Chinese mutual funds in April became the marginal buyer of Hong Kong stocks owned by institutional investors around the world, a mix that could leave Hong Kong's market on a more volatile path.
Money managers remain mostly sanguine about the prospect, as valuations in Hong Kong and Shanghai are close to historic averages even after the 100% gain for the latter market's composite index since it emerged from a five-year slumber in July.
There'll be “more opportunities than risks” for managers focused on fundamentals if momentum-driven investors from China become bigger players in Hong Kong, predicted Bradley Okita, Hong Kong-based managing director of Neuberger Berman Ltd.'s Greater China equities boutique. “The more, the merrier,” said Mr. Okita, whose team manages $4 billion in Chinese equities, roughly half in mainland-listed A shares and half in Hong Kong-listed H shares.
Still, with the Shanghai market's more than 400% gain during China's prior love affair with stocks in the 24 months through October 2007, some market veterans concede they can't rule out scenarios where their value disciplines could be tested.
“Tulip booms can last a few years,” noted Hugh Young, Singapore-based managing director of Aberdeen Asset Management Asia Ltd. “We just continue to invest in the good quality companies as cheaply as possible,” but if liquidity boosts valuations across the board, “it could be a rough time for us,” said Mr. Young.
While the risk in that scenario is “that clients leave us in search of hotter returns,” Aberdeen has staked out its ground pretty clearly as a “long-term fundamental investor,” said Mr. Young.
A March 27 move by China's securities commission — allowing mainland-based mutual funds to join high-net-worth investors as participants in the recently launched “Shanghai-Hong Kong Connect” cross-border investment program — set the stage for more collisions between momentum-driven retail money and value-driven institutions.
Amid Shanghai's ongoing A-shares rally, Chinese investors jumped at the chance to buy Hong Kong-listed H shares of mainland-based companies trading at discounts of 30% or more to those companies' listings in Shanghai.
On April 8-9, the Connect quota for “southbound” investments to Hong Kong from Shanghai hit the program's daily limit of 10.5 billion renminbi ($1.7 billion) for the first time, igniting a four-session 11% surge that saw the Hang Seng index close at a seven-year high of 28,016.34 on April 13.
And the window opened on March 27 could get bigger, with Hong Kong officials quickly noting the Connect program's quotas could be raised significantly.
Some analysts see greater volatility becoming a feature of the landscape.
With retail investors dominating 90% or more of Shanghai's daily turnover, “we can look forward to more excitement” in Hong Kong relative to the previous four or five years, said Stewart Aldcroft, Hong Kong-based chairman of CitiTrust Ltd.
The prospect of greater liquidity from the mainland prompted one sell-side research house to boost its 12-month target for the Hang Seng index, even as economic indicators for China continued to point to a slowdown. On April 13, Morgan Stanley Asia Ltd. predicted the Hang Seng index would reach 30,000 by March 2016, up 12% from its previous target. In its report, Morgan Stanley said “the marginal price-setter in Hong Kong is shifting from the typically China-skeptical global investors to a far more bullish onshore constituency.”
Aaron Costello, a Singapore-based managing director on the global research team of investment consultant Cambridge Associates Asia Pte. Ltd., noted that past predictions that Hong Kong valuations would converge with Shanghai — when A shares traded at premiums of 100% in 2007, 50% in 2009 and 40% in 2011 — have never panned out.
Hong Kong's market “is more fundamentally driven,” said Mr. Costello. By contrast, the problems of distortions in China's markets can all be tied to the fact that there's so much “trapped money in the system,” he said.
While that mainland money now has greater access to Hong Kong's market and the promise of more to come, most money management veterans say they see no need to recalibrate their investment approach for Hong Kong.
Retail liquidity might be driving up midcap and speculative names in Hong Kong on a short-term basis, but over the long term “fundamentals will prevail,” said Projit Chatterjee, a Singapore-based managing director and equity strategist with UBS Global Asset Management.
“The degree of volatility is immaterial,” agreed Mark Mobius, Singapore-based executive chairman of Templeton Emerging Markets Group. “We have specific sell limits for all the stock we buy,” and when that limit is reached “the stock will be sold,” he said.
And despite Shanghai's composite index posting the biggest gain of any major equity market over the past six months, money managers say they're still able to find value there as well as in Hong Kong.
Whenever a market moves as quickly as Shanghai's has, it's hard not to be wary, but strictly on the basis of valuations, neither Shanghai or Hong Kong is in bubble territory, said Binay Chandgothia, a Hong Kong-based managing director and portfolio manager with Principal Global Investors' multiasset advisers boutique. When Shanghai's rally began, after five years of treading water, stocks were priced for a doomsday scenario, he said.
“Valuations are not extreme, even if the rally has been extreme,” agreed Cambridge Associates' Mr. Costello.
And the March 27 concession to mainland-based mutual funds might have been a response to shorter-term concerns about a stock market bubble emerging, he said.
The fact that regulators established a higher 13 billion renminbi daily quota for “northbound” Hong Kong-to-Shanghai investments suggests that making Shanghai a more institutional market was a relatively high priority at the time of the program's launch, Mr. Costello noted.
But as China's A-shares rally began looking more frothy this year, regulators quickly moved to boost the Connect program's southbound activity. Even though combined flows for those four sessions through April 13 only came to roughly $5 billion, as the marginal buyer, those mainland-based investors were able to have a surprisingly large impact on the market, he said.
The longer-term story of China's capital market opening remains an institutional one. In 10 years, China will undoubtedly be a far more significant chunk of every institutional investor's portfolio, and that's the focus of a growing number of asset owners now, said Mark Talbot, Hong Kong-based managing director, Asia-Pacific ex-Japan, with Fidelity Worldwide Investment.
From that perspective, Shanghai's ongoing rally could leave institutional investors facing a more expensive entry point should MSCI Inc., in its annual June announcement of changes to the firm's benchmark indexes, opt to add an initial fraction of China's A-shares market to its global and emerging markets indexes, as many analysts anticipate.
In a telephone interview, Chia Chin Ping, the Hong Kong-based managing director of MSCI's Asia-Pacific research, noted that MSCI doesn't take prevailing valuations into account when deciding whether a market deserves to be part of the investment opportunity set. n
