China ETFs and the Regulatory Hammer

China has become a major area of focus as we embark upon the final months of 2011. With macroeconomic concerns weighing heavily across the globe, fears of a "hard landing" for this global economic growth engine are once again making the rounds.

Slowdown fears will likely present a challenge for ETFs designed to target the Chinese equity markets. For some funds, however, this may not be the only hurdle standing in the way.

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In addition to hard landing fears, investors learned late last week that the U.S. Department of Justice had opened up an investigation into accounting irregularities found at Chinese companies listed on U.S. stock exchanges. This is not the first time that U.S.-listed Chinese firms have faced scrutiny from regulators. In 2010 an investigation led by the Securities and Exchange Commission looked into Chinese reverse-mergers. Much is still unknown as to where the current probe will lead and it will be interesting to watch how the case progresses. A Reuters report suggests that "criminal charges may be brought in addition to civil proceedings." From an investment perspective, news of the investigation has weighed heavily on a handful of firms. During the final week of September, Chinese companies trading on U.S. exchanges like Baidu(BIDU) and Sohu.com(SOHU) fell 13% and 18% respectively. Despite these regulatory hurdles, for ETF investors, China is not entirely off limits. Gaining exposure safe from the ongoing investigation, however, will require a keen eye. The U.S. ETF universe boasts a wide collection of funds designed to provide investors with exposure to the Chinese companies. Not all are created equally, however. Rather, although they are both headlined by primarily large-cap companies, given their respective indexing strategies, a fund like the iShares FTSE China 25 Index Fund(FXI) will likely be affected differently than the PowerShares Golden Dragon Halter USX China Portfolio(PGJ). Of these two funds, FXI is the best suited to handle the current scenario. The fund takes aim at the Chinese marketplace, targeting companies like China Mobile(CHL), China Construction Bank, and CNOOC(CEO) using securities that trade on the Hong Kong Stock Exchange.

While FXI's dedication to Hong Kong-listed securities will protect it from being directly impacted by the regulatory probe, PGJ is not as lucky. According to its Website, the fund's index is, "comprised of the U.S.-listed securities of companies that derive a majority of their revenue from the People's Republic of China." While this strategy was initially utilized in order to inject the fund with transparency, it now appears to make the PGJ vulnerable to any resulting repercussions with regulators breathing down the necks of these companies.

Over the past week, the impact of the probe has been felt. PGJ has managed to underperform FXI by a noticeable margin. It will be interesting to see if these two funds continue to diverge in the weeks ahead.

Given the looming regulatory hurdles facing U.S.-listed Chinese companies, I prefer FXI over PGJ when it comes to gaining broad exposure to China's equity markets. However, any China-focused ETF should be approached with caution. Doubts swirling around this emerging nation will likely make it a risky bet in the near term. Exposure to China and other developing countries should be kept small and focused. Readers Also Like: >>Kass: 10 Questions for the Bulls>>Cramer: This Isn't 2008, and We're Not Europe

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