The uncertainties regarding the sovereign debt crisis in Europe has many investors shifting their focus from the region to strong and stable Asian markets (read Southeast Asia ETF Investing 101). These markets have long fascinated domestic as well as foreign investors from all around the globe, thanks to their lower correlation levels and the ability of some small regions to act as safer ways to play huge emerging markets in Southeast Asia and the Pacific Rim.

One such economy that is often seen as a much safer way to access mainland China is that of Hong Kong. The city has maintained its strong economic system and freedoms despite now being a special administrative region of the People’s Republic.

Hong Kong economy

In fact, not only is Hong Kong easily one of the freest regions from an economic perspective in the region, but the world as well. A recent study showed that the economy, on a scale of 100, achieved an economic freedom score of 89.9 the best in the world.

Yet despite these freedoms and the favorable business climate, the economy of Hong Kong has been slowing down. As per government data, there has been a substantial reduction in its GDP number. The economy grew just by a mere 0.4% for the first quarter of 2012 on a year-on-year basis. This is a drastic change from a growth rate of 3% in the last quarter of fiscal 2011.

The main reason for this weak growth is the reduced export of goods and services. The economy has been hit hard by reduced consumption demand from the debt plagued Euro zone (see Spanish Bailout: Did It Help European ETFs?). While consumption expenditure, government spending, investment and capital formation continue to boost the economy, exports of goods shrank by 5.7% for 1Q12 on a year-on-year basis. Likewise, imports of goods were also reduced by 2.7% for the same period.

Stock Market performance

Fiscal 2012 started on a good note for stock markets worldwide. Strong economic cues from the U.S and the Euro zone posted gains for the broader Asian markets in the January to March 2012 quarter. The Greek bailout package earlier this year and the better than expected U.S GDP number were some of the major factors responsible for the positive market sentiments.

However, the Asian markets failed to extend their gain further. The Japanese index Nikkei, South Korean index Kospi, Indian Sensex and the Hong Kong index Hang Seng slumped on account of global risk aversion caused by the negative market sentiments.

In Hong Kong, Financials (HSI-Finance), Real estate (HSI-Properties) and the Commerce and Industry (HSI- Commerce and Industry) sub indexes were hit the most and have witnessed massive corrections in their valuations. However, the Utilities sub index managed to outpace its rivals, doing better than most as a safe haven alternative (see Comprehensive Guide to Utility ETF Investing).

While the current valuations may seem attractive at this point of time, there are some major risks to consider. As a major export-driven economy, Hong Kong is largely dependent on demand from its trade partners and for its many financial services, especially from China.

If the panic in the euro zone continues, the economy could witness a further slowdown on account of weak exports. Moreover, negative sentiments and safe haven bias may further result in Asian markets extending their losses and could cause some Western investors to pull their capital out of Asia and redeploy it back on the home front (read Real Estate ETFs: Unexpected Safe Haven).

For investors worried by this outlook but still desire some exposure to the greater China region, a play on a Hong Kong ETF could be the way to go. These funds make for a cost effective and flexible investment option and help to spread the risk around a number of stocks.

For these investors, we have highlighted a bit about each of the three funds in this space below:

iShares MSCI Hong Kong Index (EWH) is the biggest and most liquid option for investors looking to get broad exposure in the Hong Kong equity market. It has total assets of around $1.55 billion and approximately 4.37 million of its shares are traded each day in the U.S markets.

EWH tracks the MSCI Hong Kong Index which measures the performance of the broader Hong Kong equity markets. The ETF holds 43 securities in total and is extremely concentrated in its top 10 holdings with 55.77% of its total assets allocated to these firms.

AIA Group Ltd is its most favored company with 12.11% allocation. However, the ETF has slumped 11.20% in the last one year, mainly thanks to its 60.75% allocation towards the financial sector.

Investor appetites decrease substantially in the financial sector in times of economic downtrend and its financial sector has been one of the worst performing sectors in the Hong Kong equity market. The ETF had posted gains of 12.80% for the January-March quarter, though on account of the downtrend it was only able to generate 2.21% gains in year-to-date terms.

The ETF charges 58 basis points in fees and expenses and pays out a decent dividend yield of 2.58%. This can be a good option for income-seeking investors, especially at a time when the interest rates on fixed income securities are extremely low.

Launched in January of 2012, the iShares MSCI Hong Kong Small Cap (EWHS) is another offering by iShares to play the Hong Kong market. EWHS offers a pure play in the small cap equity segment and tracks the MSCI Hong Kong Small Cap Index. The index measures the performance of the bottom 15% companies in terms of market capitalization in the Hong Kong equity market.

Since inception, the ETF has returned 1.75% and managed $4.94 million in its asset base. It charges 59 basis points in fees and expenses and has an average daily volume of 1,472 shares.

EWHS presently consists of 63 stocks with 42.88% allocated in its top 10 holdings. In terms of sector holdings, it is largely dependent on the Consumer Discretionary sector, with more than 41% towards the segment. Financials, Information Technology and Industrials are some other sectors allotted double digit holdings.

Small cap stocks are known to be more sensitive to market trends than their more stable large cap counterparts. As a result, they tend to move more than the broader markets. Therefore investors would be better off in avoiding a small cap exposure at such times when the markets are turning south.

The newest addition to the Hong Kong ETF space, the First Trust Hong Kong AlphaDEX (FHK) was launched in February of 2012. However, the ETF has had trouble building up assets as indicated by its $2.84 million of assets under its management and an average daily volume of just 963 shares.

The new fund tracks the Defined Hong Kong Index which selects stocks which are perceived to generate a positive ‘Alpha’ relative to the broader markets, based on various fundamental and growth factors. FKH provides exposure across the entire spectrum of market capitalization with a bias towards large cap stocks.

The ETF holds 42 stocks currently and allocates 42.09% of its total assets in the top 10 holdings. As far as sector exposure is concerned, it lays maximum emphasis on Financials (47.78%), Consumer Discretionary (22.67%) and Industrials (14.35%).

The ETF came out at a bad time and thus missed much of the run-up in the first part of the year. This has led the fund to produce a loss of almost 9.4% since inception in February.

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Zacks Investment Research