Find the right Way to Invest in China

Today, we have a handful of outstanding Chinese blue chip stocks that are finally easy to buy for Americans. They’re solid companies trading at cheap valuations. And investors are finally realizing that China is a place where they need to be invested.

According to Morningstar, the iShares FTSE/Xinhua China 25 Index ETF (FXI) is not only one of the 25 most popular exchange-traded funds on the market today, it's also the most-traded China-focused ETF. Despite the volatile Chinese market, this ETF attracted a net $3 billion of inflows in 2008.

This’s great!! But meanwhile, investors need to find to right way to invest in Chia. Just as we talked in the previous articles, each market has its own rules.

Seriously red tape
Some investors confuse FXI with a proper way to invest in the Chinese growth story. That just isn't the case, for a variety of reasons.

By investing in FXI, you're not sufficiently tapping into the entrepreneurial spirit of the Chinese people. See, FXI tracks a FTSE/Xinhua index mainly comprising state-owned enterprises (SOEs). In fact, of the top 10 holdings of the exchange-traded fund, 10 are SOEs (or are subsidiaries of SOEs, which for my purposes are one and the same).

In terms of past performance, that hasn't been so bad. Despite the recent plunge in the Chinese markets, which has sent names like PetroChina and China Mobile down considerably, the iShares FTSE/Xinhua China 25 ETF has averaged returns of 8% per year over the past three years, versus the S&P 500 -- tethered to our own mega caps like ConocoPhillips (NYSE: COP) and Verizon (NYSE: VZ) -- which has lost 12% a year over the same period.

But while FXI holdings like China Life Insurance (NYSE: LFC) and Sinopec have outpaced American counterparts like Lincoln National (NYSE: LNC) and XTO Energy (NYSE: XTO) since April 2006, looking to the future, FXI isn't the right train on which to hitch your China investment dreams.

Chinese SOEs background
SOEs have traditionally been the dominant players in the Chinese economy. In 1958, during the days of Chairman Mao, more than 97% of the Chinese economy was under the control of the government (PRC) through the use of SOEs.

Granted, things have changed over the past 50 years, following the economic reforms of Deng Xiaoping in the late 1970s and '80s. Today there are far fewer SOEs, but they still make up a significant chunk of China's gross domestic product and are mostly found in the energy, telecommunications, and financial sectors. The government keeps many of them alive by infusing them with capital, and one of the ways it does this is by -- wait for it -- taking them public.

The Chinese government has certainly reduced its ownership of some SOEs, but given the size of those companies and the size of the government's remaining ownership, it could be a long time before those SOEs are fully privatized. Just imagine if the PRC decided to suddenly dump its huge stake in China Life Insurance into the public markets. It would be an utter disaster for those shares.

The bottom line is that, despite the loosening of the PRC's grip, SOEs still do not put shareholder interests first. Their motivation is still at least partly political, so you're better off looking for Chinese companies that have your interests at heart.

This one will go to the hares
While the SOEs join the free markets at a tortoise's pace, non-SOE Chinese companies like Sohu.com (Nasdaq: SOHU), Mindray Medical (NYSE: MR), and New Oriental Education are flying by them in terms of innovation and ability to react to global economic movements. Moreover, these Chinese companies are led by entrepreneurs who represent the Chinese growth story. These, and not the SOEs, are the types of companies that may turn out to be some of the best stocks of the next 10 years.