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3 Reasons iShares China Large-Cap ETF Shares Could Fall

The warning signs are becoming more visible, and it could be just a matter of time before China's greatest treasure becomes its biggest liability.

Source: National Bureau of Statistics of China .

A lack of industry diversification

When you buy a China-based ETF, diversity may not be at the forefront of your concerns. Yet when you purchase an ETF, which grants ownership in a number of securities or investment vehicles all at once, you expect the holdings within the ETF to be somewhat diversified across a number of industries. That's not the case with the iShares China Large-Cap ETF.

As of Aug. 14, financial stocks comprised 54.5% of the market value of the iShares China Large-Cap ETF, with telecommunications comprising another 15.3%, oil and gas claiming 11.9%, and technology accounting for 10.4%.

There are two major implications here that should give investors pause.

Pie chart by author. Data source: iShares.

First, it means this ETF is primarily made up of cyclical stocks. Financials and tech stocks tend to be at the mercy of the underlying economy in which they operate. Cyclical stocks like these tend to perform even worse in a contracting economy than broad-based stock indexes.

Furthermore, high exposure to financial stocks leaves the iShares China Large-Cap ETF particularly vulnerable in the case of a housing-industry collapse. If the number of no-money-down loans is increasing, I would assume that the quality of lending is decreasing. If China's growth slows and its middle class doesn't see the robust level of wealth creation it has witnessed over the past two decades, it's quite possible that financial institutions will bear the brunt of the impact.

Considering the aforementioned data on housing and China's projected GDP growth rate of 7%-8% (well below its three-decade average of 10%), it could be time to consider whether this lack of industry diversification poses a serious risk to the iShares China Large-Cap ETF.

A trust issue

Lastly, let's not forget that a serious trust issue still exists between global investors and Chinese companies.

Source: Alexander Baxevanis via Flickr.

On one hand, larger Chinese stocks, which are what the iShares China Large-Cap ETF focuses on, tend to be more forthcoming and transparent with information simply because they're in the public spotlight at all times. They also have some of the most robust growth prospects in the world.

But on the other hand, investors still remember being burned by more than a dozen China-based stocks that essentially cooked their books back in 2010-2011. This served as a reminder to investors, and yours truly , that the way China regulates its business differs a lot from the way the U.S. regulates its companies. This lack of trust in the financial results of China-based companies is one reason why we see China stocks regularly trade at P/E multiples that are discounts compared to those of U.S. stocks.

If any new accounting issues surface in China-based stocks, no matter how small, they could be the last straw for U.S. investors.

Tying things together

China has been an economic powerhouse for a number of decades, but it may also be on the precipice of a major slowdown precipitated by weakening investments in its housing sector and the potential for poor-quality home loans mucking up the mortgage portfolios of its large money-center banks. While that in no way ensures that the iShares China Large-Cap ETF will head lower, it certainly gives pessimists and skeptics plenty to chew on moving forward.

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The article 3 Reasons iShares China Large-Cap ETF Shares Could Fall originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool owns shares of, and recommends Nike. It also recommends BMW. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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