The programme that links the stock exchanges of Shanghai and Hong Kong has debuted with a bang. Stefanie Eschenbacher finds that although news about the programme initially boosted interest in exchange-traded funds that raise renminbi in Hong Kong to invest in China, the two schemes may turn into rivals.
The popularity of exchange-traded funds that raise renminbi in Hong Kong to invest in China, known as RQFII ETFs, will be tested with the launch of the highly anticipated Shanghai-Hong Kong Stock Connect.
The Shanghai-Hong Kong Stock Connect, the “through train” as the programme is known locally, links the Hong Kong Stock Exchange and the Shanghai Stock Exchange. It has opened up a new channel for foreign investors to buy Chinese A-shares.
Foreign investors can already invest renminbi raised in Hong Kong in Chinese A-shares under the RQFII programme, but the process is cumbersome and only those who have a licence and a quota are eligible.
The importance of the RQFII programme is likely to diminish now that the delayed “through train” has pulled in.
Freddie Chen, managing director at China Asset Management Company (Hong Kong), which has one of the largest RQFII ETFs, concedes that there can be a “replacement effect” as investors have more channels to access China. “At the same time, we believe that this additional access tool will increase investor interest in the China market further,” Chen says.
“Overall interest will grow, although part of the interest will be diverted into the stock connect programme.”
Jackie Choy, an internal ETF strategist at Morningstar Investment Management Asia, says the stock connect programme may test the popularity of RQFII ETFs as it is a new channel for foreign investors to gain access to Chinese A-shares.
“The Shanghai Hong Kong Stock Connect … will diminish the appeal of China A-share ETFs as an access product, but it will continue to be a useful tool for investors to get broad exposure,” Choy says.
The stock connect programme also offers an additional channel to arbitrage the price differentials that exist between RQFII ETFs and their constituents of their benchmark indices, which Choy says should lead the market prices of these ETFs to trade closer to their net asset value.
Having an additional channel to invest in Chinese A-shares could intensify competition, and may ultimately lead to lower trading costs as well as management fees for ETFs that track Chinese A-shares.
Morningstar data shows that the total expense ratios of RQFII ETFs range from 0.49% to 1.19%, while those for non-RQFII A-shares ETFs range from 0.5% to 1.49%, and those for offshore Chinese equity ETFs range from 0.25% to 0.99%.
Jack Wang, deputy chief marketing officer at CSOP Asset Management, which manages the largest and most actively traded RQFII ETF, predicts that fees will come down once there is easier access to the market.
Still, Wang says the stock connect programme has benefited RQFII ETFs. “After the announcement of the through train, we realised more investors started looking at China,” Wang says, adding that they have received more enquiries from potential investors for the CSOP FTSE China A50 ETF.
“The access nature of these ETFs will be reduced, and investors will no longer use ETFs as a pure channel to invest in China,” Wang says. “Large ETFs will continue to do well, but smaller ones are going to find it challenging.”
This may also lead to liquidations of smaller, less successful RQFII ETFs, although this is the case in any market.
HSBC Global Asset Management already closed four ETFs in Hong Kong over the past two years and Da Cheng International Asset Management closed two ETFs.
Mirae Asset Global Investments (Hong Kong), in contrast, became the first foreign ETF provider to offer RQFII ETFs. BMO Global Asset Management entered the Hong Kong market to launch conventional ETFs.
Wang says RQFII ETFs are better suited to give investors quick and easy beta-exposure to the Chinese A-Shares market. “The RQFII programme still has its own merit,” he adds.
While some investors will feel more comfortable approaching China through ETFs, others will feel confident enough to pick their own A-shares now that the stock connect programme has launched.
The stock connect programme is subject to an overall trading quota as well as a daily trading quota.
The quota for northbound trading, through which Hong Kong and international investors can buy and hold shares listed on the Shanghai Stock Exchange, is set at 300 billion renminbi ($49 billion).
Whereas the quota for southbound trading, through which investors in China can buy and hold shares listed on the Hong Kong Stock Exchange, is set at 250 billon renminbi.
The daily quota for northbound trading is set at 13 billion renminbi, and that for southbound trading at 10.5 billion renminbi.
While market participants of the stock connect programme share a quota, RQFII products, including RQFII ETFs, have their own quotas.
Asset managers know exactly how many subscription orders they can take from investors for their RQFII ETFs, but those who trade through the stock connect programme will be restricted by other market participants.
Orders would have to be placed before the market opens, which Wang says may not work for an ETF. “We would take orders from investors in the morning, and place them in the afternoon,” he adds. On the first day of trading, the stock connect programme hit the 13 billion renminbi cap less than five hours after markets opened. More than a billion purchases were completed in the first five-and-a-half minutes.
Southbound volume, as consultancy Z-Ben Advisors had predicted, was much more muted. Some 500 million renminbi worth of Hong Kong shares was bought through the programme, with trading volume slowing considerably thereafter.
The “through train” was originally scheduled to arrive at the end of October, but only pulled in mid-November.
Some aspects have been laid out in great detail, such as the trading arrangements under severe weather conditions in Hong Kong, but various other important aspects still need to be clarified.
Arguably the most pressing one is taxation.
Individual income tax policies on dividends and bonuses of listed companies stipulate that Chinese individual investors need to pay income tax on cash dividends and bonus shares at a rate ranging from 5% to 20%, depending on the holding period of the underlying shares.
Chinese corporate income tax law also stipulates that non-resident corporates are subject to a 10% withholding tax on income tax sourced from China.
Regulators have yet to clarify with the State Administration of Taxation how stocks traded through the stock connect programme will be taxed.
“Tax is definitely a problem,” Wang says.
The stock connect programme nevertheless appears to have inspired investor interest in Chinese A-shares, including RQFII ETFs, even if the latest monthly data shows outflows.
Morningstar estimates that RQFII exchange-traded funds (ETFs) suffered outflows of 4 billion renminbi in October, or 6.5% of their starting assets under management.
This follows 17 billion renminbi of estimated total net inflows over the three months between July and September.
“The recent improvement in sentiment is a combination of better economic data as well as expectations of the stock connect programme,” Chen says.
Laura Lui, head of ETF and indices, at Mirae Asset Global Investments (Hong Kong), adds that the Chinese A-shares market has also become less volatile over the past year.
“Chinese A-shares have been trading at low valuations, and have been quite stable, but there is a limited choice of products for those who want to take more of a view on the market,” she adds.
Lui says the popularity of RQFII products is going to increase even more over the long term as the programme broadens its reach to Taiwan, Korea and Singapore, as well as the UK and France.
Investors are becoming more familiar with the RQFII programme, and Lui says they will start looking at relevant funds.
“RQFII and the Shanghai-Hong Kong Stock Connect target two types of investors with different intentions,” she adds. “They should be able to work alongside each other.”
Lui says RQFII ETFs are for investors who are looking for more diversification and a passive tracking product whereas the stock connect programme is more suitable to cater for those who want to take a trading view on a specific stock, with a shorter investment horizon and more risk appetite.
Marco Montanari, head of passive asset management, Asia Pacific, at Deutsche Bank, shares this view.
Montanari says investors will still trade China A-shares ETFs after the introduction of the stock connect programme for the same reasons they trade ETFs linked to the HIS Index or the S&P 500 Index, even though they can directly buy the underlying stocks. “If there are investors that decide to stop investing in ETFs to get direct access to the underlying market, then I believe this will have a bigger impact on the trading of Hong Kong-listed RQFII ETFs than the RQFII ETFs listed in the US and Europe,” he says. “Asian investors are generally more familiar and comfortable with doing stock picking on Chinese equities, compared with investors from outside the region.”
Montanari highlights that in the ETF markets in Europe and the US less than 3% of total ETF assets managed in Europe and the US are linked to China.
Montanari says international investors will increase their exposure to China in the future, and RQFII ETFs in Europe and the US are well positioned to take advantage of this trend.
Deutsche Bank plans to list more RQFII ETFs in Europe and the US. It launched its first RQFII ETF in the US in November and its first RQFII ETF in Europe in January.
“Our plan is to expand our product range in US and Europe in the next months and we will continue to work with Harvest Fund Management, our strategic partner in China, which has the expertise and the RQFII licence to provide efficient exposure to the Chinese market,” Montanari says.
Choy says all asset managers will have to constantly adapt to new market conditions.
When RQFII was launched, they had to adapt themselves to the RQFII capabilities.
BlackRock, for example, added the ability to buy not just synthetically but also physically through its QFII and RQFII quotas in its iShare A50 ETF.
Asset managers have to constantly adapt themselves and their product range to rapidly changing markets, offering investors something new to gain or protect their market share.
Wang argues that liquidity is what makes an ETF stand out, and asset managers still face the challenges of making investors comfortable with the currency. “Investors need to be comfortable with taking a renminbi risk,” he says. How the RQFII programme will fare under the stock connect programme is unclear, but it is likely that anything that further opens the Chinese capital account will aid asset managers.
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