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Shorting China With ETFs?

By: IndexUniverse
Posted: 6/16/2011 5:05:00 PM
Referenced Stocks: EWA;FXA;FXI;RENN;SHZ

This time, "Dr. Doom" foresees a hard landing for the Chinese economy after 2013. But, as investors well know, the market may move sharply before the data show a full-blown economic pullback.

I think it's important to note that, when it comes to China, the ETF market affords investors shorting possibilities that don't really exist in the world of individual stocks.

Despite the difficulty of shorting well-known Chinese stocks such as Renren ( RENN ) or Shen Zhou Mining & Resources Inc. ( SHZ ), as FT highlighted in a recent piece, there are plenty of ways to short Chinese equities using ETFs.

This could turn out to be another special quality of ETFs. But that's putting the cart before the horse, because first you have to decide that you do, in fact, want to short China. Moreover, as I said, what's needed before all else is an appetite for risk and a bit of creativity.

Inverse ETFs

The most straightforward options are three inverse ETFs currently trading:the ProShares Short FTSE/Xinhua China 25 (NYSEArca:YXI), the ProShares UltraShort FTSE/Xinhua China 25 (NYSEArca:FXP) and the Direxion Daily China Bear 3X (NYSEArca:CZI).

These three funds, respectively, offer single-, double- and triple-inverse exposure to the Chinese market via two different indexes, including the one on which the $7 billion iShares FTSE/Xinhua China 25 Index Fund (NYSEArca:FXI) is based.

Of course, with any leveraged fund, you have to be ever mindful that most of them-including the three I mentioned-rebalance daily. That means their returns can deviate significantly from their underlying indexes, as the chart below shows.

Over the past year, as FXI returned 4 percent, the single-exposure inverse fund, YXI, fell 12.8 percent. The double-exposure fund, FXP, lost an astounding 26 percent. These crazy numbers show that managing these kinds of funds can be too tall an order for many investors.

Here's another crazy fact that makes me wonder if things aren't a bit unhinged at the Securities and Exchange Commission:You can own an inverse ETF in an IRA, and yet outright short selling is prohibited in such retirement accounts. Go figure.


Shorting FXI And Other Options

But in the right kind of nonretirement account, an alternative to these daily rebalanced inverse leverage funds is an outright short sale of a long China ETF. And, no fund is easier to do that with than the highly liquid FXI.

The truth is there are a host of China ETFs investors could short, such as the PowerShares Golden Dragon Halter USX China Portfolio (NYSEArca:PGJ) or the SPDR China ETF (NYSEArca:GXC). And, ETF traders will tell that if you're dying to short a China ETF that isn't terribly liquid, an authorized participant can just create new shares, as long as the order is big enough.

Also, put options are available on both FXI and PGJ, providing another avenue to make a short bet on China, albeit with a bit more risk and leverage.

Again, this requires options trading authorization and the sophistication necessary to trade them effectively. But, if investors are looking to make a tactical market call as contrarian as shorting China, they're likely to want to have as many arrows in their quivers as possible.

Collateral-Damage Plays

As Jim Chanos, president of the New York-based hedge fund Kynikos Associates, argued in an appearance on CNBC last month, China is headed for a collapse based on an "unsustainable growth path and overindulgence."

Chanos said 70 percent of the Chinese economy is based on fixed investment, while the emergence of a "consumer economy" so many analysts have been predicting hasn't really materialized. In fact, the consumption share of GDP in China is actually falling.

If Chanos turns out to be right, the devastation to the world's economy related to a Chinese hard landing would be profound.

Resource-rich countries that have benefited most by selling raw materials to satisfy China's insatiable hunger stand to experience the greatest level of pain.

Australia, for example, is a resource-rich developed country that has benefited hugely from its proximity to and trade relationship with China, as the world's most populous country has sucked in all kinds of materials to build infrastructure and real estate. Australia's whole economy and its currency have been on a tear in the past decade.

So if China unravels in any major way, a short position in either the CurrencyShares Australian Dollar Trust (NYSEArca:FXA) or the iShares MSCI Australia Index Fund (NYSEArca:EWA) would be two viable short plays that might make sense for bold, high-conviction investors.

As with FXI and PGJ, EWA and FXA have options contracts, which give investors with a higher risk tolerance the opportunity to short with leverage.

The point is, if you believe China's economic miracle may be running its course before long, you've got plenty of shorting options. So, now's the time to do your homework.

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