The statistics are startling. China’s gross domestic product is growing around 10% annually, compared to 3% or so in the United States. The consumer’s wide-open wallet is driving the U.S. economy, but consumer-spending growth in China clocked in at 13% last year, compared to 8% in the United States. China’s middle class, now estimated at 150 million to 200 million people, is expected to double in size in the next five years.
But that’s not to say it can’t be done. And with China giving every indication of becoming the world’s next economic giant, it’s time to consider whether and how to expose your investment portfolio to that country’s high-revving growth engine.

Investors who have taken the plunge in China in recent years have been well rewarded. The average mutual fund that invests in China and the nearby Asian Tiger nations has gained 17.5% over the past three years, far better than the S&P 500’s ($INX) 5.4%.

But this isn’t the first time China has seen rapid growth. The country experienced a major investment boom in the early 1990s. But China added too much manufacturing capacity, too fast, and the bubble burst in 1994-1995, sending the economy into a tailspin. The Hong Kong-based Hang Seng index lost 31% in 1994 alone.

Will stocks hit another (great) wall?
Is it too late to catch this phase of China’s growth? Some analysts say it’s different this time around, and thus this boom won’t go bust. “There’s much more to the Chinese economy than in the 1990s,” says Edmund Harriss, manager of the Guinness Atkinson China & Hong Kong Fund (ICHKX). Back then, the economy “was under the government’s thumb, and the emphasis was strictly on growth.” This time, “it’s about profits, too.”

In the 1990s, the government owned almost everything, while “much of the growth this time is coming from foreign investment and Chinese public corporations as well as privately-owned companies,” Harriss says.

Let the pros do the picking
China’s growth story is enticing, but profiting from that growth isn’t as simple as buying China’s version of Google (GOOG, news, msgs) or General Electric (GE, news, msgs). Just like in the United States, fast-growing, high-profit sectors draw competition like flies. So, just like in the United States, yesterday’s highflier could be tomorrow’s busted stock. But unlike United States stocks, information on Chinese stocks is hard to come by. Most have no analyst coverage, and, depending on where they’re listed, the financial reports might be of dubious quality.

Bottom line: Unless you live there or have a staff of analysts that does, making consistent money buying individual Chinese stocks is a tough game.

Mutual funds and exchange-traded funds are the only practical way you can get unfiltered access to China’s boom. Since China is a hot item with U.S. investors, investment managers are rolling out new funds and ETFs to capitalize on the trend. So far, though, I know of only nine mutual funds and three ETFs that focus on the country.

Here’s a list of those options (one ETF is too new to include — more on that below) plus the additional information I consider most relevant for pinpointing the best prospects.

Ways to invest in China

Fund Morningstar rating (stars) Front load 1-year trailing return (avg. annual) 3-year trailing return (avg. annual) % of portfolio in China and Hong Kong Average market cap AllianceBernstein Great China ‘97 A (GCHAX) 3 4.25% -0.30% 16.80% 77% $3.9 bil Columbia Newport Greater China A (NGCAX) 4 5.75% 8.40% 15.50% 75% $9.5 bil Dreyfus Premier Greater China A (DPCAX) 3 5.75% -2.10% 13.80% 73% $3.1 bil Eaton Vance Greater China Growth A (EVCGX) 2 5.75% 7.90% 13.00% 62% $5.9 bil Fidelity China Region (FHKCX) 3 none 6.80% 11.50% 52% $12.6 bil Gartmore China Opportunities A (GOPAX) Not enough history to rate 5.75% new new 94% $2.5 bil Guinness Atkinson China & Hong Kong (ICHKX) 4 none 9.40% 18.60% 90% $7.8 bil Matthews China (MCHFX) 4 none -0.10% 17.40% 97% $3.8 bil Templeton China World A (TCWAX) Not enough history to rate 5.75% 8.50% new 53% $7.9 bil iShares FTSE/Xinhua China 25 Index (FXI, news, msgs) N/A trading comm. New new 100% $13.3 bil iShares MSCI-Hong Kong Index (EWH, news, msgs) N/A trading comm. 11.00% 12.70% 99% $12.8 bil

Data, as of 2/4/05, from MSN Money’s Mutual Fund Reports, except for the percentage of each portfolio in China and Hong Kong stocks. Those figures calculated from data found on Morningstar’s Web site.

Choosing your investment road to China
To start, let Morningstar do some work for you. Morningstar rates funds from one to five stars, with five being best. The star rating compares a fund’s past returns to its volatility. The scoring is done by fund category. For instance, the China funds are compared to other funds focusing on Asia (excluding funds specializing in Japan).

Within that category, funds with the highest ratios of returns versus volatility get the highest scores, and those with the lowest ratios get the lowest scores.

Morningstar’s star ratings aren’t perfect, but they work for a first look. If I don’t eliminate low-rated funds at the beginning, they usually flunk out anyway when I analyze them in detail. Normally I focus on four- and five-star funds. But China’s market and most of these funds’ returns were in the dumps from the late 1990s through 2002, and there are no China funds with five-star ratings. So I relaxed my standards and included three-star funds.

Use history as a guide
I’ve listed the one-year and three-year trailing returns for each fund, using Feb. 4 as the end date for each period. Usually, I look mostly at three- and five-year fund returns, which I’ve found to be a better predictor of future performance than the shorter-term numbers. But China is a special case, since so much has changed in recent years. Foreign investment is a bigger factor, independent companies are on the rise and government-controlled firms are less important.

Thus, investing styles that worked five years ago may not be the best for today’s market. Consequently, I’ve listed both the one- and three-year returns for each fund. Pay more attention to the three-year numbers, the better indicators of future performance.

Seek out the pure plays
Some funds intentionally diversify their holdings between China (including Hong Kong) and other countries in the region to reduce risk. That’s a good strategy, but the diversification dilutes your investment in China, which is the point of this exercise.

To play the Chinese opportunity, limit your selections to funds and ETFs with at least 80% of their portfolios in Hong Kong- or China-listed stocks, as shown in the table.

Size matters: For safety, think big
Next take a look at each fund’s average market capitalization, which measures the average size of company held by a fund. (A stock’s market cap is its recent share price multiplied by its outstanding shares.) In this group, there’s a considerable range of average market caps, from $2.5 billion to $12.8 billion.

Definitions vary, but firms with market caps below $1 billion or $2 billion are considered small-caps, and those with market caps above $8 billion or $10 billion are large-caps. Those in between are mid-caps.

Usually, risk-averse investors prefer large-cap stocks or funds, because the bigger companies are better able to withstand economic downturns. By contrast, because smaller firms are usually faster growers, aggressive players see better returns there. If you are averse to risk, avoid funds with average market caps below $6 billion.

Stay nimble with active managers
ETFs are portfolios of stocks that replicate the performance of a stock index. For our China ETFs, the iShares FTSE/Xinhua China 25 Index (FXI, news, msgs) tracks 25 of the largest Chinese companies. The iShares MSCI-Hong Kong Index (EWH, news, msgs) tracks the overall Hong Kong market. The new PowerShares Golden Dragon ETF (PGJ, news, msgs), which isn’t included in the above table because it was only launched in December, tracks an index of U.S. listed stocks that derive a majority of their revenue from China.

In an emerging economy like China’s, investing in an index-linked fund has some drawbacks. An active fund manager has the ability to adjust his or her portfolio as conditions warrant. By contrast, the composition of a major index usually changes only once a year, and not necessarily in a desirable direction.

Don’t make short-term bets
China’s fast growth, political structure and uneven disclosure make investing there a risky business. All sorts of things, from currency revaluations to economic overheating, could go wrong. Thus, successful investing in China requires a long-term view. Commit only two-year money to China. That will give you time to ride out the inevitable downdrafts. Also, don’t put too much money at risk. Most investment advisors recommend putting no more than 5% to 10% of your investment dollars in this sort of an emerging market.