FOOL'S EYE VIEW
China: Eastern Promise or High Risk?

By David Kuo (TMFDragon)
May 23, 2002

There are some things in this world that seem just too good to pass up on. But there is no such thing as a free lunch. All free lunches have strings attached and such stringy meals are not only very unappealing but could prove expensive over the long run. Just take a look at the promises that are made in this flyer that landed on my desk only a month ago, extolling the virtues of investing in China.

You get 100% capital protection no matter what happens to the Chinese market and you even get the potential of achieving returns of up to 11%-15% per quarter. It doesn't mention how this limit amount will be actually be decided but it does use 15% in the illustration of potential returns!

Further inspection of the small print is required before you whip out your chequebook and pen. Firstly, to enjoy capital protection you must remain invested for four years. Secondly, the investment is denominated in US dollars and the returns on the investment will be subject to fluctuations in exchange rates. Finally, and most importantly, there is a management fee of 1.15% per annum collected upfront for the full four-year period.

Lets take a look at each of those conditions to see just how they stack up. The first condition is fairly straightforward. To enjoy capital protection you must remain invested for the full four years. The reason for this is quite evident if you look closely at the fourth and final condition. And that refers to the management fee of 1.15% per annum that is collected upfront for the four-year period. That means for every £100 that you invest you are really only starting with £95.40 and its going to take a little while before your investment really starts to get going.

Lets move on to the issue of currency fluctuations and start by saying that currency fluctuations are an important consideration if you intend to invest in overseas markets. Businesses that operate in overseas markets would normally take measures to ensure that profits are protected against adverse currency swings. This is normally done through complex instruments such as currency hedges. However, it is an entirely different kettle of fish for the private investor who has little access to these types of currency instruments. Just bear in mind that a 10% drop in the value of the dollar against the pound could easily wipe out any gains that you had set your sights on.

Now onto the capped return. A sample set of 16 quarterly returns was provided in the flyer. It showed that the 15% cap was used only once but the imposition of the ceiling was enough to reduce the overall return over the four-year period by almost 3.5 percentage points. A cap of 11% would have not knocked 13% off the final sum. This is the price that you pay for 100% capital protection over the four-year period. When stock markets rise they often rise significantly so capping gains is likely to cost you a lot more that you might realise. 

China is unquestionably one of the few markets that have sidestepped the global economic downturn. The country has thus far demonstrated economic growth in the high single digits and might well continue to do so for some time to come. However, despite all the promises that the East could bring higher growth is nevertheless normally synonymous with higher risks. And for this reason few, if any, investors will be brave enough to sink their last penny into the Chinese market. Additionally a fixed four-year investment of the type described will hope to capitalise on the short-term growth prospects within the region.

Short-term punts, and yes, four years should really be classified as being short term in the context of the stock market, are never an ideal investment even with the promise of capital protection. So rather than scouring around for short-term bets look instead to the long term through, say, a UK index tracker. With plenty of international conglomerates peppering the FTSE 100, there's already enough exposure to foreign markets, which include China, without taking on additional costs and risk.