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.
 Source: HKEx
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