Why Jumping on the China, India, Russia Investing Bandwagon Might Not Work

Countries experiencing rapid economic growth like China, India and Russia should be a good place to get higher stock market returns than stolid slower-growing places like Europe, right? Oops, not so fast.

Apparently, it ain't so. There is no relationship between a country's high GDP growth and stock market returns, especially not in the long run and only weakly in the short run. In Economic Growth and Equity Returns from SSRN, professor Jay Ritter calculated that there was in fact a negative relationship between economic growth and stock returns in 16 major countries (including Canada and the USA) over the period 1900 to 2002 - this chart is taken from the paper.

Other people have found the same thing, focusing on the USA - Crestmont Research's It's Not the Economy has a decade by decade chart showing the unpredictable differences in the same or opposite directions. CXO Advisory in Update: GDP Growth and Stock Market Returns tried calculating leads and lags to see GDP predicted the US market or vice versa and found that didn't really explain much either. In Canada, CIBC's Economic Insights of August 25th has this scatter plot which again demonstrates the same point.

Ritter's explanation is that consumers and company managers get the benefit of GDP growth, not stockholders.

He also makes the dramatic statement that past stock returns are of no use in predicting future returns!

The main metric that does predict future returns according to Ritter is the smoothed earnings yield (taking a 10 year average of earnings to eliminate business cycle effects) i.e. Earnings / Price. "A low smoothed earnings yield does, however, predict low real stock price growth over the following ten years. In other words, P/E ratios revert towards the mean through price changes rather than earnings changes." The only caveats that could derail that relationship would be: if managers and employees take the profits due to shareholders (are shareholder rights well protected?) and; if some catastrophe like war, revolution, hyperinflation destroys the value of financial assets. Based on the numbers in 2004, Ritter said that real annual compounded stock returns would average 4.5% instead of the historical 7%. Crestmont's little blurb attached to their chart also says it's the P/E that matters.

Wish I had the data to do the calculation for today's markets. The Price part of the equation is down quite a bit, such that the E/P will be lower but is it enough to produce good future equity returns?

In any case, these studies suggest strongly that the assumption that China's rising economic success means assured investing success is wrong and likely to disappoint.

China ETFs and Mutual Funds - Any Difference?

The Contenders: the two largest by assets of each type

ETFs

• iShares FTSE/Xinhua China 25 Index Fund - NYSE: FXI
• SPDR S&P China - NYSE: GXC
• other China-only ETFs listed at Stock Encyclopedia's China ETF list
  

Mutual Funds

• AGF China Focus Class
• HSBC Chinese Equity Fund
• a bunch of others in GlobeFund's Greater China selection
  

1st answer: No, there is no difference
Though the ETFs are explicitly passive index followers and the mutual funds are presumably active managers trying to pick winners, their holdings all look remarkably the same. Take a look at the top ten holdings table below, where I highlighted with different colours the common companies in each fund. It is a very colourful chart!! There is only ONE company at most in each fund that is not found in at least one other. Six companies are in all four funds. Even the place of individual companies in each top ten looks quite similar. The funds are all heavily concentrated in their top ten, with the total assets devoted to the top ten ranging from 50 to 60%. Finally, even the mutual funds are more or less fully invested, with the maximum cash holding being HSBC's 4.5% - if active fund managers were to be able to time a market peak and pull back, would it not have been a good time a few weeks ago (the time of this data) when valuations seemed to be ambitiously high? Today's Globe article Shanghai exchange: Tea leaves might be helpful talks about a possible growing chinese bubble, which is after recent days' big declines.

The net result is that FXI and GXC track each other's market performance very closely (easily verified by a Yahoo stock chart). I bet HSBC's and AGF's would too, except for ...

2nd answer, Yes, there is a difference
Perhaps this is no surprise for observers of ETFs against mutual funds, but the ETF MERs are vastly lower:

• FXI - 0.74%
• GXC - 0.59%
• HSBC - 2.56%
• AGF - 2.94%

With the holdings being pretty well the same, the extra MERs will surely drag down the net performance for the mutual fund investor by about that 2% difference. Maybe a series of small trades could eat away that ETF advantage through trading costs but someone planning to buy infrequently and then hold with medium size amounts (e.g. $10 trade commission on an ETF on $1000 purchase is a 1% cost) would be much worse off in the mutual funds.

On the other hand, I have read that professional fund managers with resources to do proper research in less developed and therefore less efficient markets, such as China surely still is, can outperform and produce returns superior to an index (see this 2007 YouTube video of Random Walk Down Wall Street author Burton Malkiel - the market efficiency discussion starts at around 33 minutes).

Maybe the China mutual fund managers need to re-think their value proposition and either adopt outright passive indexing and drop their fees considerably, or start doing their job of company analysis and start earning their fees?

It Ain't Just Sports China is Good At

As we watch the Chinese pile up the medals in the Olympics, possibly displacing the USA as the top dog in the sports world, we might also note China's rise in capital markets.

This past January, the McKinsey Global Institute published its 4th annual report on Global Capital Markets and the results are amazing. (The report shows 2006 figures, so things are no doubt different today but it's the best available data.)

Maybe China isn't so democratic but it sure is becoming a capitalist country. In 2006 it ranked second, on a par with all of the Eurozone, in equity issuance and was not too far behind the USA - see this chart.

There has been a massive shift from bank deposits to equity investments in China. In 2004, equity made up only 15% of total capital in China while bank deposits were 72%. A mere two years later, equity had gone up to 30% of the total - see this chart.

And its total financial assets had climbed from a tenth that of the USA to a seventh. That's a huge shift in such a short time.

Last but not least, with their new found wealth, the Chinese are going global shopping, investing their capital in other countries and becoming the world's largest net exporter of capital in 2006. Who knows, they might get a liking for sports teams and buy the Oilers soon, though it's more likely they'll buy the oil sands. Oops, they tried that, didn't like Canada's response and have already pulled out, heading instead for Venezuela.

My investment take-aways:
1) It seems that the action and the growth for investors is coming mainly from places beyond our traditional comfort zone of North America and Europe.

2) However, the report is also interesting as confirmation of the degree of the increasing integration of world capital markets. I believe that means we can expect continuing high correlation of stock market returns across international, making international diversification less viable for an investor.

Maybe It Isn't a China Bubble, but It Looks Like One

The Chinese stock market has accelerated to the heights over the last several years as this chart of the iShares Xinhua China25(FXI) from Yahoo shows.

Inevitably the talk has started that a new stock bubble is underway. A couple of examples articles: Tom Lydon at Seeking Alpha, Business Week's China's Bourses: Fasten Your Seatbelts. Reports that major companies which are components of the FXI Index are sporting P/E's over 40, not sustainable in the long run, add to the out-of-wack feeling. China's economic growth has been especially strong but challenges lie ahead on the pollution and resource fronts. Finally, and especially worrying are the comments that ordinary people on the street in China are talking about stocks and pouring their money into the market. It is all too reminiscent of the Internet bubble days when it seemed friends and neighbours all wanted to talk about Nortel and Cisco.

As a result, despite the admonitions of the "pros" and my own general philosophy to buy and hold for periods of years, I have sold an amount equal to my original investment in FXI, which still leaves a healthy chunk due to the meteoric rise of the past year. I may be wrong and FXI will continue to go gangbusters but caution becomes more important with age!

Update March 4 - Should have sold all of it in the first place; suffered a $6/share reduction in profits before I finally got out completely of FXI. Stories like this one at CTV just reinforce that I have done the right thing. Learning slowly still but at less cost thankfully.