Opinion: Hong Kong Index (HSI) structural reform could help investors diversify risks

2 Mar, 2021 20:31
source: Dr. Cliff Zhao

Singularity Financial Hong Kong March 2, 2020 – Original title: Hang Seng Index consultation result and quarterly review: Hang Seng Index enhancement to improve industry coverage; favorable to higher index valuation in long term

About this author: Dr. Cliff Zhao, chief strategist and managing director of CCB International; founding director of the Hong Kong Institute of International Finance. This article comes from the author’s research report issued by CCB International.

The Hong Kong Hang Seng Index Company released the “Hang Seng Indexes Company Announces Consultation Conclusions on Proposed Enhancements to Hang Seng Index” after the market close on March 1, 2021, covering key indexes such as the Hang Seng Index, the Hang Seng State-owned Enterprise Index, and the Hang Seng Technology Index. The Hang Seng Composite Index, which is the basis of the Southbound Stock Connect investment scope, has also released the results of semi-annual adjustments, so it is worthy of attention.

The HSI lags behind its global peers in 2020 for the first time in ten years. However, in recent years, when China’s technology giant has grown stronger, the HSI is no longer full of financial and real estate stocks. The December 2020 consultation document detailed the proposed baseline changes. According to market value, in 2019, the information technology industry has surpassed the financial sector to become the index’s largest industry.

On the whole, the adjustment involves a wide range, and its influence cannot be ignored. After consolidating the five major adjustments announced in the Consultation Conclusions, we put forward the following views on the relevant summary for investors’ reference.

1. Expansion in industrial representation. It was targeting a certain coverage ratio for each sector. Industries such as Materials, Industrials, Consumer Staples, Consumer Discretionary, and Healthcare were identified as having low coverage ratios, while financials were seen as having very high coverage ratios. This is likely to lead to certain financials being dropped from the HSI while other sectors will see stocks added to the index. Seven industry groups were selected, targeting market capitalization coverage of not less than 50% for each group.

2. Enlargement in market coverage, with a proposal to expand constituent stocks from 55 to 80 by mid-2022, and ultimately to 100. We anticipate this expansion will be staggered on a quarterly basis (potential targets in Chart 1 below). Assuming the mid-2022 target is achieved, we will see the addition of four-to-five stocks to the HSI per quarter.

3. Prompt inclusion of sizeable new listings by reducing the minimum listing history to three months, equivalent to the most relaxed listing history requirement, currently applicable to only the top-five market cap stocks. This change would fast-track big-name IPOs to the index, encouraging more companies to consider listing in Hong Kong.

4. Maintained representation of Hong Kong companies. The enhancement is expected to maintain around the same number of Hong Kong companies as present regardless of market cap, targeting 20-25 Hong Kong local companies remaining in the HSI.

5. Adoption of a weighting cap of 8% on all HSI constituents. Secondary and dual-class shares will see their index weighting ceiling rise from 5% to 8%, while the overall ceiling will fall from 10% to 8%. This would affect Tencent (700 HK), AIA (1299 HK), and HSBC (5 HK).

Additionally, on February 26, the Hang Seng Indexes Company released Hang Seng Indexes Announces Index Review Results based on the results of its 4Q20 Index Review. Key changes included the following and are to be implemented on March 15:

– HSI to expand constituents from 52 to 55, adding three stocks, Alibaba Health (241 HK), Longfor (960 HK), and Haidilao (6862 HK).

– HSCEI reduced its constituents from 52 to 50, adding two stocks, Country Garden Services (6098 HK) and Nongfu Spring (9633 HK), and removing four.

– HS Tech Index reduced constituents from 32 to 30 as it added two stocks, Haier Smart Home (6690 HK) and GDS Holdings (9698 HK), and removed four.

– HSCI expanded its constituents from 493 to 500 by adding 36 stocks while removing 29.

To better reflect the structural change of China’s economy and the Hong Kong equity market, the HSI is likely to continue the trend of the past years of increasing the weighting of new economy stocks in the index. From 2010 to 2020, new economy sectors as a proportion of the HSI rose from 15.4% to 31.8%.

According to our calculations, previous inclusions of tech stocks resulted in the HSI valuation moving higher. There was a significantly higher movement in the price component compared with the earnings component. As weighting shifts from relatively stable financials to more volatile tech stocks, the VHSI may trend higher.

Added stocks have historically benefited from increased fund flow from passive investment tracking the indices and greater exposure. The three added stocks, Alibaba Health, Longfor, and Haidilao, will raise the P P/E ratio of the index as a whole, though the effect is likely to be smaller than the previous two rounds, which saw tech industry leaders included in the index. The previous two rounds of inclusions to the index in both added approximately 1.1 points to the P/E ratio.