Should You Reduce Your Stake in Chinese Stocks?

Chinese stocks and exchange-traded funds have been in high demand in past years, as emerging-markets investors have sought to tap into China’s growing middle class. Now, however, many investors are wondering if China is where they want to put their money.

There are several reasons for this shift in sentiment. One factor is the executive order former President Trump signed in the final days of his administration that banned investment in businesses designated as Communist Chinese military companies. Investors also point to the oppression of Uighur minorities in Xinjiang and the crackdown on freedoms in Hong Kong. Others blame lackluster returns.

Still, many investors see opportunities in China and aren’t ready to carve it out of their emerging-markets holdings just yet. Whatever side of the fence you lean toward, take some time to explore the complexities surrounding Chinese stocks before making a decision. Here are some pros and cons.

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Reasons to Divest From China

Reason No. 1: The executive order to delist certain Chinese companies. The order left off big names such as Alibaba (ticker: BABA), Baidu ( BIDU) and Tencent (TCEHY), which are holdings of many mutual funds and ETFs. It did affect some others, though, such as China Mobile ( CHL) and Cnooc ( CEO), a Chinese oil firm. After the order came out, smaller investors who held individual American depositary receipts of these blacklisted Chinese companies in some cases reported difficulties selling their shares. What happens with the executive order under the Biden administration remains to be seen.

Reason No. 2: Human rights issues. Hellen Mbugua, environmental, social and governance senior research analyst at Calvert Research and Management, says that from an ESG investing perspective, there are problems with supply chains linked to China. For example, the U.S. banned cotton imports from China’s Uighur region in January because they are “marred by the issue of forced labor,” she says. “Complexity of global supply chains further muddies this issue.”

Perth Tolle, founder of Life + Liberty Indexes and a China critic, puts it more bluntly: “They have more than a million Muslim minorities locked up in Xianjiang in camps. We’ve seen some of the stories coming out of the campus of torture and rape. Slave labor has been established.” Tolle says China also backed out on promises to keep Hong Kong autonomous and in the last year has intensified crackdowns by passing a national security law that makes it illegal for anyone to criticize the Chinese Communist Party. “It’s not just in Hong Kong. It’s anywhere in the world,” she says. “The only thing saving us is we are under the laws of the United States.”

Reason No. 3: Limits on growth. On the investing side, Tolle says, the Chinese government blocked Ant Group’s initial public offering after the firm’s owner, Jack Ma, criticized the party. “Tech entrepreneurs in China aren’t saying anything right now. And that’s not an accident,” she says. “In a country where you don’t have the personal or economic freedoms, meritocracy is discouraged.”

Tolle says that companies in China are often rife with corruption, inefficiencies, and lack of investor protections and rule of law. Industries live or die by government decree, she adds. “Any country can experience limited growth on limited liberalization,” she says. “Investing is about looking to the future [and] whether a country has the competitive environment in place to foster productivity. Investors should avoid countries where the growth story is a thing of the past.”

[See: 9 Global Growth ETFs to Diversify Your Portfolio.]

Reasons to Invest in China

Reason No. 1: A long-term focus. Some investors are focused on long-term developments in China rather than near-term politics, especially as they relate to Trump’s executive order. Chuck Self, chief investment officer for iSectors, says his firm owns China-focused equity and fixed-income funds. “Over the long term, we believe that China will continue to grow at a pace greater than the rest of the world,” he says. “Also, yields of Chinese bonds are more attractive than developed country bond yields.”

Reason No. 2: China’s pandemic response. Justin Leverenz, senior portfolio manager at Invesco, says that China has kept its appeal among many investors based on its handling of the health crisis, in particular. This “made it just about the only economic growth story in town, as most other countries struggled to mount an adequate response,” he says.

“COVID winners,” as Leverenz calls them, included sectors such as e-commerce, fintech, food delivery and drug development. But he notes that investor demand came at the expense of concerns about company fundamentals. So, overvaluations in Chinese stocks are a concern, he says.

Reason No. 3: The big picture. Leverenz admits that investing in China for the long term is complex. “It requires an appreciation of the historical background and an understanding of the political circumstances, the resulting economic policies and its equity market,” he says.

Although China saw strong domestic product growth during the past 10 years, both Tolle and Leverenz say that doesn’t necessarily equate to equity growth. Over the entire decade ending in 2019, the country’s largest mainland stock exchange in Shanghai did not deliver positive returns.

“Part of that had to do with the retail investor base, which treated the stock market like a casino. At the same time, there was a prevalence of large, state-owned companies with corporate governance policies that weren’t necessarily aligned with minority shareholders’ interests,” Leverenz says.

According to Tolle, the ownership structure of many Chinese firms favored majority owners, who often were sons or sons-in-law of high-ranking party leaders, dubbed “princelings.”

But Leverenz says that China’s mainland stock exchanges have evolved, with more high-quality Chinese companies listing in mainland China and Hong Kong. “This has been an important change with wide-ranging consequences,” he says. “We believe it should lead to improved quality of companies listed on the exchanges and better investment opportunities for domestic investors.” This, in turn, could boost the performance of Chinese equities, he says.

[SEE: 7 Emerging-Market Funds to Buy and Hold.]

Alternatives to China

Investors who are wary of Chinese stocks but still interested in emerging markets might consider investing in more democratic countries that have a better rule of law, Tolle says, such as Vietnam, South Korea, India, Mexico, Chile and Taiwan. The potential for the Biden administration to build bridges to other emerging markets via strategic alliances is a draw for investors. And Taiwan is attractive because of its thriving semiconductor industry, Tolle says.

A few emerging-markets ETFs that do not invest in China are iShares MSCI Emerging Markets ex China ETF ( EMXC), Columbia EM Core ex-China ETF ( XCEM), Freedom 100 Emerging Markets ETF ( FRDM) and KraneShares MSCI Emerging Markets ex China Index ETF ( KEMX).

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Should You Reduce Your Stake in Chinese Stocks? originally appeared on usnews.com

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