HONG KONG - Foreign investors have started rebuilding their China equity portfolios, tempted by low valuations after two years of market underperformance and signs economic growth may be stabilizing.

They have pumped nearly $4 billion into Chinese equity funds in the past two months alone, trying to get in early on what they hope will be a sustained rally.

But sentiment looks to be running ahead of fundamentals. There are clear risk signals for the Chinese market -- including sluggish earnings, rising corporate debt and retail investors looking for other opportunities -- even if the broader economy gathers strength.

"Valuations are attractive and fears of a major slowdown in China seem to be waning, while China still promises growth faster than the rest of the world," says Paul Gillis, professor at Peking University's Guanghua School of Management.

"But most of the problems affecting Chinese stocks -- accounting fraud, the variable interest entity and regulatory stand-offs between the US and China -- have not gone away and still need to be solved."

Illustrating that growth does not translate into equity gains, the MSCI China stock index has fallen more than 40 percent since its launch in 1992. Over the same period, China's nominal GDP has increased by 15 times.

Rebalancing

The shift in foreign investor attitudes is clear.

Bank of America Merrill Lynch's global survey of fund managers, covering 248 managers with $695 billion of assets under management, found confidence in China's economy was at a three-year high.

In October, Chinese shares listed in Hong Kong, known as H-shares and the main gateway for foreign investors into China, jumped 7.6 percent to easily outpace other regional benchmarks.

"I think most fund managers are looking at the fundamental mismatch in their portfolio between their direct exposure to China and the role China plays in the global economy, often very little versus one hell of a lot," said Michael McCormack, executive director at China-focused fund consulting firm Z-Ben Advisors.

"Investors are now trying to rebalance that."

One attraction is valuations. The MSCI China index, the most popular benchmark for China funds, has consistently underperformed Asian markets over the past two years, following a stellar run where it nearly tripled in value between October 2008 and November 2010.

The index trades on a forward price-to-earnings multiple of 9.2, cheaper than Brazil on 9.9 and India on 13.2, and a lure to investors hoping to get in early on another substantial upswing. The H shares are at price-to-book ratios around four times lower than in 2007, according to Thomson Reuters data.

Those valuations and signs the economy is improving -- Thursday's flash PMI reading showed the first expansion in manufacturing in 13 months -- have piqued interest, and it seems investors are worried about missing out on riding the recovery.

Data from fund-flow tracker EPFR Global shows inflows into China equity funds accounted closed in on $4 billion over the 10 weeks to mid-November, and accounted for more than half of the flows in Asia ex-Japan funds in the week to Nov 15.