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It's safe to say that China's stock market is unique. Because of capital controls on foreign investment and limits on the ability of its domestic investors to invest outside the country, the market is very isolated.

In an effort to attract foreign investment, many companies domiciled in mainland China list shares on the Hong Kong Stock Exchange. Those shares are known as "H" shares, and foreign investors can freely trade these stocks. Meanwhile, domestic investors are allowed to invest in "A" shares, which foreign investors cannot trade unless they are an institution licensed by the Chinese government. It is not uncommon for a company to have both A and H shares listed.

Because the shares trade completely separately, pricing spreads can be significant. It's almost as if the two share classes are trading in parallel universes, with supply and demand driving prices, much moreso than fundamental analysis. With the recent surge in mainland China's economy in the year or so, the spreads between the two share classes have grown to epic proportions, with the prices of the A shares far outstripping those of the H shares.

HSI Services Ltd., which maintains and calculates the benchmark Hang Seng indexes, has decided to address the issue with the launch of its Hang Seng China AH Index series, which tracks only stocks that list both A and H shares. The index family includes four indexes-one that combines A and H shares, one for A shares, one for H shares, and one that tracks the spread between A and H shares.

HSI Director and General Manager Vincent Kwan says the idea first arose roughly a year ago. "At that time, the market witnessed a very strong market in A shares," he says. When A and H shares began to diverge significantly, they began to catch some attention at the global level. And although some investors kept track of the differential for certain stocks, no one had yet begun to track the "average" difference between the share classes.

The series currently tracks 27 stocks with A and H listings. Components must either have their H shares listed as members of the Hang Seng China Enterprises Index or their A shares must meet strict requirements regarding size, liquidity and quality. In addition to the dual listing, component companies also cannot have any unlisted share capital. Kwan says the indexes provide more transparency to the market and give investors a way to track the trend and its evolution. He believes the indexes would be ideal for use as the bases for structured products.

By far the most interesting index in the series is the Hang Seng AH China Premium Index, which tracks the premium/discount between the two share classes. The backtested data on the index presents an interesting phenomenon. The index itself has back-data starting from January 2006. At that time, H shares traded at a premium to A shares. However, by early 2007, the A shares has clearly outstripped the H shares. Only a couple of days ago, the premium index hit a new high, with A shares trading at a stunning 64% premium over H shares. The A shares of one company, Datang Power, were trading at a premium of well over 300% as of the close of trading on Tuesday!

"There's been a lot of debate on whether the prices should be the same and if anything should be done to help make the difference narrower," Kwan says, describing the premium index as an objective way to measure the difference between the two types of shares. He cited the strong A shares market and buoyant market sentiment in China as some of the underlying reasons for the price divergence. After all, China's economy has been booming, and its citizens have more disposable income than ever before. With their access to foreign markets severely limited, it seems only natural that domestic investors would pour their money into the investments available to them.

The three price indexes also offer an interesting perspective on the A and H shares. The Hang Seng AH (A+H) Index combines the market caps of each component's A and H shares to track the total value of the company. Meanwhile the A and H indexes track the performance of those shares respectively. However, the weights of the components in those indexes are reset on a monthly basis to coincide with their weights in the A+H index.

Although currently the A shares and H shares markets remain largely separate, there has been some relaxation of restrictions by the Chinese government over the years. Foreign institutions are now allowed to invest in the A shares market with permission from the Chinese government (the B shares market available to foreign investors has never been very popular), and a few domestic firms are now allowed to invest in foreign stocks, meaning domestic investors in China now have some access to foreign markets. Kwan says it is the general feeling that, over the long term, prices will converge as the markets become more flexible, but he also points out that no one knows when this will happen.

Source: New Indexes Track 'Two Chinas'