Hang on tight if you ride on the rooster's back

Chinese and Indian markets offer rapid growth and the potential for high returns. But, as Simon Hildrey discovers, the 21st-century Spice Route is not a sure path to riches

They've got it all - exoticism, volatility, highly charged political risk and the promise of stellar growth.

They've got it all - exoticism, volatility, highly charged political risk and the promise of stellar growth.

That, at least, is the popular perception of China and India among investors eager to spice up their existing portfolio.

As we approach the season for individual savings accounts (ISAs) ahead of the tax year-end on 5 April, there will be many people seeking to place part of their annual £7,000 allowance in high-risk equity funds who turn their eyes to the East.

The lavish celebrations for the new Chinese Year of the Rooster, which began last Wednesday, will have given investors a taste of what to expect if they buy into Eastern companies.

Recent growth in both India and China offers a compelling case for the long-term investment prospects of these regions. China's economy swelled by 9.5 per cent last year, and that of India by 8.2 per cent.

Add to that these countries' vast populations (there are 1.1 billion Indians and 1.4 billion Chinese) and the phenomenal potential for consumer demand is obvious.

However, still greater opportunities exist in these countries for foreign investors. As the workshops of the world, China and India now provide cut-price labour and services for thousands of overseas companies - notably manufacturing in the former and call centres in the latter. Not surprisingly, foreign direct investment in China has rocketed in recent years, last year topping $60bn (£32.3bn).

But a report from the investment bank Goldman Sachs suggests it is India that has the potential to show the fastest growth of the two countries, and so wield greater influence over the world economy. In fact, India's contribution to global demand growth could overtake that of China within fewer than 15 years.

The report adds that the country's economy could exceed Japan's by 2032, while China's could be larger than the US economy by the year 2041.

This all adds up to a mouth-watering long-term investment case - if you are prepared to adopt a higher-risk outlook. And this is where a heavy dose of caution needs to be injected.

Independent financial advisers (IFAs) are circumspect about the opportunities for investors, warning that China and India both have potentially volatile political and social climates that could stymie growth.

"No one knows whether economic growth can be sustained," says Patrick Connolly of IFA John Scott & Partners.

It is worth emphasising, too, that while they are often lumped together by investors, these two emerging powers have very different economies and political and social systems. China's development has been built on a cheap manufacturing base; India's by relying on its service sector. In both cases, much will depend on the creation of jobs to match rapidly rising populations.

There is also a question mark over whether India's caste system will hold back economic development, and over political stability in China.

"China is not a democracy but has a clear view on how to generate economic growth," says Hugh Young, manager of the Aberdeen Asia Pacific and Far East Emerging Economies funds. "India is a democracy but its economic growth tends to be two steps forward and one back."

The stock markets in each country work differently, too. Mr Young points out that most of the companies listed in China are part of state enterprises and "not usually run in the interests of individual and foreign shareholders". This raises issues of transparency and corporate governance, he says.

The Chinese stock market is relatively expensive, with high share valuations.

In comparison, India has a broad-based stock market, with subsidiaries of FTSE companies such as Uni-lever, GlaxoSmithKline, ICI and Cadbury Schweppes all listed.

"Share valuations are more attractive than China too," Mr Young adds. But at the same time, he warns of corruption in both countries, which might destabilise business and political decisions.

It all adds up to a roller-coaster ride for your money. "The one certainty is that there will be volatility," Mr Connolly stresses.

A glance at indices that reflect performance in these regions highlights this concern. Despite sturdy economic growth, the S&P/Citi BMI China index fell by 4.3 per cent in the 12 months to 7 February this year. Yet, over three years, the same index has leapt by 40.9 per cent, and it has more than doubled over the past five years.

By contrast, the equivalent index for India has roared ahead by a fifth in the past year, nearly doubled over three years but inched ahead by just 2.7 per cent over five.

"Our clients, particularly the older ones, want predictable returns," says Adrian Shandley of IFA Premier Wealth Management. "By choosing to invest in China and India, you bring much greater risk into the equation."

Younger investors might want to place a small portion of their portfolio in these countries, he says, but when advising older investors, he tends to steer clear of Asia in general.

If you want to add spice to your portfolio by putting money into a fund that invests directly in China or India, there aren't too many options available. The few that are include the Gartmore China Opportunities and First State Greater China Growth funds, the JPMF Indian investment trust and the Solus Eastern Enterprise fund.

Alternatively, you could consider a fund that spreads risk by investing across different Asian countries. The IFA John Scott & Partners uses mainstream funds such as Atlantis Asian Opportunities for its clients.

In a typical individual portfolio, around 4 per cent of the fund might be invested in Asia. More aggressive portfolios might hold up to 7.5 per cent.