How to use ETFs to play a China crash

If you're sceptical about China's ability to sustain double-digit growth rates in the face of a global slow-down, you're in good company. Hedge-fund investors Jim Chanos and Hugh Hendry, Edward Chancellor of US asset manager GMO and Harvard professor Kenneth Rogoff have all warned of a possible crash. And there are clear signs of the Chinese stockmarket faltering after a solid rally in 2009.

So if you are convinced China has further to fall, what's the best way to play it? There are two ways to create short market exposure with ETFs in order to profit from a market downturn. You can either short-sell the 'long' version of a fund, or you can buy an 'inverse' ETF that does the shorting for you. Each approach has its pros and cons. Short selling yourself means operating a margin account with your broker and being prepared to pay over cash if a position moves against you. Using a 'stop' to pro-tect yourself against potentially unlimited losses is vital.

Inverse ETFs on the other hand, cap your potential losses. But because of the way they work (with daily rebalancing) they will suffer some performance divergence from the expected return if you are holding them for more than a day.

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There are no inverse ETFs available in Europe on 'pure' China equity indices, so you'll have to short sell yourself if you want to take a bearish view. The obvious choice here is the iShares FTSE Xinhua China 25 ETF (LSE: IQQC). This includes a healthy proportion of Chinese state-owned enterprises, particularly financials, that might be expected to get into trouble if China hits a brick wall. Although short selling ETFs isn't yet as easy in Europe as in America, it's worth asking your broker if you can short a particular fund when it's not available.

If you'd prefer to use an inverse ETF, two options come to mind. The db x-trackers HSI short daily ETF (LSE: XHSD) offers exposure to the inverse daily performance of Hong Kong's Hang Seng index, a benchmark that has historically been pretty well correlated to other China share indices. Or db x-trackers' Stoxx 600 Basic Resources short daily ETF (LSE: XBRS) gives you inverse exposure to the daily performance of many large commodity producers, whose share price has been intimately linked to China's economy.