The Impact of A/H Share/Red Chip Convergence on Corresponding ETFs

Hong Kong SAR Chief Executive Mr. Donald Tsang said in an interview with the Financial Times on 18 June:

There's no reason why stocks listed in Shanghai cannot through some financial instruments be traded in Hong Kong. Similarly, I do not see why Hong Kong stocks cannot be co-listed in the Shanghai stock market through an arbitrage arrangement. We are discussing the mechanics of it.

Mr. Tsang is a very smart politician and he is especially good in gaining trusts from his bosses in Beijing, which is why he could replace Mr. Tung Chee Hua, the past HKSAR Chief Executive, in the middle of Mr. Tung’s tenure.

Mr. Tsang has also been very cautious in delivering messages from Beijing; he would not disclose any plan on change of Chinese policy unless it is 100% confirmed.

As such, I would expect that the new policy leading to price convergence of dual listed shares in Hong Kong and China will be announced very soon.

The convergence has in fact already been started. We see a very strong upward momentum of Hong Kong listed Chinese companies since the Chinese market correction earlier this month. See the chart below comparing SH Composite with HSCEI (Hang Seng China Enterprises Index):

click to enlarge

A Shares in Shanghai or Shenzhen are trading at premium to their H share counterparts listed in Hong Kong. As of 22 June, H shares are discounted by 1.5% to 88%.

If you are holding any funds or ETF with A, H or Red Chip as underlying assets, you shall evaluate such convergence impact immediately.

Three such most common ETFs traded in US and HK are :

1. Morgan Stanley China A-Share Fund (CAF)
2. iShares FTSE/Xinhua China 25 Index (FXI)
3. iShares FTSE/Xinhua A50 China Tracker (2823.HK)

The following is my analysis of the potential impact to these three ETFs:

As the actual market reaction is impossible to predict, I’ve made the following assumptions in my analysis:

Only constituents of each fund which are dual listed in HK and China are considered

Uniform convergence of each dual listed stock

The price gap between H and A share would not be completed closed; for illustration purpose I assumed H shares to go up by 70% (of the gap) and A shares to go down by 30%.

Correlation of H share and Red Chip movement is ignored.

Impact to "A only” shares (i.e., not dual listed as “A” and “H”) is ignored.

Similarly impact to Red Chips is ignored.

In this table I listed the H share discount for all 44 dual listed Chinese shares and the composition break down for CAF, A-50 and FXI, and multiplied the discount and composition percentage to arrive at the potential impact. You can study the impact down to each stock in the table if you are interested.

In summary:

FXI has 39.55% of NAV invested in 10 H-Share companies (out of the 44 dual listed), giving a positive upside potential of 7.7%
CAF has 22.25% of NAV invested in 7 A-Share companies (out of the 44 dual listed), giving a potential downside of 1.8%
A-50 Tracker has 30.3% of NAV invested in 20 Chinese A-Shares Access Product (out of the 44 dual listed), giving a potential downside of 2.2%

Several very important remarks :

1. My assumption of uniform price correction to all dual listed stocks is for simplicity only. I expect high quality H shares would experience a stronger re-valuation, so buying those shares with heaviest H discounts would not guarantee you profits.
2. As Red Chips will be returning home to list as A share in China too, we can anticipate a similar re-valuation of those Red Chips, which is beneficial to FXI (or other funds or indices with strong Red Chip exposure) as it holds several high quality Red Chips such as China Mobile (CHL) and CITIC Pacific (CTCPF.PK).

What is my investment strategy to profit from this trend?

I have bought HSCEI index products, on top I have overweighed several selected H shares and Red Chips as potential profit enhancers.

Comments

[James:]

Fantastic article - great view and even better content. It never amazes me how hard you guys work with your research and statistical content you include.

I am based in Shanghai and trade A shares with my chinese girlfriend. I just wanted to add some of my views that maybe some of you may find helpful. For the past 20 sessions in the shanghai A share market, volume has been drying up significantly day by day. A lot of big players have pulled out of the market, I can also give first hand information that a very significant amount of investors have taken out considerable amount of their winnings and put it into property.

There is now a sever liquidity shortage in the market and this is the main reason for the increase in volatility. I can tell you that if I had a big trading account that there is so little liquidity it would be very easy to move the market without much trouble. Having day traded Bund for a number of years I would go as far as to say that there is almost no ''paper'' in the market what so ever. It is for this reason that you are seeing H Share/Shanghai price convergence more from aspect of shanghai falling/Hong Kong holding its ground. For those who are playing convergence trade from buying hshares etc - I believe things will get very rosy shortly. The shanghai market needs to fall a little more. Then there should be a relief rally in shanghai that will act as catalyst to appreciation in our hshare freinds. They should overperform quite strongly especially coming into QDII implementation July 5th. Mainly in my opinion through perception as apposed to increased flow. I have been long China Telecom for a while as I am playing the trade slightly different and using other factors in my favour. ie manipulation of price of China Telecom in hong kong to assist in the IPO in shanghai. Something that the chinese government/china telecom and banks (especially our under writing friends) are all going to be involved in. I think China Telecom shares are appealing to short term/long term investors as well. I am considering selling the position night before ipo in shanghai but keeping my options open as i think in 10 years this is a 200hk dollars or should i say 200rmb stock. their earning potential is very very high - but thats another story.


Anyway predicting this liquidity change over into housing this 2 months ago we purchased a brand new appartment. I could already see the early birds were following my thoughts. In all I visited 30 developments in 8 days. I can tell you that the developments were all very very busy. Infact it was very obvious that the old real estate days were returning.
And why not shanghai real estate is disgustingly undervalued. Another story....

Anyway I also advised a number of foreign investors to buy property and as a result found myself re-visiting the 30 developments over the course of the last month. Imagine what the trading pit looks like when its very busy. Well thats what I experienced at almost every development inthe past month. Every single property at all developments sold out in this time. I am not over estimating either. Every last property. The liquidity flowed from the stock market straight into real estate in a very obvious way. 80% of my chinese trading friends have bought properties in the last month. Its quite amazing, the chinese people when it come to this sort of thing are a lot smarter than people give them credit for. Especially financial press. Anyway now there is a situation that there is hardly any property in the inner ring in shanghai. So much so that now the secondhand market is very strong. It has been two years of pain for real estate agents. But now they are starting to get busy again.

Index Futures Shanghai Market:

I am not sure if western news is aware but index futures to trade shanghai 300 have been approved.
The date is not set in stone but there has now been formal acceptance that futures will begin to trade. There is division within government when to allow them to start trading. Bascially there are a few concerns - of course one is the obvious arbitrage situation that will result. Imagine being short indexes and buying main constituents in Hshare market. Also there is worry that everyone will start to trade the market intead of buyin stock. At 300rmb/point with current levels of volatility a lot of poor people will get destroyed. Having traded Dow + Dax I know its a very hard game. Also the government is not so happy that for the first time there will be leverage. The lack of leverage to date in China is of course the main reason there has not been a huge amounbt of vicitms.
Anyway the system is in place and has been tested by virtual trading for quite some time now.

This adds a new layer to the cake of financial integration between Hong Kong and China. And to future trade opportunities. I thought I would point it out. I think there is a bit of an attempt to keep it quiet.

Anyway hope this helps....I would like to finally add it is not too late to buy investment property in Shanghai or for that matter China....

2007 Jun 29 09:09 AM

[TIGER1:]

Excellent analysis James. Did someone try to buy some call options on the HSCEI?

2007 Jul 10 03:52 AM

[rbtzhang:]

great info, James

2007 Jun 29 05:23 PM