The High Ground in China's IPO Flood

The second half of 2009 promises to be profitable for ETF investors who play China.

Following an 8-month break in new stock issues ― the sixth such pause since 1994 ― 33 IPOs will hit the mainland exchanges in Shanghai and Shenzhen between now and August.

That's over 1.86 billion fresh shares about to get dumped on top of a rallying market. Understandably, some local stocks investors fear the IPO flood may "short circuit" the run up.

But the move to re-introduce new share sales looks like a net positive for the health of China's equity markets, stoking new participation and easier access to liquidity for deserving companies.

So, let's ride the IPO shock downtrend with a combination of emerging market shorts, inverse ETFs, and options. . .

Then buy back into the upswing after the new issues settle and local sotcks investors get roaring again!

Here's the angle.

"A Welcome Development"

Instead of giving priority to institutions like banks and pension funds, regulators have decided to offer retail stocks investors first crack at the Summer '09 crop of IPOs.

There will be some growing pains in the process of introducing such a huge change, of course. . .

Above all worries, an IPO onslaught could dial back the nearly 50% upswing in A-shares (as opposed to Hong Kong-traded H-shares) we've seen so far in 2009 for Morgan Stanley's China ETF (NYSE: CAF).

Those fears have led to a moderate sell off in A-shares, even with a half-trillion dollar stimulus package buttressing optimism about 2009-2010 earnings.

Are sellers way off base? Not necessarily.

The local head of JP Morgan's equity strategy unit Jing Ulrich says, "Concerns that the new offerings will divert funds from the secondary market are legitimate."

But Ulrich also called the IPO resumption "a welcome development, considering the attention paid to market-oriented pricing and small stocks investor participation."

The short-term shock should lead to medium- and long-term benefits.

Why not exploit both trends as they unfold?

Playing the Downside and the Upside Too

The Morgan Stanley China A Share Fund (NYSE:CAF) has gained more than 54% in the past six months. Even though the Dow has pulled up since early March, CAF has doubled the blue chip index's success.



A-shares also outperformed H-shares over that same period, as we see when we look at NYSE:FXI, the iShares FTSE/Xinhua China 25 ETF, in the same chart above.

The difference in China-based share varieties is important: H-shares can be bought directly by foreigners, A-shares can't.

So, on one hand, FXI didn't enjoy the same upward momentum as CAF did from February through April. But on the other hand, FXI isn't being hurt by mainland uncertainty ahead of the IPO deluge.

CAF is the one to short, while the FXI's inverse ETF ― FXP ― offers an easy option for going against the less-volatile H-share index.

As the IPOs soak in, you'll want to reverse those positions and go long again.

By September, it will be time to buy FXI again as Chinese shares tick back up.