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Less than two weeks ago, the Chinese government moved to ease the potential bubble in its mainland markets, announcing plans to allow Chinese citizens to invest directly in Hong Kong stocks. The move sent Hong Kong’s benchmark Hang Seng index on a tear, gaining more than 12% in a week and more than 17% through Aug. 31, when it closed at a record high.

The Hang Seng’s leap—which coincided with a 12.9% two-week gain for the iShares MSCI Hong Kong Index ETF—came in anticipation of a flood of money from individual Chinese investors into Hong Kong’s market. Hong Kong has long been known as a bargain-hunter’s paradise, in part because a number of mainland-based-and-focused firms sell H-class shares on the Hong Kong exchange. H-shares typically trade at a significant discount to A-shares of the same companies.

Deutsche Bank recently estimated that the shift, together with other efforts by the Chinese to increase flow to overseas funds, will inject $40 billion into Hong Kong–listed shares in the six months after the change becomes official. Other estimates place the inflow at $112 billion or more.

“It is hard not to expect the H shares to benefit substantially from this,” Credit Suisse China analyst Vincent Chan wrote last week.

That’s likely true, though there are two things potential investors in EWH should keep in mind:

First, the switch has not yet happened, and the Hang Seng’s recent surge came largely on an infusion of funds from large mutual funds and Hong Kong investors, anticipating the mainland money.

The Chinese government did not announce a date for the switch. Some hoped it would happen last week, but speculation has now spread for its possible occurrence throughout September and even October. Monday in Hong Kong saw a minor pullback on news of a potential delay.

Second, while Chan and others believe that H shares and the Hong Kong market will get a boost, Chan also told FinanceAsia.com that H shares could easily get overvalued, and that inflation and an asset price bubble in China could eventually lead to trouble in a region where broad indices seem to hit record highs almost daily.

“It might plant the seed for a much bigger correction afterward, once the H-share market has been pushed higher,” Chan said.

EWH invests heavily in the banking and real estate sectors, at about 54% of assets, and emphasizes stocks of companies owned or controlled by Asia’s richest man, Li Ka-shing.

Li chairs and owns more than 50% of top holding Hutchison Whampoa and more than 40% of No. 2 Cheung Kong Holdings (up 19.7% year to date, after recently reporting a 53% rise in first-half profits), the flagship holding company of Hutchison Whampoa’s parent, the Cheung Kong Group. The latter is involved in almost every aspect of the booming Hong Kong economy, including ports and infrastructure, property and hotel investment, retail, energy, finance and telecommunications.

The group operates in 55 countries and has more than 250,000 employees, with 11 listed companies on the Hong Kong exchange and a combined market cap of about $115 billion.

Six of EWH’s top 10 holdings and 13 of the top 20 (which recently accounted for 85% of assets) were from the financial sector, topped by No. 3 holding Hong Kong Exchanges and Clearing, which saw shares rise 9.3% the day after the news from China and nearly 30% through Monday. Like other financial stocks, HKEx, which runs the country’s stock exchanges, stands to benefit from an influx of Chinese money.

Of course, there’s more to Hong Kong than H-shares and Chinese investors. It’s been approximately 10 years since the Asian financial crisis, when real GDP for 1998 contracted by 5.5% and led to six years of deflation; and it’s been about 10 years since the city- state’s reversion to Chinese rule in 1997. The economy staggered after the crisis and struggled to find footing for several years, then had a major downturn in 2001 and a wobble in 2003, during the SARS health crisis.

The past three years, though, have seen average real GDP growth of 7.7% per year, thanks largely to Hong Kong’s China connections, through trade and tourism according to The Economist. The boom is under way, and though Hong Kong may have lessened its connection to the U.S. and the housing slowdown there, it has only tightened its relationship with Chinese markets.

That’s been great news for EWH shareholders, obviously. But it could change quickly. As Li, the billionaire, said in May, “I am worried about the stock market. ... [China's stock valuations] must be a bubble.”

Source: Tread Carefully With EWH: H.K. Not Immune to Chinese Bubble