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By Jeff Pietsch

As reported in yesterday’s Wall Street Journal, late this summer the Chinese government announced a new policy permitting its mainland citizens to invest in Hong Kong equities. Although the specific timing remains unknown, this would be the first opportunity for mainlanders to diversify their equity holdings without obtaining special government approvals. In addition, the government is reportedly exploring lifting current restrictions on short-selling.

While the two markets are clearly correlated, as shown below there has been an obvious and widening gap in performance between them. A prospective rebalancing trade here using an ETF pair would be to: (1) go short the iShares FTSE/Xinhua China 25 (NYSEARCA:FXI); and, (2) go long the iShares MSCI Hong Kong Index (NYSEARCA:EWH).

The Morgan Stanley China A-Shares ETF (NYSE:CAF)is another short candidate with even higher returns year-to-date (+124%), but would make for a significantly less correlated pairing against the EWH (2007 correlation coefficient of 64% versus 87%).

I don't pretend to know the local investment psychology, but if I were a mainland citizen, I might think hard about diversifying my holdings after this year’s tremendous run, how about you?

FXI ~ YTD Return = 81%; P/E Ratio = 24.6; 20-Day Z-Score = +2.4

EWH ~ YTD Return = 39%; P/E Ratio = 16.3; 20-Day Z-Score = +2.3