How to Hedge a China Bet

06/18/2007 12:00 am EST

Focus:

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carl Delfeld, editor of the Chartwell Advisor Global ETF Report, suggests a strategy for investors to protect their investment in China by taking out an “insurance” policy.

All the headlines about the hot China market have been about the Shanghai Composite index, which includes the Shanghai and Shenzhen and their “A” shares available only to Chinese investors. The iShares FTSE/Xinhua China 25 Index ETF (FXI) was one of the star performers in 2006, but this year is up only 3.44%.

Still, it is likely that a sharp pullback in the Shanghai Composite would have a spillover affect on FXI.

Here is a simple plan you might want to execute to capture the upside while cutting your losses if the Chinese economy hits a speed bump. First, take a broad stake in China through investing in FXI, [which comprises] 25 of the largest and most liquid China names. All of the 25 stocks included in FXI are listed on the Hong Kong Stock Exchange.

FXI provides good exposure to three key sectors of China: energy (20%), telecom (19%), and industrial (18%). The annual operating expenses of FXI are only 0.74%, compared [with] 2% plus for other alternatives, including actively managed China and greater China regional funds.

Next, take out some insurance to protect this position by purchasing a put option on the China iShares (FXI). It sounds complicated, but is actually very straightforward. An option is a right to buy (call) or sell (put) 100 shares of a security on a fixed expiration date at a set price (strike price). For this right, an investor pays a fee or premium.

While you may grumble about paying the premium with cold hard cash when you might not need it, you probably have home insurance just in case disaster strikes and no doubt you have some life insurance as well. Why not protect your portfolio as well?

It is especially important to consider hedging against more risky emerging markets such as China. While countries like China offer tremendous upside potential, the downside risk can be daunting and immobilize even the bravest investor.

Say you buy 100 shares of FXI, which is trading at [just under $123 a share]. Your total exposure is $10,500. Then purchase a put option (right to sell the China iShares) that gives you the right to sell FXI at a price of $100 on the third Friday in January 2009. I think we all can agree that a lot could happen to China, good and bad, from now until January 2009.

If the price of FXI moves down toward the strike price, the value of the option will increase. This will cost you a premium of a little over $800, but limits your potential loss to 13% plus the premium.

Emerging market countries like China should represent only a small portion of your portfolio and, whenever possible, take out some insurance.

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