The Hang Seng Is Not A Substitute For The Shanghai Composite

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Includes: CN, CXSE, FCA, FXI, FXP, GXC, MCHI, PGJ, XPP, YANG, YAO, YINN, YXI
by: Discount Fountain

Summary

While the Hang Seng has traditionally been viewed as a "back door" to gaining access to mainland Chinese stocks, this is a common misconception.

Monthly returns between the Hang Seng and Shanghai Composite indices have deviated quite dramatically in recent years.

Of the 50 largest stocks on both indices, only 9 of them appear on both the Hang Seng and Shanghai Composite.

With greater restrictions on China's stock markets in terms of allowing access to foreign investors, it has always been common belief that the Hang Seng index in Hong Kong can serve as a "back door" in this regard; allowing greater access to investors hoping to get in on growth in mainland China. However, the purpose of this analysis is to demonstrate that this is not the case, and is, in fact, a common misconception among many investors.

When comparing the 50 largest stocks by market capitalization on both indices, only 9 of them appear on both the Hang Seng and Shanghai Composite. Indeed, the vast majority of stocks available on the Shanghai Composite cannot be accessed through Hong Kong. Understanding this distinction is important - while there may be a select few stocks common to both indices, the two stock markets are fundamentally different in terms of overall returns. In other words, the Hang Seng index by no means serves as a substitute for the Shanghai Composite.

Looking at the cumulative monthly returns of both indices for the period March 2011-February 2015, we see that the Shanghai Composite has been much more volatile than the Hang Seng index:

Source: Author's Calculations

However, we can also see that the Shanghai Composite has undergone a real boom as of late, and has eclipsed the Hang Seng in terms of cumulative returns. On this basis, the Hang Seng has failed to follow suit - any investors going long the Hang Seng index hoping to capture Shanghai's stock market gains were left disappointed. On a more technical level, the principles of Ordinary Least Squares, stationarity and cointegration also demonstrate the lack of a significant relationship between these two indices.

Sources: Author's Calculations

When comparing the two indices across the same time period, as well as over a one-month lag between them (Granger Causality), we see that while our t-statistics are significant, our R-Squared values are very low, which casts doubt on the significance of the relationship. Moreover, we see that our time series is not cointegrated, i.e., any relationship between the two time series is entirely due to chance, and forecasts will be largely prone to error. This is because we can see that while the Hang Seng index is stationary across both time "t" and first differences (there is a clear trend in the data based on time), the Shanghai Composite is non-stationary across both "t" and first differences. Since cointegration requires a linear combination of the data to be stationary across first differences, our dataset does not pass this test.

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Sources: Author's Calculations

So, what does this tell us? Firstly, it reveals that it is misguided to assume any significant relationship between the two indices. Moreover, it demonstrates that in the case of the Shanghai Composite, the fact that we have a non-stationary series means that the stock price does not tend to follow a clear trend as in the case of the Hang Seng index. In this regard, investors can expect significantly more volatility from investing in this index.

In conclusion, the Hang Seng does not act as a substitute for the Shanghai Composite. The two indices only share a handful of stocks, and the return profiles of the two are very different.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.