China, and the world’s hottest stock exchange, beckons for American investors

The world’s hottest stock exchange primarily comprises securities that neither you, nor your favorite manager or index fund, has ever bought.

The Shanghai Stock Exchange Composite Index returned more than 50% last year. Meanwhile, China onshore bonds have been offering attractive yield premiums compared with offshore counterparts — known as Dim Sum bonds.

It seems like a home run: healthy returns that are not correlated with other markets around the world.

But you probably don’t own many of China’s highest-flying securities, which essentially have been off-limits to foreign investors.

That’s changing. The Chinese government’s major reforms include opening domestic financial markets to more foreign investment. In addition, a range of new products is giving advisers access to China’s noncorrelated return potential.

Advisers must now choose between fully embracing the world’s second-largest economy , or missing a possible opportunity to diversify client portfolios.

DRAMATIC YEAR

Last year was a dramatic one for global investors.

Central banks continued historic monetary interventions to boost growth in developed economies, helping to deflate returns

on financial assets and launching many investors into more-esoteric and global investments.

The sinking cost of energy also reverberated around the globe. Oil producers, including Russia, took a hit, as did their investors: The Market Vectors Russia ETF (RSX) lost more than 40% of its value last year.

SIGNIFICANT EVENT

But fast-growing developing economies took solace in the sliding cost of energy, a major cost for a number of industries. In India, where prime minister Narendra Modi is considered a business-friendly reformer, the benchmark S&P BSE Sensex leapt 30% in 2014.

Yet the most significant event last year for investors may have been China, where the classification “emerging market” increasingly seemed ill-equipped to convey the nation’s complexity and power.

In the latest sign of the importance of foreign investors to the reformist economic agenda of president Xi Jinping, Chinese officials approved Shanghai-Hong Kong Stock Connect, a program that gives offshore investors significantly expanded access to securities traded in mainland China. (Some Chinese companies trade exclusively in mainland markets, while others are listed in Hong Kong or abroad.)

Stock Connect “signals the regime’s willingness to resolve to open up its market,” said Howard Lee, an analyst at ETF.com.

Easing restrictions on foreign investment is part of a process known as capital account liberalization, which ultimately could lead to the full convertibility of the Chinese yuan.

That investment could help finance Chinese companies and link China to the global economy. But economists warn it also could make the country more susceptible to swings in asset prices because of flows from speculative investors, as happened during the 1997 Asian financial crisis.

Paul W. Speltz, a former U.S. ambassador to the Asian Development Bank, said China’s opening its capital markets will follow the principle expressed in a proverb associated with Deng Xiaoping, the longtime leader who put China on its current economic path: crossing the river by feeling the stones. That is, the government will proceed cautiously and, perhaps more importantly, in strategic fashion.

“Are they going to be identical to U.S. capital markets? I don’t think so,” said Mr. Speltz, who now runs a private sector consultancy and spends about half of each year in the region. “That’s not in their interest.”

A telephone message left with securities regulators in Beijing was not returned.

The development of financial markets, combined with anti-corruption and other measures, is seen as part of government officials’ highly orchestrated plan to put China’s economy on a more sustainable growth path.

Their agenda includes prodding the export- and savings-oriented economy to look more like its consumption-oriented peers in the developed world.

CHALLENGES AHEAD

U.S. fund managers are devouring the chance to access China’s onshore markets. Seven China ETFs were launched in 2014 alone, according to ETF.com, with the KraneShares, Global X, Market Vectors, Deutsche X-trackers and PowerShares brands all promising access to onshore securities, including a class of stocks called A shares.

Among the latest round of products, the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) has been the runaway success, gathering $853 million in assets since its debut in November 2013.

But investing in these targeted funds presents challenges. Each has a different approach to accessing the onshore securities, and some funds are limited in the amount of money they can deploy because they rely on licenses subject to government-imposed quotas.

Also, a quirk in index-construction rules means the U.S.-listed Chinese e-commerce giant Alibaba (BABA) doesn’t show up in many funds tracking China or U.S. tech stocks.

That company, the subject of a much-discussed initial public offering last year, may benefit from a more consumer-oriented China.

Traditional indexes are market-cap-weighted, meaning their exposure to companies is related to their size in the market. In China, that means state-owned enterprises in the financial services sector — not consumer-product makers — receive the heaviest allocations.

“There are a lot of indexes that have shortcomings because it’s a complex market,” said Dennis Hudachek, an analyst at ETF.com. “Some people might say there’s a case to be made for active management.”

Mr. Hudachek said some funds, such as the Deutsche X-trackers Harvest MSCI All China ETF (CN), do offer comprehensive coverage. He said a portfolio without exposure to onshore securities makes about as much sense as investing only in companies listed on the New York Stock Exchange and ignoring those on the Nasdaq.

A HARD SELL

Fidelity Investments is among those U.S. companies exploring active management. Its approach to analyzing stocks in China involves more-exhaustive examinations of companies.

To manage its $1.4 billion Fidelity China Region Fund (FHKCX), the company employs a Shanghai-born analyst with a background in forensic accounting to inspect corporate governance and outside transactions involving company owners and their relatives, according to Robert Bao, the fund’s Hong Kong-based portfolio manager.

“You cannot take anything at face value in China,” said Mr. Bao, who has beaten 97% of his competitors and the Chinese MSCI index benchmark by more than 5 percentage points since taking over the fund in 2011, according to Morningstar Inc. “It makes the work so much more complex.”

No matter how extensive the manager’s due diligence, many investors won’t see the benefits of putting money into China as worth the risk. It’s not always easy to persuade investors to make substantial, long-term allocations to emerging markets. Medium-term returns don’t help make the argument, either. Over the last five years, mutual funds focused on China returned just a fourth of the 16% return of the S&P 500 benchmark.

“When the emerging market’s doing well, everybody wants in, and when the emerging market’s not doing well, then everybody wants out,” said Benjamin H. Woo, a San Francisco-based financial adviser with Morgan Stanley Wealth Management. “As an investor, I would say China from an absolute-return standpoint has not been a good place to be.”

Nonetheless, Mr. Woo is excited about the potential for investing in China and is overweight in his allocation to Chinese equity funds.

Daniele M. Donahoe, president and chief investment officer of Rinehart Wealth Management in Charlotte, N.C., said she sold off Chinese stocks and chose managers who underweighted the region several years ago on concerns that China’s capital markets are insufficiently transparent.

Ms. Donahoe said the country’s appeal has increased as sentiment has turned negative on its economy, making valuations potentially more attractive.

“You’ve seen the broader market just attack China,” she said. “But we haven’t kicked the tires on it because I feel like we still have time.”

But whether investors embrace it or not, the world has fundamentally changed.

Mr. Woo, who moved with his family to the U.S. from China as a teenager in 1987, said attitudes have evolved as that country of 1.3 billion has lifted millions out of poverty.

“Back in the “80s it was just starting — economic reform — and we were still experiencing very difficult, very low living standards, and we were just happy to have meat every other week,” he said. “Now people come study and they tend to go back because they’ve found there’s better opportunity in China.”

But advisers’ attitudes are more ambivalent.

China’s growth is felt worldwide, particularly in commodity-exporting emerging markets. If the slowdown being engineered by Mr. Xi is the soft landing his government promised, global investors will have something to cheer. But for others, the safe haven of the United States is about as much risk as they’re willing to stomach.