February 18, 2015
Robert A. Gillam, CFA Chief Investment Officer McKinley Capital Management, LLC
Gregory S. Samorajski, CFA Director of Investments McKinley Capital Management, LLC
The market for Chinese securities has typically been divided into several categories. The first category is those securities that trade on domestic exchanges such as the Shanghai and the Shenzhen Stock Exchanges. The shares are usually known as Ashares. Until recently, A-shares could only be purchased by Chinese residents (with a few exceptions). The market capitalization (“market cap”) of the most important companies with listed A-shares is likely in excess of $3 trillion dollars1. Some of these Chinese companies also list shares on the Hong Kong Stock Exchange. These shares, called H-shares, are usually eligible for investment by foreign investors. The market cap of the companies included in the MSCI China Index of Hong Kong traded shares is over $1.65 trillion2. Some of that $1.65 trillion of market cap is represented by companies that only list H-shares. Tencent Holdings is a prime example of such a company. It is apparent that some, but by no means all, Chinese securities with Ashare listings also trade in H-share form on the Hong Kong Exchange. Finally, a few Chinese securities, such as Baidu and Alibaba, only trade on overseas markets.
The Chinese government appears to be interested in attracting foreign investment into its domestic stock markets, offering its nationals more opportunities for investment outside of China, and in internationalizing its currency, the Renminbi (“Rmb”)3. To that end, under the sponsorship of the Chinese government, the Shanghai and Hong Kong Stock Exchanges have entered into an agreement to form a system called the Shanghai-Hong Kong Stock Connect. This system is often referred to as the “Thru Train”. With some exceptions, the Thru Train allows larger Chinese investors to purchase Hong Kong listed large and mid-cap H-shares as well as other securities that are otherwise available as A-shares. All trades – even if listed in Hong Kong Dollars – are settled in Rmb, and must be executed through Chinese brokers through an electronic link between the two exchanges. This is known as “Southbound” trading. Of importance to international investors is the “Northbound” trading capability. With Northbound trading, international investors can purchase any of approximately 568 Ashare listings through normal Hong Kong Exchange brokers via an electronic link between exchanges. Such trades are settled in Rmb. Significantly, many of these Ashare listings have never been available as H-shares. This Northbound Thru Train feature opens an important segment of the Chinese market to the global investing community.
The Thru Train began operation in November 2014. So far, most of the volume has been Northbound. For example, as indicated in Table 1, in January the average daily volume of Northbound trading was about $800 million while the average daily volume of Southbound trading was about $200 million4 as shown in Table 2. For international investors seeking to access A-shares it appears the system is off to a promising start. However, there are some barriers to overcome and details to settle before the Northbound Train can be fully utilized by international investors. A major barrier is custody. In order to own an A-share, the security needs to be held in custody at a Chinese custodian. For most global institutions, that means their custodian will need to set up a sub-custodial relationship with a Chinese custodian. As of the writing of this paper, it is the understanding of McKinley Capital Management, LLC (“McKinley Capital”) that none of the major global custodians are set up with Chinese sub-custodial relationships. As soon as custody issues are resolved, McKinley Capital is prepared to consider the purchase of Chinese A-shares for its clients who choose to register in China. Until then, it is possible to access the Chinese market through P-notes. Some of the international brokerage firms are set up with Chinese custodians through their prime brokerage departments. These firms are often able to buy A-shares for their own account and create P-notes against those shares. To date, McKinley Capital has purchased several P-notes based on Chinese A-shares for client accounts who allow these investments.
Finally, there is the possibility that the major indexing firms – MSCI, FTSE, and S&P – will at some point include Chinese A-shares in their indexes. If that happens, the impact could be significant. McKinley Capital believes its clients and their custodians should begin now to gain access to this opening market.
Your McKinley Capital client service representative would be pleased to discuss these opportunities with you in greater detail.
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1 According to Bloomberg, as of 02/12/2015, the total market cap of the Shanghai Stock Exchange 180 A-Share Index stocks plus the market cap of the Shanghai Stock Exchange 380 A-Share Index exceeds $3 trillion.
2 According to Bloomberg as of 02/12/2015.
3 See The Thru Train Strategy produced by CLSA in cooperation with CITIC Securities. August 19, 2014.
4 Hong Kong Stock Exchange website. http://www.hkex.com.hk/eng/csm/chinaConnect.asp?LangCode=en