Shanghai-Hong Kong Hedge Funds

Shanghai-Hong Kong stock connect scheme to lure hedge funds

Linkage of the Shanghai and HK bourses will allow foreign investors to buy mainland shares without having to borrow QFII quota from banks

Hedge funds may drive initial demand for Shanghai-listed stocks through a linkage of the city’s bourse with that in Hong Kong, which opens up a new route for foreign investors to buy mainland shares, according to Goldman Sachs.

The link would tap into pent-up demand from hedge funds to buy yuan-denominated A shares in Shanghai, said Shane Bolton, the head of Asia prime brokerage at the New York-based bank. Long-only managers might grapple with pre-requirements that were different from their usual practice at the beginning, he added.

Foreign investors so far can only buy yuan shares listed on the mainland through the qualified foreign institutional investor (QFII) and the renminbi QFII programmes. The link, set to start next month, would allow investors, with or without their own QFII licences, to buy as much as 13 billion yuan (HK$16.4 billion) of Shanghai-traded yuan stocks a day, said a statement posted on the Hong Kong stock exchange’s website.

“Stock connect will be a game changer for most hedge funds, allowing them to access A shares for the first time without having to use banks’ QFII quota,” Bolton said.

Few hedge funds have been able to win their own QFII licences, which are typically reserved for long-term investors such as mutual fund managers, endowments and sovereign wealth funds. Instead, hedge funds have been borrowing QFII quotas from banks to buy A shares with such quotas in short supply when demand is high.

Shanghai-listed stocks accessible to foreign investors through the link will account for about 90 per cent of the bourse’s market value and 80 per cent of its average daily turnover, according to a May presentation posted on the Hong Kong exchange’s website.

Investors have been betting the link will help narrow the pricing gap between the two exchanges. The Hang Seng China AH Premium Index advanced to 97.7 in May after the plan’s initial announcement. It trades at 100 when prices between dual-listed shares are equal.

“We have seen an increase of interest in A shares after stock connect was announced in April,” Bolton said. “The interest is coming from both relative-value funds keen to exploit the price differences between A and H shares, and also fundamental stock pickers.”

The bourse connect rules required an asset manager to transfer shares held in a custodian bank account to the broker the day before they executed a sell order, the Hong Kong exchange’s website said.

In most other markets, long-only managers can have the securities delivery and payment between the custodian bank and the broker done on the settlement day, after the trade has been executed. Long-only managers may struggle with the rule in the beginning as it may signal to the market their sell intention.

Hedge funds were spared the problem by using prime brokers that could act as custodian and execute trades, as well as providing synthetic products, said Bolton.

Synthetic products are created artificially to simulate another instrument. For example, a synthetic stock can be created with simultaneous trades of call and put options.

Citigroup had worked with Hong Kong Exchanges and Clearing, the operator of the city’s bourse, to develop a solution that would not require pre-delivery of shares from custodian to broker, said Cindy Chen, the bank’s Hong Kong head for securities services.

Beijing has granted US$59.7 billion of QFII quota to 254 financial institutions, according to an August update posted on the website of the State Administration of Foreign Exchange. Goldman Sachs had US$300 million of such quota and held a further US$600 million quota through its asset management arm, the document said. Banks have been lending out their quota for fee revenue.

“Even after the implementation of stock connect, there will still be demand from both long-only managers and hedge funds for QFII quota,” said Jignesh Patel, a managing director on Goldman Sachs’ prime brokerage team. “QFII allows them to trade other products, such as Shenzhen-listed stocks and convertible bonds, which stock connect at present doesn’t cover.”

In addition, for investors to trade through stock connect, both the Shanghai and Hong Kong exchanges need to be open on the day. QFII did not have such restrictions, Patel added.