With the latest forecast that China could take the reins as the world's largest economy as soon as 2030, experts are debating how its growth should be measured and if it will indeed outmuscle the United States. But regardless of when (and if) China will reach that milestone, the country's powerful and growing influence on the world economy cannot be ignored.
Should you reserve a spot in your portfolio for this emerging superpower? Investors would be wise to consider the country's big economic picture, which isn't as black and white as the numbers. That picture is full of contrasts. Factors fueling China's incredible growth include an influx of foreign capital, a boom in productivity, growth in foreign trade, the creation of a middle class, and economic reforms. But concerns remain over China's currency policy, heavy dependence on exports, its regulatory environment, and the deterioration of its actual environment—to name a few.
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"It's more complicated than saying 'I'm going to pick the biggest, most fast-growing country,'" says Bill Rocco, Morningstar's lead analyst on China funds. "There's going to be ups and downs—political events along the way, trade issues ... and there's a debate about whether superior economic growth translates to superior stock market performance. There's certainly research that shows no correlation."
As is the case with other emerging markets, Chinese investments are notoriously volatile. Consider the performance of China-region mutual funds over the past few years. Virtually all stripes of mutual funds took a deep dive in 2008, but China funds particularly fell hard. During that year, the average fund focusing on this region lost more than half of its value, making China-region funds the second-worst performing category behind Latin America, according to Lipper. China funds made a big comeback in 2009, rocketing nearly 70 percent, but they're down about 1.5 percent so far this year (still less than the average world equity fund). Look at historical calender-year returns and you'll see similar swings in performance. Given the singular focus of these funds, investors should be "risk-seeking and risk-tolerant," says Lipper senior research analyst Tom Roseen.
Although China funds haven't offered a smooth ride, the category has rewarded investors with an average gain of 14.3 percent per year over the past five years through August 19. Over that time period, the average domestic stock fund lost an annualized 0.3 percent. "It's a big, growing, burgeoning country with just a slew of opportunities and obviously a very large population to work with if they can get rolling and free up things—by that I mean the free-enterprise concept—there are great opportunities for China going forward," says Roseen.
Another factor to consider before jumping into China: You may already have it in your portfolio, Rocco points out. Vanguard Total International Stock Index, for example, holds a quarter of its assets in emerging markets, including a 5 percent stake in Chinese stocks. And T. Rowe Price's actively managed Emerging Markets Fund has nearly 20 percent of its assets in China, but investors also get exposure to countries including Brazil, South Korea, India, and Russia. Even domestic funds can provide China exposure, as many U.S.-based companies are big beneficiaries of the country's growth. Caterpillar is an indirect play on China, says Rocco, where the maker of construction and mining equipment is rapidly expanding its operations.
"To make a bet on a particular market is not a good idea for most investors," says Rocco. "Who it does make sense for is people who already have a well-balanced portfolio and understand that they may already have a significant amount in China. It's more akin to buying a stock than fund—high-risk and high-reward for people with a long time horizon who understand what they're doing."