Investing Into the Abyss of Uncertainty and Political Risk

By Anthony Lawry

2017 is a dangerous year for political risk outside of China and unfortunately Chinese and major market indices are relatively correlated during times of downturn, thus exposing Chinese equity markets to this political risk. There is little doubt that unforeseen political events which have not been priced into the market tend to have a negative impact on markets. This is what happened after Brexit (the negative impact of which have not yet fully been realized since Article 50 has not been enacted) and it is also what immediately happened after the Trump victory, although markets have been rallying on what many stock analysts have called a sugar high waiting a market correction (a downturn of 15%).

As mentioned, risk is abounding in outside markets for 2017. Elections in France, the Netherlands, and Germany may lead to populist, anti-EU leaders in those countries. If France's Marine Le Pen is elected, many have suggested it will lead to the end of the European Union as we see it now. Also, the US congress' leading Republican Party is split on how to pursue healthcare legislation which must be addressed before tax cuts can be, a major speculation as to why the market is booming in the wake of Trump's victory. If Democrats are successful in pursuing the Russian links to Trump, the tax cuts plan could be derailed causing the bubble to pop. Besides, market downturns typically occur every eight years and it has been nine years since the last one. Overall, we are overdue for a correction and the risk pool is large.

So what is the investor interested in Chinese stocks to do? Many stock theorists suggest China is too risky in the global climate. Yet, there are ways to invest in China and insulate oneself from the risk embedded inherently within the market. Low beta (risk) is the name of the game and there are plenty of low beta stocks to choose from. However, individual stock picking typically is only a successful tactic in up-times. Low beta ETFs and mutual funds are the way to go. Although China carries with it an inherent degree of risk since it is considered an emerging market, there are still places you can make smart investments if you know where to go. Here are a few options you can choose from which give direct exposure to mainland China.

MSCI Emerging Markets Index (EEM) is a classic index to go to in order to have exposure in China which boasts of a portfolio with 25% exposure to China. This is the largest exposure to any other single market in the fund. The risk is relatively low with a beta of .89 (anything lower than 1 is considered low risk) and a distribution yield (the measurement of cash flow) of 2.15%. The Chinese funds that this popular emerging market stock invests in includes Tencent Holdings, Alibaba Group Holdings, China Mobile, China Construction Bank, Baidu and the Industrial and Commercial Bank of China. The fund as a whole is mostly invested in financials, information technology and consumer discretionary totaling about 60% of the entire fund. Overall, this fund was hit relatively hard during the 2008 financial crisis but not nearly as bad as other emerging market funds. It has been up and down, relatively flat since the crash, but was up nearly 10% in the last year alone.

Another fund to take into consideration includes Deutsche's X-trackers Harvest CSI 300 China A-Shares ETF (ASHR). This fund has a 5-year beta of .97 and a 5 star Morningstar rating (out of 5 stars) for its 3-year performance. Its portfolio is 100% exposed to China with all large-cap stocks, but a diversified sector weighing includes financials, industrials, tech companies and many others. The portfolio also includes a blend of growth and value stocks mixing some risky investments with a higher blend of average and low-risk stocks. No single stock accounts for more than 2.4% of the total fund, the highest portfolio weight of which belongs to the Industrial Bank of China, followed by China Minsheng Banking (2.3% holdings), Ping An Insurance (2.1% holdings), China Merchants Bank (2% holdings), and Kweichow Moutai Co (1.8% holdings).

While it is hard to predict when the next stock crash will occur, there is no doubt there will eventually be another one. China is unfortunately no exception. Yet, with the number of careful investments, thoroughly researched ETF, and the stomach to ride the ups and downs of the market, a sound portfolio can be found in times of trouble with low-risk funds that are mildly and even heavily exposed to China. Yet, nothing is for sure and the aforementioned funds could still find considerable losses in a downturn. Nonetheless, these lower risk funds are better bets to take in the sea of uncertainty and volatility which could creep up on investors without warning despite their record low levels.

--- END ---