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Difficulty: Moderate

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An earlier version of this article had a typo in Section 1 for the second diagram. For “Stocks to be removed”, the median stock outperformance in Period C is -1.1%, NOT -4.5%.

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1) For the HSI & HSCEI, index inclusions appear to have an effect. Just not in the way you might expect!

• For the stocks that are to be INCLUDED
  • they outperform from announcement till rebalancing
  • but they underperform in the four weeks after rebalancing
• For the stocks that are to be REMOVED
  • there’s no particular tendency from announcement till rebalancing
  • but they underperform in the four weeks after rebalancing
• This outperformance/underperformance is relative to the index in question

2) HSI & HSCEI will rebalance on 7^th September

• TO BE ADDED to HSI/HSCEI: Alibaba (9988 HK), Xiaomi (1810 HK), WuXi Biologics (2269 HK), Meituan Dianping (3690 HK).
• TO BE REMOVED from HSI/HSCEI: Sino Land (83 HK), Want Want China Holdings (151 HK), China Shenhua Energy (1088 HK), BYD (1211 HK) and Citic Securities (6030 HK).

3) Here’s the expected ETF buying/selling for each stock

• ETF selling pressure on Sino Land and Want Want will approximate US$68mm and US$75mm, or 7.8 days and 6.1 days respectively of these stocks’ daily trading volumes, according to Goldman estimates.
• Meanwhile, Alibaba and Xiaomi are expected to see ETF buying demand of US$1.2bn and US$510mm, or approximately 1.8 days of these stocks’ daily trading volumes.

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The InvestQuest’s View

Disclaimer: Our thesis below is based on a fairly small sample size (~40 stocks each) and the trend may not hold up consistently. Plus, stock-specific factors may also interfere.

For the stocks that are to be INCLUDED: The results might suggest that 1) there is a tendency to outperform prior to the rebalancing and 2) a tendency to underperform after the rebalancing. This may be relevant for counters like Xiaomi, WuXi Biologics, Meituan Dianping which have rallied >10% in the 5 trading days since the announcement. It may also apply to Alibaba, but perhaps to a smaller extent.

For the stocks that are to be REMOVED: The results might suggest that 1) there might be no particular tendency prior to the rebalancing and 2) there’s a tendency to underperform after the rebalancing. Part 2 may be especially relevant for counters with high expected selling pressure (relative to average trading volume). This includes Sino Land, Want Want, and China Shenhua Energy.

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Disclaimer: We initiated shorts on China Shenhua Energy (1088 HK) and Want Want China Holdings (151 HK) on 20 August. Please do not take this as a recommendation! This is a speculative trade. Note that we have a higher risk tolerance compared to most investors. These shorts are intended to be short-term trades.

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Appendix 1: Difference between the HSI and HSCEI

Appendix 2: Individual Stock Returns vs HSI / HSCEI

Appendix 3: Recent studies show that the “Index Inclusion Effect” for the S&P 500 has weakened significantly

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1) For the HSI & HSCEI, index inclusions appear to have an effect. Just not in the way you might expect!

What is the Index Inclusion Effect? It posits that a stock’s inclusion to an index is associated with positive excess returns, while a stock’s removal from an index is associated with negative excess returns, relative to the Index.

To be clear, indices don’t physically hold stock, but the ETFs tracking them do. So when an index includes/removes a stock, the ETFs tracking the index will be forced to buy or sell the stock to faithfully replicate the index.

To check if the Index Inclusion Effect has been observed in the HK market previously, we looked at 79 stocks that have been INCLUDED and REMOVED from the Hang Seng Index (HSI Index) and Hang Seng China Enterprises Index (HSCEI Index) since 2015.

TIME PERIODS WE LOOKED AT

In short, we looked at stock vs. index performance for different time periods. “Announcement” refers to the Index Rebalancing Announcement.

• Period A: From “Announcement” to “1 Day After”
• Period B: From “Announcement” to “Day Before Rebalancing”
• Period C: From “Day Before Rebalancing” to “Four Weeks After Rebalancing”

Note that the time between the announcement and the actual rebalancing VARIES. But typically, the announcement is 2 to 4 weeks prior to the actual rebalancing.

STOCKS TO BE INCLUDED

Here’s the MEDIAN performance for stocks to be INCLUDED. Note that the performance is relative to the index. The white boxes show the proportion of stocks that underperformed/outperformed for that period. For more details of individual stock performance,you can check out Appendix 2.

STOCKS TO BE REMOVED

Here’s the MEDIAN performance for stocks to be REMOVED. Note that the performance is relative to the index. The white boxes show the proportion of stocks that underperformed/outperformed for that period. For more details of individual stock performance,you can check out Appendix 2.

OUR TAKEAWAY

• For the stocks that are to be INCLUDED
  • they outperform from announcement till rebalancing
  • but they underperform in the four weeks after rebalancing
• For the stocks that are to be REMOVED
  • there’s no particular tendency from announcement till rebalancing
  • but they underperform in the four weeks after rebalancing
• This outperformance/underperformance is relative to the index in question

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2) HSI & HSCEI will rebalance on 7 Sept

For the HSI & HSCEI, the announcement was out on 14 Aug (after market close). It’s been five trading days since then. See the quarterly index review results for more info. The stocks will be added or removed from the indexes on 7th Sept 2020.

Additions to Hang Seng Index (with weighting change within the Index):

• Alibaba (9988 HK): From 0% to 5.00%
• Xiaomi (1810 HK): From 0% to 2.59%
• Wuxi Biologics (2269 HK): 0% to 1.75%

Removals from Hang Seng Index (with weighting change within the Index):

• Sino Land (83 HK): From 0.36% to 0%
• Want Want China Holdings (151 HK): From 0.39% to 0%
• China Shenhua Energy (1088 HK): From 0.53% to 0%

Additions to HSCEI (with weighting change within the Index)::

• Meituan Dianping (3690 HK): From 0% to 5.00%
• Alibaba (9988 HK): From 0% to 5.00%
• Xiaomi (1810 HK): From 0% to 3.73%

Removals from HSCEI (with weighting change within the Index):

• Sinopharm Group (1099 HK): From 0.46% to 0%
• BYD (1211 HK): From 0.87% to 0%
• Citic Securities (6030 HK): From 0.73% to 0%

Naturally, some of the impacted stocks have already started to move after the announcement. See the two tables below.

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3) Here’s the expected ETF buying/selling for each stock

For each stock, we list 1) the expected index weight, 2) the expected buy/sell amounts of the stock and 3) the buy/sell amounts in terms of no. of days of the stocks’ average daily trading volume, as quoted from Goldman Sachs research.

The larger the buy/sell amounts relative to the average daily trading volume, the larger the price move expected when rebalancing occurs.

Goldman: Stocks that will see the largest SELLING pressure

• Sino Land: US$68m of ETF selling, or 7.8 days of average trading volume
• Want Want China Holdings: US$75m of ETF selling, or 6.1 days of average trading volume
• China Shenhua Energy: US$101m of ETF selling, or 2.5 days of average trading volume

Goldman: Stocks that will see the largest BUYING pressure

• WuXi Biologics: US$333m of ETF buying, or 3.2 days of average trading volume
• Alibaba: US$1.2b of ETF buying, or 1.8 days of average trading volume
• Xiaomi: US$510m of ETF buying, or 1.7 days of average trading volume

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The InvestQuest’s View

Disclaimer: Our thesis below is based on a fairly small sample size (~40 stocks each) and the trend may not hold up consistently. Plus, stock-specific factors may also interfere.

For the stocks that are to be INCLUDED: The results might suggest that 1) there is a tendency to outperform prior to the rebalancing and 2) a tendency to underperform after the rebalancing. This may be relevant for counters like Xiaomi, WuXi Biologics, Meituan Dianping which have rallied >10% in the 5 trading days since the announcement. It may also apply to Alibaba, but perhaps to a smaller extent.

For the stocks that are to be REMOVED: The results might suggest that 1) there might be no particular tendency prior to the rebalancing and 2) there’s a tendency to underperform after the rebalancing. Part 2 may be especially relevant for counters with high expected selling pressure (relative to average trading volume). This includes Sino Land, Want Want, and China Shenhua Energy.

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Disclaimer: We initiated shorts on China Shenhua Energy (1088 HK) and Want Want China Holdings (151 HK) on 20 August. Please do not take this as a recommendation! This is a speculative trade. Note that we have a higher risk tolerance compared to most investors. These shorts are intended to be short-term trades.

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Appendix 1: Difference between the HSI & HSCEI

The Hang Seng Index (“HSI”) is the most widely quoted gauge of the Hong Kong stock market, which includes the 50 largest and most liquid stocks listed on the Main Board of the Hong Kong Stock Exchange.

The Hang Seng China Enterprises Index (“HSCEI”) comprises the 50 largest and most liquid Mainland securities listed in Hong Kong. This means that non-China firms such as HSBC will not be on HSCEI Index, despite featuring on HSI Index.

We list the largest 5 stock holdings within both indices for reference below.

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Appendix 2: Individual Stock Returns vs HSI / HSCEI

For stocks that were previously included or removed from HSI/HSCEI, we looked at their performance vs. index performance for the periods surrounding Index Rebalancing. “Announcement” refers to the Index Rebalancing Announcement.

• Period A: From “Announcement” to “1 Day After”
• Period B: From “Announcement” to “Day Before Rebalancing”
• Period C: From “Day Before Rebalancing” to “Four Weeks After Rebalancing”

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Appendix 3: Recent studies show that the “Index Inclusion Effect” for the S&P 500 has a weakened significantly

Most finance professionals view the Index Inclusion Effect as a truth, since it is a logical conclusion to make and prior studies have proven it.

However, more recent studies have concluded that the Index Inclusion Effect has been weakening significantly (apparently since as early as 2007), particularly for large-cap and mid-cap stocks. We highlight two very recently published academic papers for reference below.

Sources:

Anthony A. Renshaw, The Weakening Index Effect, The Journal of Index Investing Summer 2020, Volume 11, Issue 1. Available for download at: https://go.qontigo.com/WP20200717-TheWeakeningIndexEffectJII_Registration.html

Bennett, Benjamin and Stulz, Rene M. and Wang, Zexi, Does Joining the S&P 500 Index Hurt Firms? (July 20, 2020). Fisher College of Business Working Paper No. 2020-03-017, Charles A. Dice Working Paper No. 2020-17, European Corporate Governance Institute – Finance Working Paper No. 690/2020, Available at SSRN: https://ssrn.com/abstract=3656628