| Illustration by Sebastien Thibault |
When China opened up access to the Shanghai Stock Exchange in November, hedge funds and other investors stormed the gates of the newly unlocked capital market. Under the Shanghai–Hong Kong Stock Connect program — which allows foreigners to buy Shanghai-listed A shares through Hong Kong–based brokers and mainland investors to trade H shares on the Hong Kong Stock Exchange — investors can now capitalize on price differences for dual-listed companies.
“Why would you buy something for 100 in one market if you see it’s valued at 50 or 60 in the other?” asks George Philips, chief executive of Hong Kong–based Northwest Investment Management. The firm has seen its hedge funds soar as much as 46 percent this year from trading A and H shares.
As Shanghai rallied last fall on monetary easing by the People’s Bank of China, prices on A shares overtook their corresponding H shares, which now trade at a 30 percent discount to their Shanghai-listed counterparts, on average. Betting that prices will converge over time, hedge funds have devised strategies for taking long positions in H shares while gaining short exposure to their more expensive A-share equivalents.
The price gap, and potential profit opportunity, will persist as long as China maintains its current restrictions on financial markets, according to HSBC’s Hong Kong–based head of equity strategy, Asia-Pacific, Herald van der Linde. If the country removed current barriers to capital flow and lifted restrictions on buying and shorting Hong Kong– and Shanghai-listed stocks, the pricing disparity for dual-listed companies should disappear, he contends. But drastic change will not happen overnight. “We’re not talking weeks here,” van der Linde insists. “We’re talking months, quarters, years.”
Until that day all eyes are on the spread as it fluctuates, getting wider or narrower in response to government policies and market news. “It’s probably one of the biggest strategies in town,” says van der Linde. “Basically the belief is that, over time, through financial liberalization, A and H should be very close together or equal if you’re buying the same company. That’s not the case yet.”
If Stock Connect facilitated a free flow of capital, arbitrageurs would quickly shore up the price gap as they bought shares at cheaper valuations on one exchange and sold them on the other for a profit, van der Linde explains. However, for now A and H shares are restricted to trading on their respective bourses.
Although China opened its doors to foreign short-sellers in March, borrowing A shares to sell is still no easy feat. The primary patrons of the mainland stock market are retail investors, and fund managers face a scarcity of shares when trying to borrow from brokerages or one another. Moreover, China restricts the number of stocks and the quantity of shares that can be sold short.
Hedge funds have had to get creative to gain short exposure to A shares. Some short whatever shares they can get their hands on; others short highly correlated stocks or gain exposure via swaps. Northwest shorts the A-share index while going long on H shares and related derivatives. “Whether it’s the trade of the year or the trade of the decade is yet to be seen,” says Northwest’s Philips. “But these things don’t occur very often. It’s all part of a capital market cycle that we think everybody should be fully embracing.”
