The Matthews China Fund takes a diversified approach with big bets on banks and insurers.

What’s going on in China — the MSCI China Index has returned 43% this year? That’s almost four times the gain of the U.S. benchmark index.

And it’s been a smooth upward ride:

FactSet

If you hold shares of the iShares MSCI China ETF MCHI, -1.29% which tracks the index, it’s been a wonderful 2017. The S&P 500 Index SPX, -0.76%  of the U.S. has returned 12.2% this year.

But what some investors don’t realize is that the MSCI China index is heavily weighted toward the country’s hottest internet and computer stocks. With a fast-rising middle class in the world’s most populous nation, China’s other industries — banking and insurance, among others — also will benefit.

That’s why investors might consider owning an actively managed mutual fund.

A review of the top 10 holdings of the iShares MSCI China ETF shows how it skews toward tech:

Company Ticker Share of portfolio Total return – 2017 through Aug. 31
Tencent Holdings Ltd. 0700, +0.87% 16.1% 74%
Alibaba Group Holding Ltd. BABA, -0.65% 13.1% 96%
China Construction Bank Corp. 0939, -1.33% 5.2% 21%
China Mobile Ltd. 0941, +0.12% 4.8% 8%
Baidu Inc. ADR BIDU, -3.16% 4.2% 39%
Industrial and Commercial Bank of China Ltd. 1398, -1.38% 3.9% 33%
Ping An Insurance (Group) Co. of China Ltd. 2318, -0.49% 2.9% 62%
Bank of China Ltd. 3988, -0.99% 2.9% 26%
JD.com Inc. ADR JD, -1.41% 1.9% 65%
China Life Insurance Co. Ltd. 2628, -1.42% 1.6% 26%
Source: Morningstar Direct

Tencent Holdings Ltd. 0700, +0.87%  and Alibaba Group Holding Ltd. BABA, -0.65% made up a combined 29.2% of the MSCI China ETF (and a similar share of the index) on Aug. 31. So with Tencent up 74% this year and Alibaba nearly doubling, it’s no wonder the index has rocketed 43%.

According to Andrew Mattock, the lead manager of the Matthews China FundMCHFX, -0.72% the median year-to-date performance for the roughly 2,000 stocks included in Hong Kong’s Hang Seng Index HSI, -0.62% is “closer to zero.”

In an interview on Aug. 31, Mattock said “it’s very easy to generalize” when talking about China’s economy and its industries, so he and his team focus on selecting companies based on assessments of the quality of management.

Matthews Asia is headquartered in Westborough, Mass., and has $31 billion in assets under management. Mattock is based in San Francisco. He became the lead manager for the Matthews China Fund in June 2015 after working at Henderson Global Investors for 15 years.

It has been “very hard to keep up” with the MSCI China Index because of the tech weighting in the two aforementioned internet giants, Mattock said. But such popular stocks “tend to tend to get bid up eventually,” to unsustainable levels, he added.

“Such a large concentration in those two stocks gives us an opportunity to outperform the passive alternative. This is the opportunity for us, because this internet space is such a large part of that index and ETF,” he said.

U.S. investors are constantly told to choose passively managed funds because active managers tend to lag the performance of stock indices. That makes sense in a bull market, but the heavy weighting of the largest stocks in an index could lead to additional volatility and greater risk in the long run.

The three-year chart for the ETF and the Matthews China Fund show that investors have been faced with plenty of volatility, with the active strategy coming out slightly ahead: MCHFX, -0.72%

The Matthews China Fund has $760 million in total assets. Mattock aims to hold about 35 stocks, and the fund is rather heavily concentrated, with its top 10 holdings making up half of the assets as of July 31:

Company Ticker Share of portfolio Total return – 2017, through Aug. 31 Total return – 3 years Total return – 5 years
Tencent Holdings Ltd. 0700, +0.87% 11.0% 74% 162% 603%
Alibaba Group Holding Ltd. BABA, -0.65% 6.7% 96% N/A N/A
China Life Insurance Co. 2628, -1.42% 6.2% 26% 19% 31%
Ping An Insurance (Group) Co. of China Ltd. 2318, -0.49% 5.1% 62% 106% 138%
Industrial & Commercial Bank of China Ltd. 1398, -1.38% 4.5% 33% 35% 87%
China Construction Bank Corp. 0939, -1.33% 4.5% 21% 40% 80%
Bank of China Ltd. 601988, -0.23% 3.9% 29% 81% 100%
China Merchants Bank 3968, -0.86% 3.5% 68% 124% 182%
Ctrip.com International Ltd. ADR CTRP, -0.65% 2.6% 29% 60% 538%
Sina Corp. SINA, -0.77% 2.4% 82% 154% 109%
Source: Morningstar Direct

You can click on the tickers for more information, including news coverage of each company. You can see that Mattock has plenty of conviction about the prospects for Tencent and Alibaba, as these stocks made up a combined 17.7% of the Matthews China Fund as of July 31. But that’s a lower share than their weighting in the MSCI China Index, and Mattock said he was “comfortable with those weights, as those companies are so dominant in China.”

Tencent and Alibaba

One can consider Tencent the Facebook Inc. FB, -0.76%  of China and Alibiba the Amazon.com Inc. AMZN, -1.33%  of China. Mattock says the two Chinese companies have far more potential than their American counterparts.

“Facebook and Amazon, particularly, are competing with established infrastructure,” he said.

For Amazon, that includes old retailers that seem to be dying. Others, such as Wal-Mart Stores Inc. WMT, +1.82% are well-established and trying to give Amazon a run for its money in the U.S. China, in contrast, never had a U.S.-like brick-and-mortar retail industry for Alibaba to compete with.

Mattock noted another difference.

“If Facebook and Amazon wanted to roll out payment systems, they would have to take market share from PayPal PYPL, -0.31% or Visa V, -0.86% ” he said. But Alibaba and Tencent “are able to monetize verticals that weren’t established in China. There was no effective competition. Both dominate the payment side aggressively, with Tenpay and Alipay.”

In addition to being used for online purchases, Tenpay and Alipay can be used by consumers to pay local merchants or even vending machines with their smartphones.

So Mattock is enthusiastic about the companies’ ability to create more varied revenue streams than their American counterparts.

“If you want to buy any game in China, you do it on Tencent’s platform,” he said.

Meanwhile, Alibaba is increasing its advertising efforts to leverage its user base. The company reported having 529 million active mobile users during the second quarter.

Mattock gave insights about two other industries that are well-represented among the fund’s top holdings:

Life insurance

China Life Insurance Co. 2628, -1.42%  and Ping An Insurance (Group) Co. of China Ltd. 2318, -0.49%  were the fund’s third- and fourth-largest equity holdings as of July 31.

“As the Chinese consumer becomes slightly more sophisticated, because the wealth generation has been quite strong, they are now looking for what you may call proper life-insurance products,” Mattock said.

He explained that life insurance has traditionally been considered an “investment alternative” in China. A recent trend has been for consumers to look for term life-insurance coverage to protect their families, as is done in the U.S.

“As the market starts to evolve in terms of consumer preferences, [the insurers] will sell accident coverage as well as life coverage. Obviously, the companies are making good money on these products, rather than just on interest-spread products,” he said.

Banking

For years we have been seeing headlines warning of a coming crisis for China’s banking system, owing to nonperforming loans. But Mattock said the large national banks held by the Matthews China Fund were largely unaffected by the Chinese government’s stimulus push in the wake of the 2008 financial crisis.

“You should not throw the entire banking system together,” he said. “We have seen those bigger banks less exposed to risk, and at the same time, the economic cycle has improved in China.”

The government’s efforts to limit overcapacity in certain industries has led to what Mattock calls “oligopoly pricing.” So the fund manager believes the cycle of nonperforming loans, which was looking like a major problem three years ago, “is not as prevalent” now.

“This is why we are no longer underweight banks,” he said.

Performance

Here’s how the Matthews China Fund’s performance compares with its Morningstar category and the MSCI China Index:

Total return – 2017 through Aug. 31 Average return – 3 years Average return – 5 years Average return – 10 years Average return – 15 years
Matthews China Fund 43.5% 10.2% 10.0% 4.5% 13.7%
Morningstar China Large Blend category 31.6% 8.1% 10.9% 3.5% 10.6%
MSCI China Index 42.9% 10.3% 12.6% 3.8% 15.0%
Sources: Morningstar Direct, FactSet

 

By PHILIP VAN DOORN
Market Watch

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