When Shanghai and Hong Kong first opened their stock markets to each other late in 2014, one hedge fund launched just to arbitrage the different valuations the two markets offered on the same companies.
Eighteen months on, that fund has closed and the valuation gap has widened. Yet even as worries grow over how China will balance growth with its need to work out its still-growing pile of debt, investors and index providers believe interest in trading Chinese stocks in Hong Kong and on the mainland is greater than ever — so much so that the first exchange-traded fund just launched offering a similar arbitrage as the failed fund.
Two looming developments could bring a little more reality to what is still largely a theoretical opportunity since by most estimates foreigners hold just 2 per cent of China’s vast stock markets.
Last month MSCI revealed a road map for including mainland-listed companies in its benchmark emerging markets indices. A straw poll of analysts suggests they think the chances are rising that the index provider will indeed go ahead when it concludes its consultation in early June.
Also in the coming weeks, authorities are expected to confirm the inauguration of a direct link between the Hong Kong and Shenzhen bourses, expanding the companies available via the “Stock Connect” that joined Shanghai and the former British colony in November 2014 and provided international investors with their first direct access to mainland stocks.
Making it easier for investors to access, and exit, mainland markets is key to China’s inclusion in internationally followed benchmarks.
“It’s no longer a question of if, but of when and how,” says Mark Makepeace, head of FTSE Russell.
The index provider last year introduced a series of “transition” indices that include a gradually increasing weighting to mainland stocks to allow index-tracking investors to adjust their China exposure at their own pace. Currently China A-shares account for 5.9 per cent of those indices.
Underlining the opportunity — or risk — of China, if mainland-listed stocks were fully included in its benchmarks tomorrow, China would make up 27.6 per cent of FTSE’s emerging market index based on the investment quotas granted to foreigners.
Assume those are lifted, and it would jump to 36 per cent. For MSCI, if China were fully included, mainland companies, together with US-listed Chinese groups such as Alibaba, would account for 40 per cent of its benchmark emerging market index — tracked by up to $1.5tn of funds.
Combined, Shanghai and Shenzhen have a market capitalisation of almost $7tn, second only to New York, and in spite of last year’s rout still comfortably ahead of Tokyo’s $5tn. The opening-up of China’s equity market can only be described as a once-in-a-lifetime opportunity — or risk.
“China is still very much considered a market you buy or sell on the macro view. But we believe that over time will change,” says Marco Montanari, Asia-Pacific head of Deutsche Bank’s passive asset management unit, which is setting up a series of China-focused funds including the arbitrage one. To give it its full name, the fund is called the DB x-trackers Harvest FTSE China A-H 50 Index ETF. It follows the 50 biggest companies in China, but allows the fund to choose either the A or the H share.
When Shanghai and Hong Kong opened their Stock Connect, mainland A shares and Hong Kong-listed H shares were trading at roughly the same prices. Now, according to the Hang Seng’s A-H Premium index, A shares are 30 per cent more expensive. Bring in valuations and the gap widens further: China’s CSI 300 trades on 13 times expected earnings, Hang Seng’s China Enterprises Index, made up of H shares, on just 7 times.
Mr Montanari adds: “Investors will need to be exposed to China in some amount as from being a tactical play, it becomes a strategic one. And that is why we’re focusing our efforts here.”
He is right that China is becoming strategic, even if the valuation gap suggests there will be no stampede when the Shenzhen link opens or if MSCI changes its rules. But each of those moves, and each new fund launch, brings China one step closer to international investors. Now if only every tactical thinker could figure out what strategy to apply.