Despite its growth, China remains a small portion of the MSCI EM Index and the MSCI All Country World Index. Index investors, therefore, only get 2% of China.
“You ought to have at least 9% of your portfolio in China because China’s GDP is officially 9% of the world’s GDP and will undoubtedly be larger than that of the U.S. by the end of this decade.”
Further, as the fastest growing economy in the world, China was responsible for 30% to 40% of world growth in 2010-2011. Add some currency appreciation to the mix and the case for China become even stronger.
Malkiel then offers three investment strategies to benefit from China’s growth story.
Pure indexing
For at least the core of the portfolio, Malkiel says indexing makes sense as it outperforms 80% to 90% of actively managed China funds. “When you go active, you’re much more likely to get an underperforming manager than an outperforming manager.”
The FTSE/Xinhua (FXI), the MSCI and all other indices are badly flawed, he added. “For one thing, the MSCI and the FXI don’t include NY listings so a company like Baidu, which is the Chinese Google, is not even included in those indices,” he said. “Also the indices tend to be much less diversified.”
Ninety five percent of the FXI, for instance, is concentrated in three industries: banking; oil; and telecom. It has zero exposure to the consumer goods and technology, sectors in China that Malkiel says are going to grow the fastest.
Hedged strategy
A strategy that takes advantage of the greater volatility of Chinese stocks. “China is extremely volatile; the ups and downs are fierce. We calculate the implicit volatility of the Chinese market in the same way we calculate the CBOE Volatility Index, or VIX [in the US].”
In the case of China, it is calculated for the FXI and the Hang Seng Index and is called the CHIX, which is the implied volatility of Chinese stocks.
“We find that Chinese stocks have been twice as volatile as the U.S. stocks. What that means is that option premiums on the Chinese indices are very large and [by applying] the hedge strategy we take advantage of that volatility by writing options.”
A simple strategy of buying the index and writing a call option against it should produce “index like returns or a bit better with about two-thirds the volatility,” he says.
“By selling the options you provide the insurance for the investors and that’s why the strategy has been enormously successful.”
Mixed strategy
This involves direct investment in ‘H’ and ‘N’ shares and indirect investment in multinational companies that benefit from growth in China.
Mixed strategy takes advantage of growth in China without owning Chinese stocks. “[It involves] some direct ownership of Chinese stocks and some indirect investment in companies that benefit from China, and can be done entirely indirectly,” said Malkiel. “The idea is to buy multinational companies with better transparency, better accounting and less corruption.”
A portfolio made up of these companies that benefit from China’s demand for materials, industrial goods, consumer goods and luxury goods includes such international names as Coca-Cola, Pepsi, McDonald’s, Louis Vuitton, KFC, FedEx and Nike.