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AH shares arbitrage

August 06, 2014 | About:
phadkekaran

phadkekaran

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Background

A trend focused publication surfaced the recent phenomenon of A shares (listed on the Shanghai stock exchange) trading at a 7 year low relative to H shares (listed on the Hong Kong Stock Exchange). Usually A shares trade at a premium to H shares because local Chinese investors are restricted in how they can invest and therefore must deploy capital into A listed equities, therefore driving prices higher than the more open Hong Kong markets. Foreign investors are not able to purchase A shares unless it is via a special program called QFII. As of late, the A shares have been trading at ~10% discount to H shares.

Thesis

The local Chinese investors market may be reacting more negatively to policies detailed by the Communist Party on Nov. 15, 2013 which include steps to expand farmers’ land rights, let qualified private investors set up small-to-medium-sized banks, accelerate the convertibility of the yuan and free up interest rates. This uncertainty regarding reform has likely created the gap between A and H shares.

This trade is therefore predicated largely on mean reversion, law of one price, and gaining from short-termism by local investors. It can be tracked easily and there are catalysts that are likely to tighten the price dislocation.

It should be noted that the Morgan Stanley CAF fund / index contains multiple stocks that are trading at deep discounts relative to their H share prices, making it more attractive than plain exposure to an A share ETF.

Catalysts & Signal Tracking

In April 2014, China announced that it will allow cross border stock investment between Shanghai and Hong Kong. A small step towards letting Chinese individuals gain exposure to foreign equities and also let Hong Kong investors purchase A shares. This pilot scheme still incorporates quotas on investments, but it is a step closer towards open markets and will be rolled out late in the year. Officials have also pledged to increase the investment quota for the QFII program, allowing capital to enter the Shanghai exchange and prop up the underperforming Chinese equities. While both these catalysts have already occurred, we believe that over 2014 as capital actually starts flowing between the exchanges and more investors pile into the discounted A shares, there will be strong annualized returns to be had.

Another attractive feature of this trade is that the thesis can be tracked in a straight forward index, the Hang Seng AH Premium index (currently at 93.5). Historically it has reached well over 100, indicating A shares trading at a premium to H shares.

Sell signal would be if the index approaches 105–110 or parity (if exchanges are opened by year end).

Risks

This is a pure mean reversion strategy that should theoretically work given that shares listed on both exchanges ought to trade at the same price. However, pessimism and uncertainty on reform could drive the AH premium more out of line in the short term.

Furthermore, there is risk associated with the equity basket constructed by Morgan Stanley. It is quite heavily weighted in financials (12%) and security specific exposures could outweigh any discrepancies in relative pricing. That being said, many of the largest individual stock holdings are trading at historical lows with respect to AH premiums and they seem to be on the uptick.

It should be noted that the CAF fund has a 1.8% MER which is a further drag on performance.


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