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Capturing pricing anomalies: China A- and H-shares (part 1 of 2)

By: Eddie Pong, Director, Research and Analytics

The Chinese equity market has seen enormous growth over the last two decades. This growth partly originated when China permitted its State Owned Enterprises (SOEs) to list on the Hong Kong Stock Exchange (HKEx) in 1992.[1] Now, Chinese companies can choose to be listed on domestic exchanges (A-shares), the HKEx (H-shares) or both. If a company chooses to be dual-listed, what is the effect of the price differences in the foreign and domestic markets when the company is included in an index? 

In the first part of this two-part series, we will look at how an index might be constructed to capture any pricing anomalies from dual-listed companies. In an ideal environment where capital flows freely and information is perfectly symmetrical, there should be a single, prevailing price on both exchanges. However, we all know that environments are rarely “ideal."

The illustration below shows the price differentials between A- and H-shares over time based on free-float-adjusted market capitalization. As we can see, A-shares have most often traded at a premium to their H-share counterparts.

Using the constituents of the FTSE China A Index as the starting universe, an A/H index could be constructed with the specific index objective to capture any potential pricing differentials. By identifying each dual-listed stock in the starting universe, the A/H index could select the cheaper of the two share classes at each rebalance period. To remain analogous to the starting universe, the market cap calculation of the A/H index would use the number of free-float A-shares and the A-shares prices regardless of whether an A- or H- share was selected.

As we can see below, the proportion of H-share constituents within the hypothetical A/H index rises and falls in tandem with the discount available in the H-share market versus its A-share counterpart. Consequently, the number of H-shares in the hypothetical A/H index is expected to increase as the discount level widens.

So what does this all mean for the return/risk characteristics of this hypothetical A/H index? The expectation would be that the A/H index would record higher index returns than the market-cap weighted China A-shares index when the prices of A- and H-shares converge and lower index returns when they diverge. More on that to come…

Stay tuned for part 2 of this series, which will focus on the simulated performance of a hypothetical A/H index and some potential weaknesses of the built-in assumptions. For further details on this subject, read the corresponding research paper, Capturing the China A-shares and H-shares Anomaly.

 

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[1] Source:  HKEx

 

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