handle the crush of foreign investors wanting to get in, Mobius says.

Chinese companies issue both A and B classes of shares--reserved for citizens and foreigners, respectively. Mobius estimates that the total value of all B shares is now only $1.1 billion--smaller even than some individual international funds.

“The bottom line is that there’s too much money chasing too few shares at this time,” says Mobius, who has lived in Hong Kong for 25 years.

The supply of Chinese B shares is likely to increase over time as the communist giant further embraces capitalism, but Hong Kong already offers ample liquidity with a market capitalization of $250 billion, Tuttle says.

In fact, some Chinese companies have listed their shares on foreign exchanges, especially Hong Kong’s, in a bid to appeal to foreign investors.

Hong Kong stocks now trade at only about 10 times earnings despite profit growth of 22% a year on average, Tuttle says. The market’s low price-earnings valuations are largely explained by fears over the future of the colony, which transfers from British to Chinese rule in 1997.

At the same time, the sparkling profits of Hong Kong companies reflect a surging economy in China, where real growth is running about 12% a year--a level that Tuttle considers sustainable for the next five years.

A high domestic savings rate in China bodes well for fledgling Chinese companies that will be needing investment capital. It also means the local population will have cash to spend on quality consumer goods as they become more readily available.

Anyone wanting to invest in China through Hong Kong can choose from several open- and closed-end funds. The latter are professionally managed portfolios that issue a fixed number of shares and thus trade like stocks on exchanges.

Some investors believe the closed-end funds are a better way to play volatile, emerging markets because they do not have to keep a stockpile of cash on hand to meet shareholder redemptions, as their open-end cousins do.

“In an emerging-markets fund, a headline could cause a big swing in price,” says Jon Chatfield, editor of Frank Cappiello’s Closed-End Fund Digest in Santa Barbara.

However, closed-end funds must be purchased through a broker. And they add an extra dimension of risk--and opportunity--in that their prices often rise to premiums or fall to discounts relative to the “net asset value,” or per-share worth, of the underlying securities held.

Recently, the three China-oriented closed-end funds, all of which trade on the New York Stock Exchange, were selling close to NAV.

Chatfield recommends that investors look into the dividend-reinvestment plans that most closed-end funds offer. Such programs allow for dollar-cost averaging, or the gradual accumulation of shares over time.

Open-end funds also routinely offer dollar-cost averaging--a sensible approach in general and especially when dealing with promising yet erratic foreign markets.

China Plays The following open- and closed-end funds have some of the largest holdings of stocks from Hong Kong and China. Most were launched within the past year.

Hong Kong/ China Sales Name Type weighting* load Phone China Fund Closed-end 43% N/A 800-421-4777 Eaton Vance Greater China Growth Open-end 46% 4.75% 800-225-6265 Greater China Closed-end 72% N/A 212-713-2000 Jardine Fleming China Region Closed-end 60% N/A 800-638-8540 Newport Tiger Open-end 50% 5% 800-776-5455 T. Rowe Price New Asia Open-end 30% None 800-638-5660

* Approximate current percentage of fund assets invested in Hong Kong and Chinese companies.