Qualified Foreign Institutional Investor (QFII) funds delivered an average return of 123.54% in 2007, according to Lipper data.

Although the QFII funds turned in a stellar performance on-average, the consensus performance was still below gains achieved by a key benchmark index in China and local fund managers. The CSI 300 index, which tracks the performance of the 300 most active stocks in the yuan-denominated A-share markets in Shenzhen and Shanghai, posted a return of 161.55%. Equity funds managed by local fund management houses delivered a return of 137.66%.

LipperÆs head of China research in Shanghai, Zhou Liang, says sentiment towards QFII funds changed in the course of the past year. Up to the end of November, a total of $2.2 billion in investments exited these QFII funds, reflecting a worrying level of cautiousness among international investors towards the China A-share market after a banner year in 2007, he says.

However, Zhou notes itÆs the B-shares û a long-ignored class of mainland Chinese stocks denominated in G3 currencies û that have surprisingly taken over A-shares as the best performing market in the world in 2007. The B-shares market posted a gain of 181.23% in 2007, much higher than the A-shares marketÆs 137.66% rise.

Amid the stock mania in 2007, the country saw an explosion of assets inflow from retail investors. A total of 2.6 million of new mutual fund accounts were set up last year, while total assets managed by ChinaÆs 62 fund houses tripled, reaching Rmb3 trillion ($413 billion) by end-December.

However, the QFII fund universe is still rapidly expanding, especially in a period that follows the two rounds of strategic economic dialogue between China and United States, in which US Treasury Secretary Hank Paulson was said to have urged China to open up further for foreign investments. Indeed, the total QFII quota was raised to $30 billion from $10 billion by the State Administration of Foreign Exchange in late November.

Currently, there are 20 QFII funds investing $8.18 billion in China. Newcomers in 2007 include W.I.S.E CSI 300 Tracker Fund by BOCI-Prudential, PCA China Dragon A-share Fund, HSBC China Dragon Fund, Lyxor China A Fund, and Shenyin Wanguo-Aizawa China A-Share Fund.

Among these investments, the Morgan Stanley China A-share Fund managed by investment manager James Cheng in Singapore, has most consistently outperformed the others. It was the top performing fund last year, delivering a 174.38% return over the 12-month period. Another clear winner is FortisÆ FLEXIFUND Equity China A, which has gained 530.76% over the past three years.

Zhou believes ChinaÆs outlook is uncertain. For 2008, he advises fund investors to shift allocations from A-shares towards QDII-centric H-share investments in Hong Kong.

He is concerned by the fast rising inflation in China and the renminbi and their impact on the price advantage that ChinaÆs exporters have long enjoyed, which may gradually dissolve over the course of the year.