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Difficulty: Moderate

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1) Recap: China A-shares vs H-shares

2) A-H premium is now at 48%

3) Historically, when A-H premiums reached this level, H-shares outperformed significantly

4) How to Invest: Ways to implement a spread trade (buy H-shares, sell A-shares)

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Appendix 1: Computing the A-H share valuation premium for specific China companies

Appendix 2: Sector Differences and Top Stock Holdings between China Indices

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The InvestQuest’s View: China A-shares are currently trading at its most expensive levels compared to H-shares of the same companies, since the 2008 Financial Crisis. We see an opportunity for a convergence trade (buy H-shares, sell A-shares), with a view that a Biden win and a strong Democratic showing in the Senate / House race could be short-term catalysts. Significant outperformance of H-shares vs A-shares was also observed historically, when A-H premiums had widened to current levels previously.

Disclaimer: We initiated this trade on 15 October 2020, buying the H-shares via the HSCEI Index Futures and 2828 HK, while simultaneously selling A-shares via the FTSE A50 China Index Futures. We have a 1-year investment horizon for this convergence trade.

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1) Recap: China A-shares vs H-shares

China companies can choose to list onshore (such as on Shanghai or Shenzhen Stock Exchange), offshore (such as on the Hong Kong Stock Exchange), or both. China A-shares are onshore stock listings that are denominated in RMB and predominantly traded by a Mainland investor base, while H-shares are Hong Kong stock listings denominated in HKD and largely traded by foreign investors. We note that in recent years, H-shares are increasingly being traded by Mainland investors using the “Stock Connect”.

For more details on A- and H-shares, you can read this Investopedia article.

For the SAME COMPANY, A-share valuations typically DIVERGE from H-shares valuations

For China companies that chose to list their shares BOTH onshore and in Hong Kong, we note that the shares often trade at different values (after adjusting for the stocks’ traded currency denomination). This can be linked to several reasons:

• Difference in market environments between Mainland and Hong Kong
• Difference in investor base (the proportion of retail investors is much greater in the A-shares vs H-share market)
• Inconvertibility between A-shares and H-shares
• Limited supply of shares in the A-share market, compared a much larger free-float in the H-share market, particularly for financials (banks, brokers and insurance stocks). See chart below.

Generally, A-shares tend to trade at a valuation premium to the same company’s H-shares though there have been instances in 2010-14 where this was not the case.

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2) A-H premium is now at 48%

A-H premium has been 22% on average

On average, A-shares have traded at a 22% premium to H-shares, but this premium has widened significantly in recent months to 48% currently (see image above). This is the widest A-H share valuation premium since the 07-08 Financial crisis and is in-line with peak levels seen during the 2015 China Stock Market Bubble.

What factors contribute to high A-H premiums?

In general, we observe that A-share valuation premiums grow wider when:

1. the world is experiencing a crisis (such as in 2008 and 2011 and now), where international investors are likely to fuel selling pressure of H-shares.
2. there is irrational exuberance within the domestic China market (such as in 2015), where A-shares would see more substantially more buying demand from Mainland retail investors.

Here’s the A-H premium for specific companies

What we referred to before was the AVERAGE A-H premium for the various companies that have both A-share and H-share listings.

In the below image, we compiled the “Current” and “Historical” A-H share valuation premiums on specific large-cap China companies. We note that all of their A-shares are trading at a wider valuation premium compared to the five-year historical average (see rightmost column).

For details on how the below figures are computed, please see Appendix 1.

Is there a way to arbitrage the A-H valuation premium?

There is no way to make a riskless profit on the A-H valuation gap, as 1) A-shares are not convertible to H-shares, even though they represent ownership stakes of the same company and, 2) Naked short-selling of A-shares is not allowed. However, we do believe that valuations for the same company should not diverge indefinitely.

In the next section, we review if a spread trade (buying H-shares and selling A-shares) makes sense. We attempt this by compiling the historical returns of A-share vs H-shares, when the A-H premium touched 48% in prior instances.

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3) Historically, when A-H premiums reached this level, H-shares outperformed

The A-H premium has reached 48% before! In our analysis, we looked at the relative returns of H-shares and A-shares in the 6-month, 1-year, 2-year and 3-year periods AFTER the A-H valuation premium widened above 48%.

For this analysis, we use the HSCEI Index as a proxy for H-share returns and the FTSE China A50 Index as a proxy for A-share returns. The HSCEI Index is comprised of 50 Mainland China securities listed in Hong Kong, while the FTSE A50 Index is comprised of the 50 largest A-shares stocks listed on the Shanghai & Shenzhen exchanges. There is an overlap of 16 companies that are represented in both indices.

The row highlighted in yellow below shows the outperformance of HSCEI compared to the FTSE A50, across the varying starting dates and investment holding periods. HSCEI had successfully outperformed the FTSE A50 in each data set, with an average cumulative outperformance of 13%, 24%, 34% and 34% across a 6-month, 1-year, 2-year and 3-year holding period respectively.

While what we have shown above is hardly scientific, we do believe that there is an element of valuation mean reversion at play. Looking at fundamentals, the FTSE A50 China Index now trades at 14.3x P/E vs HSCEI at 9.3x, the largest valuation gap in the last 10 years. This provides an attractive set up for a convergence trade in our view.

A possible near-term catalyst for this convergence trade would be a Biden win and a strong Democratic showing in the Senate / House race. This scenario is projected to result in calmer geopolitical tensions between US-China and a weaker USD, which might be the push that international investors need to revive investment interest in China.

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4) How to Invest? Ways to implement a spread trade (buy H-shares, sell A-shares)

In order to implement a spread trade, one must buy H-shares AND sell A-shares simultaneously, with a matching nominal exposure for each leg of the trade.

Part 1: Ways to BUY H-Shares

BUY HSCEI Index ETF: The HSCEI Index ETF that we deem optimal would be 2828 HK.

BUY HSCEI Index Futures: The Mini Hang Seng China Enterprises Index Futures (ticker “MCH”) trades with a contract multiplier of 10. This means that with the HSCEI Index currently at approximately 10,000, one mini-futures contract will give you roughly HKD 100k exposure to the Index.

Note that if you have a larger investment bite size, you can opt for the Hang Seng China Enterprises Index Futures (ticker “HHI”), which has a contract multiplier of 50, or approximately HKD 500k Index exposure per contract.

Part 2: Ways to SELL A-Shares

SELL CFD on FTSE A50 China ETF: There are CFDs on CSOP FTSE A50 ETF (2822 HK) which have high trading liquidity.

SELL FTSE China A50 Futures: The FTSE China A50 Index Futures is denominated in USD and traded on the SGX. It trades with a multiplier of 1, or approximately USD 16k Index exposure per contract.

Note: Using the Index Futures will likely be the cheapest way to implement the spread trade. However, do note that trading Futures can be risky, particularly since it is a derivative product and involves the use of leverage. You may read this Investopedia article on some of the common risks.

Is there a way to use Equity Options instead?

We had also looked at implementing the trade via options – executing a bullish risk reversal and bearish risk reversal on HSCEI and FTSE A50 respectively, but the pricing isn’t particularly attractive compared to the above-mentioned methods at the moment.

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The InvestQuest’s View

China A-shares are currently trading at its most expensive levels compared to H-shares of the same companies, since the 2008 Financial Crisis. We see an opportunity for a convergence trade (buy H-shares, sell A-shares), with a view that a Biden win and a strong Democratic showing in the Senate / House race could be short-term catalysts. Significant outperformance of H-shares vs A-shares was also observed historically, when A-H premiums had widened to current levels previously.

Disclaimer: We initiated this trade on 15 October 2020, buying the H-shares via the HSCEI Index Futures and 2828 HK, while simultaneously selling A-shares via the FTSE A50 China Index Futures. We have a 1-year investment horizon for this convergence trade.

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Appendix 1: Computing the A-H share valuation premium for specific China companies

To illustrate how the below figures are computed, we use China Construction Bank (CCB) as an example.

• On 14^th October 2020, CCB’s closing price for its A-shares and H-shares was CNY 6.17 and HKD 5.30 respectively.
• The corresponding CNYHKD FX rate was 1.15075.
• Rebasing CCB’s A-share to HKD terms would imply that the A-share is valued at HKD 7.10 (6.17 multiplied by 1.15075)
• CCB’s A-share currently trades at a premium of 34% (7.10 divided by 5.30 minus 1)

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Appendix 2: Sector Differences and Top Stock Holdings between China Indices

For the data presented in the below three images, some adjustments have been made so that the data can be comparable.