Shorting China: Top Ways to Utilizing ETFs

The numbers are in: China's economic growth in 2015 slowed even further to 6.9% (and 6.8% in the final quarter, the softest since the global financial crisis). What would be exceptionally healthy growth in most of the rest of the world represents China's slowest rate in 25 years (since 1990 in the wake of Tiananmen Square, when growth was 3.8%). Whether you actually believe the economic statistics, which many believe to be fiction and merely a way for China's Communist Party to remind all of us that their economy is planned, it's clear that the trend is downward.

So let's look at the bigger picture: China is the second-largest economy in the world, which had made it a phenomenal growth story for many years. However, in order to maintain growth, China overbuilt its infrastructure, assuming that the relentless growth would continue. Without that expected demand coming to fruition, China continued to build while using excessive debt to do so. To make matters worse, retail investors jumped on the bandwagon because they were making so much money in stocks. When real economic growth slowed, the Chinese government encouraged already overleveraged investors to keep investing. In order to maintain the façade and halt the bleeding, the Chinese government temporarily halted IPOs, arrested bearish writers, banned short selling with the threat of arrest, and poured money into the stock market in order to buoy prices. (For more, see: China's Crisis Caused by Unhealthy Stock Market Growth.)

We have seen this story many times before. There have been more sequels than Rocky, and predicting the ending is just as easy. You know how it ends; money managers know how it ends. (For more, see: Is China's Economic Collapse Good for the U.S.?)

That said, anyone managing money has a biased interest and will continuously spew bullish stats because they don’t want to frighten clients. To be fair, I have shorted Chinese equities on several occasions, and I’m currently shorting China in an indirect manner (more on this below). However, that’s not why I’m writing this article. I’m writing this article to warn others to be careful with Chinese equities, or with any American stock where the company relies heavily on the Chinese consumer. The Chinese population is aging, which slows consumer spending. This is also why the Chinese government reversed its one-child policy, but this obviously won’t have an immediate impact. (For more, see: Understanding China's Former One Child Policy.)

This article should NOT be seen as a recommendation to short Chinese equities. If you do so, you will have to take on significant risk, and the majority of investors and traders will make emotional decisions, which will lead to losses. Instead, the information provided here should be looked at as different ways to short Chinese equities if you are comfortable with risk and only considering allocating a small percentage of available capital to this venture. (For more, see: Stocks to Consider with China's One-Child Policy Over.)

The context for my recommendations is inverse ETFs. If you believe that China's economy is on a downward path, they should pay off, though you'd probably be a little late to the game at this point. That said, they give you the opportunity to trade the trend; just be sure you have an exit strategy plan in place so you can get out quickly/minimize risk. And even if future economic growth reports look more positive, most believe that any rally would not be sustainable and could spell a buying opportunity. (For more, see: Benefits of China Changing Its One Child Policy.)

All numbers below as of Jan. 18, 2016.

Direxion Dly CSI 300 Chn A Shr Br 1X ETF (CHAD) tracks the inverse performance of the CSI 300 Index, or the Chinese A-share market. The average daily trading volume is 303,896, making it liquid enough for trading. With a 0.80% expense ratio, it’s not ideal for investing, but this is a lower expense ratio than most inverse ETFs, and CHAD has appreciated 27.74% since its inception on June 17, 2015. It has also appreciated 11.56% over the past three months.

If you want to take on a little more risk, then look into ProShares UltraShort FTSE China 50 (FXP), which tracks 2x the inverse performance of the FTSE China 50 Index, or the 50 largest and most liquid stocks listed on the Hong Kong Exchange. The average daily trading volume is lower than CHAD at 258,849, and the expense ratio is higher at 0.95%. On the other hand, FXP has appreciated 38.42% over the past year. (For more, see: Chinese Sector Investing with ETFs.)

If you have absolutely no fear and risk is a meaningless word to you, then consider Direxion Daily FTSE China Bear 3X ETF (YANG), which tracks 3x the inverse performance of the FTSE China 50 Index. It has a higher average daily trading volume of 471,655, and while the expense ratio is high at 0.95%, many 3x leveraged ETFs charge more than 1%. YANG has appreciated 42.31% over the past year, but it’s extremely volatile and currently trading at a 52-week high. (For related reading, see: China's GDP Explained: A Service-Sector Surge.)

If you want to limit risk while still having an opportunity at benefiting from what’s taking place in China, then you take a more diversified approach by shorting emerging markets via ProShares Short MSCI Emerging Markets (EUM), which tracks 1x the inverse performance of the MSCI Emerging Markets Index. As a 1x inverse ETF, volatility will be relatively muted. By shorting the MSCI Emerging Markets Index, you are shorting Brazil, Chile, Colombia, Mexico, Peru, Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, United Arab Emirates, Russia, South Africa, Turkey, China, India, Indonesia, Korea, Malaysia, Philippines Taiwan, and Thailand. EUM traded at an all-time high of $137.49 at the height of the financial crisis. While it wouldn’t be an easy task, if the current global economy is deflationary, then it’s possible for EUM to reach that point again. Another big selling point is that EUM survived throughout a six-year bull market. Since the next six years are highly unlikely to present a bull market environment, this means that a well-designed dollar-cost averaging strategy could pay off.

The Chinese economy is mostly smoke and mirrors. An aging population combined with overbuilt infrastructure and excessive debt makes for a dangerous investment environment. Value-based investors would likely be best off sitting on the sidelines and waiting for buying opportunities down the road in regards to China, because these opportunities will eventually present themselves – years down the road. If you’re aggressive, then consider one of the inverse ETFs above. The above information should not be seen as a recommendation. These are all opinions. Please do your own research prior to making any investment decisions. (For more, see: Top 6 Factors That Drive Investment in China.)

Dan Moskowitz is long EUM. He indirectly owns CHAD. He has no positions in FXP or YANG at this time.