China Internet ETF: The "opportunity" of a lifetime

(MoneyWatch) The other day a friend, and fellow investment advisor, sent me a link to an article announcing that the new exchange traded fund player KraneShares had added another China-related fund strategy focused on the growing Chinese Internet industry. One of his clients wanted to invest, and he asked me if I could provide some insights and advice. I thought I would share my response on this particular investment "opportunity," as well help you learn how to think about similar opportunities that come your way.

China's growing Internet sector

The KraneShares CSI China Internet ETF (KWEB) will track the performance of the CSI Overseas China Internet Index, which includes Chinese Internet and Internet-related companies. The fund has an expense ratio of 0.68 percent. The underlying index will hold about 20 to 30 different securities. In promoting the new fund Brendan Ahern, managing director of KraneShares, said in a statement, "KraneShares CSI China Internet ETF provides U.S. investors with an opportunity to gain exposure to China's growing Internet sector with the cost efficiencies of ETF investing." He added: "We see two powerful demographic trends driving China's Internet sector: Since 2000, Internet spending by urban Chinese has increased 14 percent annually, and China's rural population continues to migrate to urban areas, further fueling Internet usage."

Sounds enticing, doesn't it?

The idea is that the China Internet-themed ETF will help investors capitalize on the emerging middle class and growing Internet usage in mainland China. In a press release Dr. Zhigang Ma, general manager of China Securities Index, said, "We believe the China Internet sector offers an excellent opportunity for U.S. investors. There are approximately 600 million Internet users in Mainland China. Chinese Internet company market capitalizations now rival the largest U.S. and global industry leaders, along with the potential for Chinese internet IPOs to come later this year, this is definitely a sector that warrants attention."

The article also noted that the KraneShares had recently came out with the KraneShares CSI China Five-Year Plan ETF (KFYP) that focuses on companies in targeted sectors of China's 12th five-year plan.

Think before you leap

While many investors will be tempted by such products, there are three important issues you should consider before you take that leap. The first is that for information to be useful, it has to be "value relevant."

1) If you know it, they all know it

One of "Swedroe's Laws of Prudent Investing" is that if you know something, you can be sure that the managers running the large institutional funds and hedge funds that dominate trading, and thus set market prices, are also fully aware of the same facts. That's important because it means the information is already incorporated into prices. Therefore, it's too late for you to act on it.

Whether you're reading about a great opportunity in a press release on some Internet site, your stockbroker called to tell you about it, or you heard about it on CNBC, you can be sure it isn't some national secret. And that means that while it may be true (there are powerful demographic forces driving Chinese Internet usage), it's nothing more than information. It's not value-relevant information. The takeaway is that information doesn't have any value unless you're the only one who knows it or you can somehow interpret it better than your competitors. And since neither of these two criteria is likely to be met, you're best ignoring the information. In other words, a little knowledge can be a dangerous thing, especially when combined with the all-too-human tendency toward overconfidence.

2) High demand doesn't always mean high profit

The second issue is that just because there's rapidly growing demand for a product doesn't mean that companies will be able to generate large profits, or that stock investors will generate large returns. If you doubt that just think about how investments in companies like Nokia (NOK) and Research in Motion (BBRY) have fared despite the rapid growth in demand for cell phones. And if you think that China's more rapid economic growth rate will translate into high stock returns, the historical evidence actually shows that there has been a negative correlation between economic growth rates and stock returns -- countries that have faster economic growth tend to have lower stock returns.

The expectations of faster economic growth rates are already incorporated into prices. Thus, markets price for risk, not growth. And countries that experience slower economic growth might be seen to be riskier places to invest. Thus, investors demand a higher expected return to compensate them for taking the incremental risks.

There is a big difference between economies and their stock markets. In the four years from 2008 through 2011, China's economy didn't skip a beat. Its GDP grew 9.6 percent in 2008, 9.2 percent in 2009, 10.4 percent in 2010 and 9.1 percent in 2011. During this period, the U.S. not only suffered through a recession, but the ensuing recovery was the weakest in the post-war era. The rate of growth in our GDP was -0.4 percent in 2008, -3.5 percent in 2009, 3.0 percent in 2010 and 1.7 percent in 2011.

Given these results, most investors would be confident that an investment in Chinese stocks would far outperform an investment in U.S. stocks. However, the data tells another story. Based on the changes in net asset value (NAV), the SPIDER S&P China ETF (GXC) returned -50.7 percent in 2008, 65.5 percent in 2009, 6.7 percent in 2010 and -17.2 percent in 2011. Each dollar invested in GXC at the start of 2008, would have been worth 72 cents by the end of 2011. For the same period, Vanguard's 500 Fund (VFINX) returned -37 percent, 26.5 percent, 14.9 percent and 2 percent, respectively. A dollar invested in VFINX would have been worth about 93 cents, or 23 percent more than a similar investment in GXC.

Bringing the data up to date, we know that China's economy continued to grow much faster than ours in 2012 and 2013. Extending our analysis to include 2012 and through Oct. 22 of this year, we find that GXC returned 21.7 percent in 2012 and 6.3 percent in 2013. VFINX returned 15.8 percent and 25 percent, respectively. Beginning in 2008, a dollar invested in GXC would have grown to 93 cents, while a dollar invested in VFINX would have grown to $1.35 -- a 45 percent difference.

Our economy grew at a much slower pace, yet U.S. stocks provide much higher returns to investors. The takeaway is don't be fooled by fanciful tales of expected rapid economic growth leading to high stock returns.

3) Separate the good risk from the bad

The third issue is understanding that in investing there are two different types of risks -- good risk and bad risk. Good risk is the type you are compensated for taking. Investors get compensated for taking systematic risks -- risks that cannot be diversified away. The compensation is in the form of greater expected (not guaranteed) returns. Bad risk is the type for which there is no compensation, which is why it's called uncompensated, or unsystematic, risk.

Thus, investors should only take systematic risks. Investors in stocks know that they accept economic and geopolitical risks which cannot be diversified away, no matter how many stocks you own. Prudent investors diversify those risks as much as possible, avoiding the risks of owning a single stock, a single sector/industry or a single country fund (other than a U.S. fund).

The takeaway is that you should diversify the stock risks you decide to take by building a globally diversified portfolio with allocations that approximate how capital is allocated. For a U.S. investor that would mean an allocation of approximately 50 percent U.S., 37.5 percent developed markets and 12.5 percent emerging markets. And the vehicles you use to implement that strategy should all be low-cost, passively managed funds that provide broad exposure to each of the asset classes you want in your portfolio (such as small, large, value, growth and REITs). Clients of my firm have portfolios that typically hold about 12,000 stocks. Such a portfolio diversifies away the idiosyncratic risks of individual stocks, sectors and countries. The result is that investors are taking the only type of risk they should be taking -- systematic risk for which they are compensated.

If you follow my prescription, there's one other bit of good news. You can ignore all the noise created by Wall Street and the financial media, allowing you to focus on your family, friends, hobbies, community service and so on. In other words you get to focus on things that are far more important than whether the Chinese Internet sector will outperform the S&P 500. And that is the most important takeaway of all.   

Image courtesy of Flickr user Foxtongue