China Portfolio Insurance

Do you feel excited by the potential upside of China, but are unable to pull the trigger due to the substantial downside risk? This is how you can invest in China’s growth while still sleeping at night.

China has been the largest country in the world for 18 of the last 20 centuries. It is determined to restore its position as Asia’s hegemonic power and challenge the U.S. leadership in global affairs. It will be able maintain its 10% economic growth rate, quash rural discontent, create a sound financial system that is market-based, privatize state-owned enterprises, and move towards democracy and openness. This is a difficult task and I can be considered skeptical.

However, China’s industrial potential, momentum, and the palpable ambitions of the Chinese people could all make it a very attractive investment. Protecting against the substantial downside risk is smart.

This is a simple plan that you can use to maximize your gains and minimize your losses in the event of a slowdown in the Chinese economy.

First, invest in the China iShare Exchange-Traded Fund (FXI), which is made up of 25 of China’s most liquid and largest names. The Hong Kong Stock Exchange lists all 25 stocks in the China iShare. Some are listed on the Hong Kong Stock Exchange (H shares), while others are listed in mainland China (red chips). China iShare is growing at a rapid pace and has risen to just over 12% in the first half of this year.

China iShare gives you good exposure to three important sectors in China: energy (20%) and telcom (19%). Depending on your perspective, this concentration could be seen as either a plus or a drawback. Some smart investors place a greater bet on China’s consumer market. 40% of the index is made up by the top five companies. China iShare’s annual operating costs are just 0.74%, compared to 2% for alternative funds such as actively managed China or greater China regional funds. Remember that many of these companies still remain largely owned and controlled by the Chinese government.

To protect your position, you can purchase a put option on China iShare (FXI) to get insurance. Although it sounds complicated, it is really quite simple. Option is the right to purchase (call) or sell 100 shares of a security at a specified price. An investor must pay a premium or a fee for this right.

While you might grumble about having to pay the premium with hard cash, it is likely that you have home insurance in case of disaster and some life insurance. You should also consider protecting your portfolio. Hedging against emerging markets like China is a good idea. Although countries such as China have tremendous upside potential, they can also be very dangerous and could even stop a brave investor.

Let’s take a look at some examples. Let’s say you purchase 100 shares of China iShare (FXI), which trades at $62 per share. Your total exposure amounts to $6,200. You can then purchase a put option (rights to sell China iShare), which gives you the right of selling FXI at a $60 price on the third Friday January 2008. We can all agree that China could experience a lot of changes between now and January 2008. The option’s value will rise if the China iShare price falls towards the strike price.

You will pay a premium of just over $500, but your loss is limited to $2 per share plus the premium. You can also buy a put option with a strike price $50. Your premium will drop to $200, with a worst-case scenario of a loss equal to $12 per share plus your premium.

Another example: Another example is that you know Latin American markets have been hot and expect the bull market to continue, but are concerned about the possibility of a sharp pullback. For $11,300, you could purchase 100 shares of the Latin America 40 iShare, which gives you exposure to Brazil and Argentina. You can also buy a put option that allows you to sell 100 shares at $100 per share in March 2006. This premium is approximately $300. The worst-case scenario would be a loss up to 15%, but with unlimited upside.

When investing in emerging markets like China, keep your cool. These countries should not be more than a portion of your portfolio. If possible, get insurance.

Chartwell Partners President & Publisher Carl T. Delfeld

Carl Delfeld is a global investor with over 20 years experience. He has a strong Asian background.

* Author of “The New Global Investor”, a primer for global investors

* Chartwell Partners is the President of Chartwell Partners, a global investment advisory firm

* Chartwell Advisor ETF report and Asia-Pacific Growth Publisher

* Columnist for Forbes Asia on Global Investing: “Global Gambits”

* Ex-Representative of the United States to the Executive Board of Asian Development Bank

* ChartwellAmerica is the Chairman of ChartwellAmerica’s global economic strategy think-tank ChartwellAmerica

* Asian specialist at the U.S. Joint Economic Committee (US Treasury)

* Ex-member of the U.S. Asia Pacific Economic Cooperation Committee

* Ex-investment executive at Robert Baird & Company, and UBS

* Fletcher School of Law & Diplomacy graduate with an economics scholarship from the U.S. Japan Friendship Commission

* Student exchange at Sophia University, Japanese Ministry of Education Fellow in Keio University