"China has been the world's growth story," exclaims noted Princeton University economist Burton Malkiel. "Its rate of expansion over the last 20 years has been unprecedented. No country in modern times has grown at anything like this-not South Korea, not Japan, not the U.S."

For Malkiel, China has been a game-changer. It has not only focused his attention on the other side of the globe, where it is kick-starting markets that do business with it, but China has also prompted this most committed passive investor to reconsider how he sees the world.

Author of the venerable tome A Random Walk Down Wall Street, and co-author of From Wall Street to the Great Wall and The Elements of Investing, Malkiel has long been critical of active portfolio managers and analysts, proclaiming that a blindfolded chimpanzee throwing darts at The Wall Street Journal could select a portfolio that would do as well as the experts.

This led him early on to profess the superiority of low-cost broad market index funds over active management. But China and the gathering strength of emerging markets have challenged Malkiel's belief that market-cap weighting alone is the best way to skin a market.

Something Different
In fact, he is making a decisive turn toward a more active strategy himself in the model portfolio he suggests for a 40-something family bread earner. Sanguine about the future, he's recommending 80% exposure to stocks, with half of that in foreign companies. That's not too far off the non-U.S. global weighting of 56.14% in the MSCI All Country World Index. But Malkiel does goes off the path of simple market-cap weightings with his 25% exposure to both the MSCI EAFE index (which includes the developed world, without the U.S. and Canada) and to emerging markets. MSCI EAFE represents 41% of the global market cap. MSCI emerging markets make up less than 13%.

To Malkiel, this major adjustment is simply his acknowledgement of the new economic order. He doesn't believe Europe and Japan-the key components of EAFE-will see significant growth in the coming years. He believes emerging markets will be driving global economic expansion, and that long-term investors will be best served by a significant exposure to places like Brazil, India and China.

While he continues to teach at Princeton, Malkiel also works as the chief investment officer of the Chinese fund advisory AlphaShares. This company has crafted a series of indices that capture specific Chinese sectors such as infrastructure, consumer products and technology, as well as broader swatches of the market. ETFs now track several of these indices: a real estate index (whose ETF ticker is TAO), an all-cap index (YAO) and a small-cap index (HAO).

The firm also has developed a unique set of private, actively managed funds as well. To access China from the ostensibly safer shores of more established markets, Malkiel created a China-linked fund that invests in non-Chinese firms benefiting from the mainland's growth. Another portfolio, the Enhanced Index (Red Dragon) Fund, bets that broad-market returns can be improved by overweighting small-cap and value stocks. And the firm's AlphaShares' Buy-Write (Green Dragon) Fund tries to exploit Chinese equity volatility by investing in the highly liquid FTSE Xinhua 25 Index and writing options against it to pick up premium income.

So with so many active, discretionary plays, is Malkiel changing his stripes? If not, his stripes certainly don't appear in the same pattern they used to. His funds are making an argument that shrewd market observers can indeed outperform traditional indices, especially when markets aren't completely transparent or efficient.

By shifting from developed to emerging markets, he explains, "my portfolio strategy remains passive; I'm not picking stocks. But I am adjusting for economic realities which go beyond market capitalization."

Moreover, he emphasizes that it takes active management to accurately capture the Chinese market, which is fractured into mainland share classes, Hong Kong shares and foreign-based shares (for example, ADRs). This trifurcated offering keeps indices from capturing the true dimensions of China's market capitalization by focusing only on the limited free float.

He also contends that the Chinese government's currency policy of fixing the yuan to the U.S. dollar has kept its currency artificially cheap, distorting the valuation of ordinary shares. What investors must do, he says, is start with China's GDP (as a way to initially weight the country) then adjust that percent upwards by factoring in the country's artificially weak currency to more accurately capture the country's value in the global economy. When taking these factors into account, he finds that the proper Chinese equity exposure in a global portfolio is between 6% and 12%. And yet the country currently represents only 2.25% of the MSCI All Country World Index.

Performance And Risks
Malkiel squares his actively managed products with his long-term embrace of passive investing by again citing the inherent inefficiencies in the way the Chinese market functions and is tracked. Profiting from the mainland's vitality, Malkiel says, means capturing Chinese growth from the safety of more evolved and transparent offshore markets. It also means focusing on cheaper, faster growing companies and exploiting the high volatility of Chinese stocks.

Like China itself, the AlphaShares' funds initial two-year results have been volatile. The Real Estate ETF lost 57% in 2008, but then soared 81% in 2009. The Small-Cap ETF  appreciated 55.6% in 2008 and then doubled in 2009. The All-Cap ETF came to market last November and is off 6% in its first three months of trading.

Last year, Malkiel's China-linked fund, which started in late 2007, soared by 51.47% after collapsing by 47.15% in 2008. The Buy-Write strategy started in April 2009, ending the year up by more than 39%. The Enhanced China Fund was off 8.65% during its first month of trading in January 2010.

Counterpoint
Not everyone is so certain about China, and some are downright bearish-none more so than James S. Chanos, manager of the hedge fund Kynikos Associates, who has made some incredibly prescient short calls in the past, including those on Enron and Tyco International.

Chanos is troubled by the Chinese government's hyper-stimulation of its economy (through its implementation of one of the world's most aggressive stimulus packages). He's worried that China has created excess goods and services that may find no buyers.  He's concerned by the soaring credit and rising amount of bad loans in the country. Furthermore, he believes deep government reserves can perpetuate dangerous economic imbalances, and he likens China's real estate bubble to Dubai on steroids.

Bubbles are created when asset prices continuously inflate without correcting. And according to Tony James, president of the alternative asset manager Blackstone, Chinese corporate securities are on such a trajectory. He now thinks that India offers "some very attractive growth [opportunities] similar to China, but with not nearly as high of multiples."

David Shambaugh, the director of the China policy program at George Washington University, sees Chinese economic policy as schizophrenic. One moment, the country is opening markets and enforcing more transparent behavior, but in the next it is cracking down at home and lashing out abroad. Political reforms have also stalled.

Shambaugh, also a senior Fulbright visiting research scholar at the China Academy of Social Sciences Institute of World Economics & Politics in Beijing, sees in China "a deteriorating foreign business climate, with multinationals complaining of a host of new operating constraints and protectionist measures."

If economic success is leading the country to more open, enlightened behavior, Shambaugh doesn't appear convinced that it has stuck. He is troubled by the leadership's regular anachronistic parade of advanced weaponry, its censorship of President Obama during his recent visit, its harsh treatment of dissidents, its unhelpful posture in climate control discussions in Copenhagen, its inadequate help in curbing the Iranian pursuit of nuclear arms, its open fight with Google and, finally, its reliance on a dollar-linked currency, which has unfairly tilted global trade in its favor. This is fueling adoption of retaliatory trade tariffs and anti-dumping duties between the U.S. and China. According to Shambaugh, Chinese relations with the European Union, India and even Russia are suffering as well.

Does any of this worry Malkiel?
"Certainly," he says. "In terms of asset prices, when anything grows fast, bubbles occur." But China has had real estate bubbles in the past, he adds. "The country is going through intense urbanization, and I think that real estate bubbles are more likely to be temporary as migration and increasing wealth catches up with where jobs are being created."

China has also known banking crises. Since many borrowers and banks are partially state-owned, officials have simply forced banks to keep lending to financially broken companies rather than restructure or close them, which would throw thousands of people out of work.

This sends the number of nonperforming loans soaring. When banks' balance sheets deteriorate, the government does what governments all over the world do: They bail out their banks without necessarily addressing the underlying problems. The Chinese government can do this because the costs, relative to GDP, are small. "The Chinese are, however, slowly shutting down the poorest state-owned businesses," Malkiel notes.

The Princeton professor does question the smoothness of the Chinese economy's high annual growth rate of nearly 10%. He cites anecdotal contradictions: a disconnect between automobile production and gasoline sales, and another between power generation and GDP growth. And there is competition among local governments to meet imposed growth goals-so much so that it's doubtful the results always are what these governments say they are. "But even if one doesn't completely trust the numbers," says Malkiel, "visiting Shanghai every year tells you that something quite real is happening."

He thinks Beijing has to alter its export-led growth policies for both geopolitical and economic reasons. China's trading partners are waking up to the internal costs they're paying for such trade imbalances. China could have the largest consumer market in the world, Malkiel says. But consumption has been stuck at under 40% of GDP for the past decade. In the U.S., the ratio is about 70%.

Consumer demand in China is so low because there are virtually no government safety nets. Workers need to save. And the one-child policy makes it very difficult for children to adequately care for their parents.

What worries Malkiel most is the divide between the haves and the have-nots. "There are seismic income gaps in China, especially between the affluent east and the impoverished central and western regions."  This has already led to unrest, and the potential for instability is great. "But this is why the government is developing infrastructure, education and a nascent social safety net," observes Malkiel.

As for China's future, Malkiel thinks columnist Thomas Friedman of The New York Times said it best: If you think education, hard work and the worth derived from human capital will determine who the big winners are in the coming century, don't be so quick to sell China short.

"Even if we are in a bubble now," says Malkiel, "the Chinese economy will not collapse. It will correct, and then restart because of the strength of the underlying story."