Valuation differentials give ETFs advantage

HK-Shanghai bourse connect plan likely to create 'one-China market'

The Shanghai-to-Hong Kong stock price convergence trade is spurring record inflows into exchange-traded funds that invest in the Chinese mainland.

The two biggest ETFs tracking A shares attracted about $2.5 billion from the end of May through Wednesday, the most for any similar period since they both started trading.

By contrast, the largest ETFs that buy Hong Kong-traded Chinese companies, known as H shares, posted just $5 million of inflows.

Investors are betting valuation discounts of about 8 percent for A shares will narrow as a link between exchanges in Shanghai and Hong Kong, scheduled to start in about two months, makes it easier for arbitragers to close gaps between dual-listed securities.

The ETFs are getting an added boost from signs that China will take steps to maintain growth in the world's second-largest economy from falling below its 7.5 percent annual target.

"Why would you buy the Hong Kong stocks if you could buy them in the mainland at a discount?" Brendan Ahern, managing director at New York-based Krane Fund Advisors LLC, said in a phone interview on Wednesday. "You might be able to capture that gap with the connect coming online."

The inflows have been so big that some fund managers are seeking additional quotas from the mainland regulators, which currently allow only qualified institutions to access the mainland market.

CSOP Asset Management Ltd, which runs the second-largest ETF investing in mainland shares, said on July 30 that most of the existing quota for its fund has been used.

"We are begging for more quota," Cheah Cheng Hye, chairman of Hong Kong-based Value Partners Group, which runs the best-performing greater China equity fund of the past five years, said on Aug 2.

"We think the A-share market has become too cheap."

Since China unveiled plans to connect the bourses in April, the Hang Seng China AH Premium Index, which trades at 100 when prices between dual-listed shares are equal, has fallen 2.2 percent, signaling a deeper discount for mainland stocks.

The gap will disappear as the exchange tie-up leads to the creation of a "one-China" market, Jonathan Garner, the head of Asia and emerging-market strategy at Morgan Stanley, said in a Bloomberg Television interview on Tuesday.

Shanghai-HK stock link enters final testing	Top 10 largest stock exchanges