This content is from: Portfolio

Shanghai–Hong Kong Connect Will Remove Valuation Gap Between Markets

As a new program prepares to go live, expect cross-border trading and arbitrage activity to eliminate the valuation gap between H and A shares.

There has been incredible global interest in the Shanghai–Hong Kong Stock Connect program, which is due to launch next Monday, November 17. Stock Connect will allow mainland investors to buy Hong Kong–listed equities directly and waive the need for investment licenses for global investment funds looking to trade mainland shares. The program will accelerate cross-border investment flows and help valuation converge between mainland-listed China A shares and Chinese companies’ internationally traded H shares, which are listed in Hong Kong.

The pace at which China liberalizes cross-border equity investment will keep surprising the market on the upside. In addition to the new Shanghai–Hong Kong link, there will be expansion of existing quota systems for cross-border investment, such as the Qualified Foreign Institutional Investor (QFII) program, which gives foreign investors access to mainland shares, and the Qualified Domestic Institutional Investor (QDII) program, which enables Chinese funds to invest globally. These initiatives will eventually eliminate the difference in valuations between A and H shares, although arbitrage trading at the outset of the Stock Connect program could cause a short-term spike in volatility. The new program may also pave the way for the inclusion of A shares in such global benchmarks as the MSCI indexes as well as similar products from the FTSE arm of the London Stock Exchange Group and from S&P Dow Jones Indices.

Prices between the two share classes have already started to converge. Since Stock Connect was announced in April, the valuation premium that H shares have enjoyed relative to A shares has narrowed considerably. Since September, sell-side analysts have been covering A share companies. In July and August the two largest A share exchange-traded funds saw $2.7 billion in inflows, according to Lipper. A share blue-chip companies without a Hong Kong listing stand to be the biggest beneficiaries of the new program.

Our analysis at Nasdaq Hong Kong suggests that in Stock Connect’s early days, global investors will do arbitrage trades according to three key strategies. One is to go long on discounted A shares and short their dual-listed H share counterparts. Another option would be to hedge between popular sectors in either market: Gaming and TMT (technology, media and telecoms) stocks in Hong Kong, for example, and autos, defense and renewable energy in Shanghai. A third play would focus on high-dividend-yield companies.

In the near term, southbound (mainland China to Hong Kong) trading may lag behind northbound (from Hong Kong to the mainland). With the gradual merger of the investor base across listings, we should see the liquidity premium start to fall. Over the long term, with the program covering more stocks and the Shenzhen Stock Exchange, northbound and southbound trading should start to sync up.

A hurdle facing Stock Connect is mainland China retail investors’ unfamiliarity with Hong Kong stock market regulations. Also, the weak performance of foreign investment returns from QDII funds may cast doubt on the enthusiasm for southbound trading. Demand for QDII funds dropped in 2014, suggesting that mainland investors are not as interested in Stock Connect as regulators or the media might expect. By contrast, QFII-approved funds have been increasing sharply over the past two to three years.

For finance heads and their investor relation teams, they should focus on the changes in their shareholder bases as well as understand the short- and long-term variables because of the differences in trading behaviors. Understanding Stock Connect’s potential impact is of utmost importance. Companies that want to ensure their success in this new trading environment need to reach out to current investors, target new ones and be prepared for shareholder migration.

Esther Luo is the head of advisory services, greater China, for Nasdaq in Hong Kong.

Get more on emerging markets and equities.

Related Content