Investing in China may garner top billing at some international investment conferences, but 1.3 billion people building an economy with near double-digit growth rates still isn't enough to attract the interest of most CPA advisors.The risks and complications of investing in China keep most advisors away, but booming growth keeps the topic on the radar, and it's attracting additional fund companies.

The risks of investing in China range from political to economic to social. Political risks include lesser-developed contract law and property rights. "The level of corporate governance in general is a concern," says Jason Thomas, Ph.D and CFA with San Francisco-based Kochis, Fitz, Tracy, Fitzhugh & Gott Inc. "We don't even have that right yet in this country, as developed as we are."

As chief investment officer, Thomas has evaluated the potential of China for clients, but thus far declined to buy in. "Aside from the obvious risks, the rules of ownership are confusing," he says. "Different share classes trade on each exchange, on both the mainland exchanges and Hong Kong."

The main share classes are A, B and H. Both the A and B shares are companies incorporated in mainland China, and trade on their respective mainland markets. A shares are quoted in the renminbi currency and are available only to mainlanders and selected foreign institutional investors. B shares are quoted in foreign currencies and only recently became available to mainlanders as well as foreigners. H shares are companies incorporated in mainland China and listed on the Hong Kong Stock Exchange and other foreign exchanges.

Risk stems from these and other factors of immature markets. Complex and confusing rules keep liquidity low on the mainland markets. "There's no equity culture to speak of in mainland China," said Andrew Clark, senior research analyst at Lipper, a Reuters company, in Denver. "Even in Hong Kong the behavior of the equity investor is different."

Low liquidity magnifies the risks of Chinese investor behavior. "When new issues come out, investors dump the old paper to buy the new ones," said Clark. "With an average holding period of a few months to maybe a year, unless you're in something very liquid you can get caught."

Accounting regulations and lack of transparency compound the risks. Chinese companies keep several sets of books, following rules that serve different entities like tax collectors or investors. "We had to look at investing in a country that's growing that fast, but we're just not comfortable with the numbers," says James M. Luffman, CPA/PFS, of Chas Smith & Associates, in Lakeland, Fla.

Despite the risks, the potential for growth in the Chinese economy is too great for most advisors to ignore completely. Luffman and his colleagues buy individual issues of stocks for their clients, not mutual funds. "If we want to invest in China, we look for something more along the line of picking U.S. companies that have invested in China," Luffman said.

Crossing the Wall

A few mutual funds offer U.S. investors access to the growth potential in China. But most focus on the more liquid and more developed Hong Kong exchange rather than smaller mainland exchanges. "Mainland funds are few and far between," said Clark. "An investor needs to really look at the prospectus of a Chinese fund to know what they're investing in."

One of the biggest U.S.-based Chinese funds is the Matthews China, offered by the Matthews Asian Funds family. Launched in 1998, the fund now manages over $400 million. A look at the prospectus of September 2005 reveals that 33 percent of assets are in shares trading on the Hong Kong exchange, and another 29 percent in the H shares. Only 8 percent of the assets are allocated to the B mainland exchanges.

The potential for profit attracted the Chicago-area Oberweis Funds to find ways to balance out the risks. The company, known for its specialty growth funds, added the Oberweis China Opportunities Fund in October with $4 million in seed capital. "We look for companies with high growth rates and interesting products or services that can sustain competitive threats," said portfolio manager and president of Oberweis Securities James W. Oberweis, CFA.

The firm also seeks investments where the stock price does not reflect the potential. "Most institutions buy the 20 or 30 largest Chinese companies and mostly on the Hong Kong exchange," said Oberweis. "We're looking at the emerging group of entrepreneurs where the growth is the most rapid and where there are the greatest inefficiencies."

Oberweis acknowledged that there's no way to completely eliminate the risks, but built the fund in such a way as to mitigate them. "We reduce risks by diversification among companies, but also by getting to know the people," he says. "When you get in with a network of locals, you hear whispers about who are the bad guys."

The on-the-ground presence mitigates several risks, including differences in social mores.

Oberweis' team is led by a former Bear Stearns analyst who is native Chinese. "With technology, we can talk with China every day, see the same news wires as they see and crunch numbers here or there," said Oberweis. "But we need to do there what we do here - and that's go pound on the door, talk to management, and really understand the model behind the company."

Talking to the management of Oberweis' target companies takes a different kind of approach. "In the U.S., we sit down with a CEO and get right to the grilling with questions," said Oberweis. "That doesn't work there. Relationships take a bit longer to develop."

The relationship between Chinese equities and U.S. advisors might take as long.

Investors still want to see improved governance and regulations, simplified ownership structures, and greater liquidity in the Chinese markets.

"We know the conditions that are necessary before investing, but even when the problems are solved, we're not sure we can invest in a way to profit," said Kochis Fitz's Thomas. "But we believe we'll know it when we see it."

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