by: Carl Delfeld

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 2006 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.

About the author:
Carl Delfeld is head of the global advisory firm Chartwell Partners
and editor of the the "Asia-Pacific Growth" newsletter and is the
author of "The New Global Investor." For more information please
visit http://www.chartwellasia.com