Passive, index-tracking exchange-traded funds are in huge demand — but are they always wise investments? The WisdomTree China (NYSE:SNP) Dividend Ex-Financials Fund is an example of an index fund with a lot of unnecessary risk–the index it follows is based on investing in Chinese dividend-paying stocks. The year-to-date return is -5.08% and a dividend has yet to be established or paid (see the price chart below).
Some of the risks I see are as follows: currency translation, accounting style differences, political risks, and basic cultural differences.
Foreign companies conduct business measured in their own currency and accounting formats. After a foreign corporation has undergone extensive investigation and applied procedures applicable to our markets, shares are available for trade in the US. Such shares are called American Depository Shares (ADS). These are claims to foreign shares and reflect the currency translation in the value. ADSs have foreign currency risk embedded. Reports that are issued in the home currency and format may further cloud actual financial and operational performance. See the Chinese yuan exchange rate price chart and the ETF share price chart below.
The first position in the WisdomTree China Dividend Ex-Financials Fund is China Mobile Ltd. (ADR) (NYSE:CHL). This ADS has posted a one-year return of 2.13% and represents an 8.1% position, as of May 1, for this ETF. The price below indicates range-bound trading for the past year and the volatility seems to be declining. Regarding earnings, what is available is a gross figure labeled profit attributed to equity shareholders expressed in renminbi billions. The amount for the first quarter of 2013 is 27.88 and first quarter of 2012 reported 27.8. The outlook for the Chinese mobile phone market appears to be strong. As a stand-alone investment, China Mobile Ltd. (ADR) (NYSE:CHL) offers some great long-term promise — provided the effects of currency translation can be reduced to a manageable level.
Following this holding in the WisdomTree China Dividend Ex-Financials Fund is China Petroleum & Chemical Corp (ADR) (NYSE:SNP). This ADS has given a one-year return of 16.35% (see the price chart below). This is an example of difficulty in accessing timely information. The most current information on the company website is the 2012 annual report. The year ending Dec. 31 reports diluted earnings per share at 0.704 renminbi and for 2011 at 0.795 renminbi. Forward-looking comments made by the chairman talk about taking efforts to improve internal operations and resolve organizational issues that have created inefficiencies. From a single stock to consider, I would not choose this one. There seems to be a veil of secrecy surrounding this company and any information that I would review may not be timely or say a lot.
The third position, with a weighting of 4.5%, of the China Petroleum & Chemical Corp (ADR) (NYSE:SNP) is PetroChina Company Limited (ADR) (NYSE:PTR). The one-year return of this stock is flat (see the price chart below). This company does exploration, development, and production of oil and natural gas. Fortunately, PetroChina Company Limited (ADR) (NYSE:PTR) does release an English version of a quarterly statement. The first quarter of 2013 reported earnings of 0.20 renminbi per share (diluted), versus 0.21 renminbi per share (diluted) for the same period of 2012. Management states that the weakened global economy and geopolitical turmoil have been contributing factors to the 8% drop in per share earnings. I find little benefit to allocating capital to an offshore oil company such as PetroChina Company Limited (ADR) (NYSE:PTR) when there are numerous domestic choices available.
The fourth ADS held in the China Petroleum & Chemical Corp (ADR) (NYSE:SNP), with a holding of 4.2%, is CNOOC Limited (ADR) (NYSE:CEO). This is another oil and gas company and has delivered a one-year return of 0.45% (see the price chart below). The first quarter 2013 release is well adapted to US standards. The opening comments state that oil and gas revenues when compared to the same period of last year are up 13.03%. Five new discoveries have been made and six successful appraisals of wells have been achieved. All the production is taking place off the coast of China, with one project in Algeria. These press statements are the most open I have seen in this group. Yet, when I look at the price performance, I still see the same currency concerns. I remain cautious about this as a stand-alone investment at this time.
In my opinion, the China Petroleum & Chemical Corp (ADR) (NYSE:SNP) is an exchange-traded fund that contains a lot of flaws not properly addressed due to the passive management style. I believe in the long-term prospects of investing in China’s largest and profitable companies. I feel that the best way to do this is by hiring an active manager that has office space in one of the major cities of China, such as Hong Kong or Beijing. The ability of a local and active money manager that is well acclimated to the local markets is a value added proposition that is worth the extra costs. Anybody that makes an investment in such a place with no close proximity to monitoring the portfolio adds displacement risk to the list already mentioned. A lot can happen that goes unnoticed.
The article Significant Risks in Passive Chinese ETFs originally appeared on Fool.com and is written by Jeff Stouffer.
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