China Portfolio Insurance

China Portfolio Insurance
Are you​ excited about the​ upside potential of​ China but can’t pull the​ trigger because of​ the​ significant downside risk? Here is​ a​ way to​ invest in​ China growth and still sleep at​ night .​
China has been the​ largest economy in​ the​ world for eighteen of​ the​ past twenty centuries and it​ is​ clearly determined to​ regain its role as​ the​ hegemonic power in​ Asia and then challenge U.S .​
global leadership .​
Will it​ be able to​ sustain its 10% economic growth rate,​ quell rural discontent,​ build a​ sound market-based financial system,​ privatize dominant state-owned enterprises and move towards openness and democracy? This is​ a​ tall order and you​ can put me in​ the​ skeptic column .​
Nevertheless,​ China’s raw industrial power,​ momentum and the​ palpable ambition of​ the​ Chinese people could realistically yield a​ huge return .​
I​ advise my clients to​ go ahead and invest in​ China but emphasize that this is​ a​ speculative investment .​
It is​ smart to​ protect against the​ considerable downside risk .​
Here is​ a​ simple plan you​ might want to​ execute to​ capture the​ upside while cutting your losses if​ the​ Chinese economy hits a​ speed bump .​
First,​ you​ could take a​ broad stake in​ China through investing in​ the​ China iShare exchange-traded fund (FXI) that is​ comprised of​ 25 of​ the​ largest and most liquid China names .​
All of​ the​ 25 stocks included in​ the​ China iShare are listed on​ the​ Hong Kong Stock Exchange .​
Some of​ them are incorporated in​ mainland China (H shares) and some of​ them are incorporated in​ Hong Kong (red chips) .​
The China iShare has been picking up steam in​ the​ last few months and is​ up just over 12% so far this year .​
The China iShare provides good exposure to​ three key sectors of​ China: energy (20%),​ telcom (19%) and industrial (18%) .​
This concentration can be viewed as​ a​ plus or​ a​ minus depending on​ your perspective .​
For example,​ some smart investors are placing a​ bigger bet on​ China’s consumer markets .​
The top five companies represent 40% of​ the​ index .​
The annual operating expenses of​ the​ China iShare are only 0.74% compared to​ 2% plus for other alternatives out there including actively managed China and greater China regional funds .​
Keep in​ mind that most of​ these companies are still largely controlled and owned by the​ Chinese government .​
Next,​ you​ could take out some insurance to​ protect this position by purchasing a​ put option on​ the​ China iShare (FXI) .​
It sounds complicated but is​ actually very straightforward .​
An option is​ a​ right to​ buy (call) or​ sell (put) 100 shares of​ a​ security on​ a​ fixed expiration date at​ a​ set price (strike price) .​
For this right an​ investor pays a​ fee or​ premium .​
While you​ may grumble about paying the​ premium with cold hard cash when you​ might not need it,​ you​ probably have home insurance just in​ case disaster strikes and no doubt you​ have some life insurance as​ well .​
Why not protect your portfolio as​ well? It is​ especially important to​ consider hedging against more risky emerging markets such as​ China .​
While countries like China offer tremendous upside potential,​ the​ downside risk can be daunting and immobilize even the​ bravest investor .​
Let’s look at​ a​ couple of​ examples .​
Say you​ buy 100 shares of​ the​ China iShare (FXI) which is​ trading at​ $62 per share .​
Your total exposure is​ $6,​200 .​
Then purchase a​ put option (right to​ sell the​ China iShare) that gives you​ the​ right to​ sell FXI at​ a​ price of​ $60 on​ the​ third Friday in​ January 2008 .​
I​ think we all can agree that a​ lot could happen to​ China,​ good and bad,​ from now until January,​ 2008 .​
If the​ price of​ the​ China iShare moves down toward the​ strike price,​ the​ value of​ the​ option will increase .​
This will cost you​ a​ premium of​ a​ little over $500 but limits your potential loss to​ $2 per share plus the​ premium .​
Or buy a​ put option at​ a​ strike price of​ $50 and your premium drops to​ about $200 with a​ worst case scenario of​ a​ loss of​ $12 per share plus the​ premium .​
Here is​ another example .​
You know Latin American markets are hot and believe the​ bull market will continue but are wary that there is​ the​ potential for a​ sharp pullback .​
You could buy 100 shares of​ the​ Latin America 40 iShare (ILF) giving you​ exposure to​ Brazil,​ Argentina,​ Mexico and Chile at​ a​ price of​ $113 for a​ total exposure of​ $11,​300 .​
Then buy a​ put option giving you​ the​ right to​ sell 100 shares at​ a​ strike price of​ $100 in​ March 2018 for a​ premium of​ around $300 .​
Your worst case scenario would then be a​ loss of​ 15% with unlimited upside .​
Keep a​ cool head when investing in​ emerging market countries like China .​
They should represent only be a​ small portion of​ your portfolio and,​ whenever possible,​ take out some insurance.

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