China funds: Inside the market, key risks & how to choose

It’s understandable why investors are drawn to China. It’s the world’s second-largest economy and is packed with innovative businesses in a variety of sectors. But what do you need to know about the country before committing your cash? Here is our guide to investing in China and choosing the right fund to meet your needs.

• China is the world’s second-largest economy
• It has thousands of companies in sectors such as technology
• Funds may be run very differently, so research is vital
• A manager’s track record and the fund’s costs are key considerations

What are China funds?

China funds are pooled investments that invest most of their assets in equities from China, Hong Kong and Taiwan. This can include those listed on the Shanghai and Shenzhen stock exchanges (known as A-shares) as well as Hong Kong. It can also include prominent Chinese companies listed overseas. Investors wanting broader regional exposure can also look at Asian equity funds.

Why UK investors look at China

It’s the world’s second-largest economy and is packed with technology companies leading the way in fields such as AI and electric vehicles. China also has a rapidly growing middle class and is seen as a great diversifier from Western financial markets. It’s simply one building block within a wider investment strategy, as we explain in our guide on how to build your investment portfolio.

The China share class puzzle

Investing in China can be confusing because Chinese companies are available through several different stock markets, depending on where they are incorporated, listed and who controls them. This can affect which companies and parts of the Chinese economy a fund gives you exposure to.

• A-Shares: Shares in Mainland Chinese companies that are listed on the Shanghai or Shenzhen stock exchanges and are denominated and traded in Chinese renminbi (RMB).
• H-Shares: Shares in companies incorporated in Mainland China but listed on the Hong Kong Stock Exchange.
• Red Chips: Shares in companies incorporated outside Mainland China, usually in Hong Kong, but controlled by the Chinese government or state-owned entities.
• P Chips: Shares in companies incorporated outside Mainland China but controlled by private Chinese individuals or businesses.

Sub-categories within China funds

China funds aren’t all the same. Some will concentrate on the domestic market, others on the multinational giants based in the country. The best China funds to choose will depend on your investment needs and approach.

Greater China funds

Greater China funds are more diversified as they can invest in companies listed in Hong Kong and Taiwan, as well as mainland China. This makes them an attractive option for UK investors wanting broad exposure to the sector.

All-China funds

These funds generally focus on Chinese mainland companies, embracing both A-Shares and offshore listings such as H-Shares in Hong Kong and ADRs in the US. However, it’s worth double-checking the scope of individual China funds.

China A-shares specialist funds

These concentrate on domestic China exposure. However, there are thousands of Chinese companies, so these portfolios can still be well diversified in terms of sectors.

Hong Kong / offshore-focused China funds

Companies listed in Hong Kong and overseas will be the primary focus. This generally includes mainland companies incorporated outside of China and Chinese businesses trading on US exchanges.

Indices and what’s typically inside a China fund

There are various China benchmarks. Here are some of the most popular and where they focus their attention.

• CSI 300: This is often referred to as China’s equivalent of the S&P 500. It’s a market-cap-weighted index of the 300 largest companies on the mainland Shanghai and Shenzhen exchanges.
• MSCI China Index: The most common benchmark for international investors. It includes large and mid-cap companies within H-Shares, ADRs, Red chips, P chips and some A-Shares.
• MSCI China All Shares Index: It blends A-Shares and offshore listings and is seen as a broad representation of the Chinese equity universe.
• FTSE China A50: This features the 50 largest A-Share companies.
• Hang Seng China Enterprises Index (HSCEI): As its name suggests, this tracks H-Shares. These are mainland Chinese companies that are listed in Hong Kong.

The construction of China investment funds will depend on their objectives and focus. Typically, China funds have a lot of exposure to technology, e-commerce, financials and industrials.

The biggest risks to understand

There are plenty of potential benefits to investing in China funds, but you also need to acknowledge the specific risks of exposure.

Geopolitical and regulatory risk

Regulatory crackdowns can affect investments in China. Examples have involved the artificial intelligence sector, digital media platforms and offshore cross-border brokerages.

There have also been well-documented tensions between China and other major global powers. These could lead to sanctions and restrictions affecting particular industries.

VIE structure and ADR risk

There are more than 200 Chinese companies listed in the US, most of which trade as American Depository Receipts (ADRs). Many use a Variable Interest Entity (VIE) structure, in which investors hold shares in offshore holding companies with contractual rights over the underlying Chinese business, rather than direct equity ownership.

State-owned enterprise concentration

Some Chinese benchmarks have significant weighting in state-owned enterprises, where shareholders’ interests may not be the primary motive. Many active fund managers try to limit such exposure.

Currency and capital controls

There are currency considerations for UK investors. This is because China investment funds will hold renminbi or Hong Kong dollar-denominated assets. Converting back into Sterling, therefore, means there are foreign exchange issues that will influence your overall returns.

Volatility and index concentration

A potential downside for investors is the fact that many Chinese companies are more volatile than those in developed markets. This is due to factors such as unpredictable regulatory crackdowns. It also means a longer investment time horizon, of at least seven years, is more appropriate.

Active vs passive in China

There’s arguably a greater need for active management in China due to the complexities surrounding different share classes and benchmarks. Passive investment is a cheaper option but also means investors can’t escape heavy concentration in different areas.

How to choose a China fund

So, how should you choose the best China funds for your needs? Our guide on how to make an investment walks through the practical steps.

Define your objective

First, you need to be clear on your investment goals. What are you trying to achieve? Why do you want exposure to China? Do you want to focus on the domestic Chinese market or have broad exposure to the sector? This will dictate the best China funds to invest in.

Check the share class mix

Look at the breakdown of share class exposures. For example, how much is in A-Shares and H-Shares? What kind of risks are being taken? Does it have a higher concentration in global giants or smaller, domestically-focused companies?

Confirm the geographic remit

Look at its geographic exposures. Don’t draw conclusions from its name alone, as that might be misleading. The reality is that China-only and Greater China mandates can differ enormously, so you need to make sure the structure meets your needs.

Assess the manager and team

The manager – or managers – at the helm are the most crucial aspect when it comes to choosing the best China funds to invest in. Their knowledge, expertise and process will be crucial to potential returns. That’s why a search for the best China funds must include a detailed analysis of their track records in different market conditions. Do they have a strong track record or is it patchy? However, don’t just focus on the best-performing China funds. Look closely to see whether they have substantial resources or are a niche operation.

Review costs and currency policy

Charges can affect your returns. The fees levied by China investment funds can vary, so you must be clear on what costs apply. Pay close attention to the Ongoing Charge Figure (OCF), which is a percentage representing a fund’s annual operating costs, entry and exit charges, and transaction costs. It’s also important to check if any performance fees apply.

Where China funds fit in a portfolio

This depends on a combination of your investment objectives, attitude to risk, and existing holdings. Generally, most UK investors regard China funds as satellite positions in broader investment portfolios, rather than core holdings. It’s important to remember that other investments, such as a global emerging markets fund or global fund, may already have meaningful exposure to China. Adding a dedicated China fund could therefore increase your overall exposure to the country.

Our process & how we select China funds (Elite Rated)

FundCalibre has been researching these markets for many years and can help you identify the best China funds to meet your needs. Our experts have been scrutinising the best-performing China funds to understand how their performance has been generated. This research starts with AlphaQuest, a proprietary quantitative screening tool that estimates the likelihood that a fund manager will deliver superior returns. China funds passing this test will be quizzed on their investment philosophy and portfolio construction approach. This analysis will be subject to peer review before a decision is made. Only the very best China funds to invest in will be awarded a prestigious Elite Rating. This signifies they have a skilled manager, a repeatable investment process and a history of consistent long-term returns.

FAQs about China funds