The Chinese market carries a unique set of risks that investors in other regions may not be familiar with. Today, you’ll learn the pros and cons of investing in China and how to add exposure to Chinese firms to your portfolio with minimal hassle.
What is the Chinese Stock Market?
China’s economy began reopening to the rest of the world in 1978, shortly after the death of Mao Zedong. Chinese stock markets had been completely closed since the Communist Revolution in 1950 and all publicly traded entities had been liquidated. The 1978 reforms began a gradual reintroduction of foreign investment and capitalist influences, but a true China stock market didn’t reappear until 1990.
In 1990, after over a decade of economic reform, China stocks once again became available to the public through the opening of the Shanghai Exchange. Chinese stocks are a mix of state-owned industries, mixed-ownership companies and public companies operated by individuals. Additional stock exchanges reside in Beijing and the industrial province of Shenzhen. The major Chinese stock market index is the Shanghai Composite Index (SSE). Other smaller indices include the CSI 300 Index and the Hang Seng Index based in Hong Kong.
Ways to Invest in Chinese Companies
If you live outside of mainland China, you likely won’t be able to directly buy stock in Chinese companies (unless you have specific connections to the firms issuing the shares). There are several alternatives to directly owning shares of Chinese companies. Check out a few to know about:
- American Depositary Receipts (ADRs): An ADR is a security traded on a U.S. public exchange like the NYSE or NASDAQ. Unlike actual shares of stock, ADRs function a bit like a professional proxy. The receipt you receive when purchasing an ADR is a claim for a share of stock held in an American bank used by the Chinese company. For example, Baidu Inc. (NASDAQ: BIDU) is a blue-chip Chinese company listed on the NASDAQ exchange. When you buy Baidu shares, you actually buy a receipt for shares held in the firm’s custodial bank (in this instance, the Bank of New York). ADRs can be bought and sold like any stock on the exchange, but you won’t actually have the company’s shares in your brokerage account.
- ETFs and mutual funds: A Chinese stock index trading on an American exchange is one of the easier ways to gain broad exposure to the country. Plenty of ETFs and mutual funds collect baskets of Chinese stocks, such as the iShares MSCI China ETF (NASDAQ: MCHI). The MSCI China ETF holds a combination of ordinary shares and ADRs from some of China’s largest publicly traded companies.
- China A-Shares: Qualified investors can purchase a specific stock class known as A-shares directly from the Shanghai and Shenzhen exchanges. Unlike ETFs or ADRs, A-shares represent direct ownership of Chinese equities and are quoted in yuan, China’s local currency. However, potential buyers must choose from two paths: become part of the Qualified Foreign Institutional Investor program, which is mainly reserved for large institutions, endowments and accredited U.S. investors, or use the Hong Kong Stock Connect market, which allows A-share trading in Hong Kong where there are fewer restrictions. Over 1,400 Chinese companies trade on Stock Connect.
How to Invest in Chinese Stocks
There’s a bit of a curve when learning how to invest in the Chinese stock market. Not only can spreads and volatility vary from traditional equity investments, but the regulatory regime is often unpredictable (see China’s recent cryptocurrency crackdown as an example). If you want to invest in Chinese stocks from outside mainland China, here’s how to get started.
Step 1: Open and fund a brokerage account.
Opening a brokerage account is always the first course of action, but Chinese stocks are harder to access than other shares. Be sure your brokerage of choice can locate the particular Chinese stocks or funds you want to add to your portfolio. Create a short list and come up with pros and cons for each before deciding on opening an account.
Step 2: Decide on the type of exposure you want.
When asking how to invest in Chinese stocks, you’ll need to decide what type of security to purchase first. If you want exposure to a handful of large-cap Chinese stocks, you can purchase ADRs or buy a basket of companies through a China stock ETF or mutual fund. But if you want access to a wider range of Chinese firms, you’ll need to use the Hong Kong Stock Connect or a broker credentialed by the Qualified Foreign Institutional Investor program.
Step 3: Buy and hold your desired stocks.
Markets in China can be volatile (especially when the Chinese Communist Party gets involved), so set profit goals and have an exit strategy with your Chinese stocks. Also keep an eye on any leadership decisions or geopolitical events that could influence the Chinese stock market.
How to Trade Chinese Stocks
Traders have a different time frame than long-term investors, so more precision is required when entering and exiting positions. Trading Chinese stocks often comes with high transaction costs.
Step 1: Develop a trading plan.
A detailed plan can help trading in Chinese markets. Consider the current market environment and set goals for each individual trade. It’s important to develop a plan you can consult later when faced with buying or selling decisions.
Step 2: Purchase Chinese stocks.
Buy the necessary stocks to execute your trading plan. You’ll need to decide between securities trading on U.S. markets like ADRs and ETFs, or to use a specialized broker or the Stock Connect market to access Chinese A-shares. Always consider the transaction costs of trading foreign shares when entering or exiting positions.
Step 3: Take profits or cut losses based on your trading plan.
Trading is always more risky than long-term investing. That risk is magnified when investing in markets like China. Follow the rules set out in your trading plan — take profits when you reach your goals and cut losses if the trade turns against you. Always stay up to date on current events and regulatory rumblings coming out of mainland China.
Risks Associated with Investing and Trading Chinese Stocks
Investing in Chinese stocks is risky, and not always for the reasons you’d expect. Keep these risks in mind when determining how to invest in China:
- Limited access: Comparatively, only a handful of ADRs trade on U.S. exchanges, which means you can only access the majority of the Chinese stock market through certain brokers and the Hong Kong Stock Connect system. Trading from a traditional brokerage account will limit Chinese investment options for foreign investors
- Authoritarian regulatory concerns: Chinese markets are often referred to as “state capitalism” since the eye of the CCP hovers over all. Regulatory action can be swift and unpredictable and many investors eschew China altogether because of these concerns.
- Higher spreads on ADRs: If you’re trading ADRs, you’ll lose more capital to transaction costs than if you traded regular shares on Chinese stock exchanges. Since ADRs are simply a receipt for a claim on an actual share of stock, the bid/ask spread tends to be higher compared to other equities.
- High expense rates on Chinese ETFs and mutual funds: Chinese index funds are a great way to get broad exposure to the market, but investors certainly pay for the privilege. Funds holding Chinese stocks charge high expense rates, often over 40 or 50 basis points. Getting exposure to the firms you want can be a costly venture in foreign markets.
Chinese Stocks: Different Opportunities with Different Risks
The Chinese stock market has been open for business for more than 30 years now and a number of companies from the mainland have made international impact. Firms like Alibaba Group Holdings (NYSE: BABA), JD.com Inc. (NASDAQ: JD) and Tencent Holdings (OTC: TCHEHY) have large global client bases. New innovative tech companies pop up frequently in Chinese markets. China is still quite closed off compared to capitalist nations, but opportunities do exist if investors would like to weather the risks involved.
Erratic regulatory action is common, such as the tech stock crackdown that saw many companies suffer losses (and even led Alibaba founder Jack Ma to move to Japan). Successful investing in Chinese stocks can be difficult and requires you to set aside firm convictions and emotions. Research different companies and exchanges and learn the unique market holiday calendar before putting any capital to work in Chinese companies or the China stock index.
Investing in foreign markets isn’t for everyone and China carries its own separate set of risks in the China stock market index. Here are a few important questions to ask yourself when considering how to invest in Chinese stock market.
Can I buy Chinese stocks if I don’t live in China?
Yes, Chinese companies are open to foreign investment, but unless you’re involved with the Qualified Foreign Institutional Investor program or using Stock Connect, you’ll have to invest through a proxy like an ADR, ETF or mutual fund.
Is investing in Chinese stocks a good idea?
It depends. China is home to some of the most innovative companies and industries and its economy is one of the fastest-growing in the world. However, the Chinese Communist Party rules with authority, and predicting the path of Chinese regulation can be a massive headache. Proceed with caution when investing in Chinese stocks.
Is investing in Chinese stocks risky?
All investments carry risk, but an investment in Chinese stocks means dealing with a few unique ones, such as an unpredictable regulatory regime, limited access and high expenses. Always consider the pros and cons before investing, even with China’s most trending stocks. Pay attention to regulatory rumblings and geopolitical events and always have a detailed entry and exit strategy.