Relative attractiveness of H-share Fund vs. A-share Fund

Hong Kong market reacted very favorably to Chinese policy maker’s relaxation of QDII (Qualified domestic institutional investor) restrictions, Hang Seng Index and Hang Seng China Enterprises Index (HKCEI) went up 2.49% and 5.35% respectively yesterday.

China started the QDII program in July 2006, allowing QDIIs to raise renminbi funds from domestic individuals and institutions and convert them into foreign currency for overseas investment. So far, 30 financial institutions (11 domestic banks, seven foreign banks, 11 insurance companies and one mutual fund) have been granted QDII status. Total quotas granted are about US$19B (~ RMB 146B), which is about 2.7% of free floated A-share market cap. Previously QDII funds were only allowed to invest in fixed income products until last week when the Chinese government announced removal of such restriction. Under the new policy QDII funds are allowed to invest up to 50% of assets in overseas stocks and structured equity products, with no more than 5% of assets invested in any single stock. Hong Kong is the only market endorsed by the Chinese authority for such investments and as such there is a high expectation that HK listed H Shares, Red Chips and blue chips would be the major beneficiaries of this new policy.

Can the latest relaxation increase QDII’s attractiveness to Chinese investors?

Take a typical Hong Kong equity fund as reference, the Manulife Hong Kong Equity Fund retuned 31% in last 12 months, and 23% annualized in last 3 years. Even if the performance of Hong Kong market is still as promising as it did in the past 3 years, any QDII fund with 50% investment in equities (mainly Hong Kong listed blue chips, red chips and H-shares) can provide no more than 10-15% annual return. So is that a strong reason for Chinese investors to re-balance their portfolios into QDII funds?

Now let’s examine the following figures :

The size of Chinese household saving is 3.2 times of the free floated A-share market capitalization, i.e., Chinese are only investing around 30% of their savings into stock market. (Taking corporate saving into account, that would be around 15%). Though the QDII potential return is still far less than that provided by the A-share market, as the total size of QDII is only 0.4% of the total domestic saving pool, it would be easy to siphon such tiny amount from the huge pool to Hong Kong especially for corporate clients who aim at longer term investment horizon.

Is Hong Kong’s market reaction justified?

As can be seen from the above table, QDII is only 1/96 of the total market cap of Hong Kong Stock Exchange, and 1/48 of those Hong Kong listed H and Red Chips. The best case scenario shall further be halved as only up to 50% is allowed to be invested in equities. Look at it from another angle, total fund size of QFII is around 1.5 days of Hong Kong Stock Exchange’s trading turnover. (~HK$50b daily). Based on the above figures, investors may have over-reacted to such news.

Is H-share a more attractive investment than A-share now?

Will QDII close the gap of those dual listed stocks with H shares on average having ~50% discount over their A share counterparts ? Is that a good opportunity to switch from A-share funds such as Morgan Stanley China A-share Fund (CAF) or iShare A-50 tracker (2823.HK) to H-share funds such as Hang Seng China Enterprises Index (“H-shares Index”) tracking ETF (2828.HK)?

My view is that, unless there are drastic change in Government policies leading to a hard landing, A-share market is still more attractive than H-share because the craze can sustain for a long period of time:

• A-share traded in a closed market, only domestic investors or QFII can participate, as a result more rational international investors would have no impact to A shares market price. (because total QFII quota is only a negligible 1% of A share market cap)

• Investment alternatives to local investors are extremely limited, apart from parking their money with saving accounts which give ~2% after tax return, they can only invest in property, stocks and mutual funds.

• Chinese investors speculate on mutual funds the same way as they do on stocks, they have a common mis-conception that lower priced funds would provide higher upside, what they do is to redeem old funds and subscribe to new and ‘cheaper’ funds. To supply ‘cheaper’ funds to the market, managers will split old funds into sister funds so as to lower the unit NAV and make the new sister funds look ‘cheap’. Besides, more and more new funds are introduced to the market to address investors’ huge demand which will push the market even higher.

• As of end of April, domestic individual equity accounts has reached 94 million which is over 7% of population. New account openings on April 30 alone exceeded 1 million, and total new individual account openings in the month of April exceeded the sum of years 2005 and 2006. As a result, about 17% of the total existing accounts were opened just in the past 4 months. Suddenly investment related books become top sellers in all bookstores, investment talk shows also flooded all TV channels. There are more gamblers than investors in China, what can you do to stop gamblers from placing higher bets? I’m not saying investors in Hong Kong are not gamblers, otherwise Hong Kong would not become the largest warrant market globally in terms of turnover. The only difference is that Hong Kong investors in general have a higher level of risk awareness. Most investors in China with only a few months' investment experience have never experienced any major market correction and never burnt their fingers before.

As a result, I believe the A-share craze will still go on until one of the followings happened:

Chinese Government starts dumping stated owned shares into market

Free floated A-shares constitute only around 30% of all issued shares, majority of the shares are owned by the Government. Apart from those ‘pillar industries’ such as Telecommunication, Banking and Insurance, Government can gradually reduce its holdings and increase the size of free floated shares. This is a more effective way to absorb the excess liquidity originated from household savings than increasing interest rates which would itself affect the well managed RMB appreciation rate.

Introducing Index Futures

Currently Chinese investors can only bet one way as there is no channel to express pessimism.

Trial run of index futures has already been started and the initial trial result was that it significantly increased market volatility, as such it is believed that the policy maker will need more time and further estimation of the impact before such products are introduced to market.

Unless the above happened I think other measures such as imposing capital gain tax, increasing interest rates (unless a drastic increase or very frequent small step increments) etc could hardly clam down Chinese investors’ overly excited sentiment.

If the Government cannot or do not want to manage the “P” in P/E, what it can do in the meantime is to increase the “E” so as to lower the P/E to a more reasonable range:

Injection of profitable unlisted assets into listed company

• For example, Guangzhen Railway (0525.HK,ADR: GSH,601333.SS) returned home and listed as A-share in Shanghai in Dec 2006. The newly raised proceed RMB10.3B was used to acquire new railway assets from its mother company. With the acquisition Guangzhen Railway’s total railway operating distance is extended to 481km from 152km, however, it is still only a faction of the 4400km owned by its unlisted mother company. This is an example of the huge assets injection potential.

Red Chip Companies To Return Home

Under the current policy Red Chip companies (e.g. China Mobile, CITIC Pacific) are not allowed to list in Chinese market because those companies are not registered in China. It is rumored that policy amendment is ready and Red Chips can return home very soon. With such high quality listings Chinese investors would have more choices and hopefully they would divert their investments into those less risky stocks.

To conclude, I do not believe the price gap of H and A dual listed shares will be completely closed though it would be tightened a bit because A share price is going up at a much faster rate than its H share counterpart. I would maintain my long term positive view on A share market performance. In the meantime I would closely monitor Government’s action such as introduction of index future.

Disclosure: I do not own any of the above mentioned stocks