The Hang Seng Index changes present new opportunities for investors looking for growth

Hong Kong’s Hang Seng Indexes has announced that it plans to include weighted voting right companies (WVRs) and secondary-listing companies in its benchmark Hang Seng Index (HSI). This represents the Hang Seng’s most significant index methodology revision in more than a decade.

Following its May consultation on the inclusion of WVRs and secondary-listed firms from the Greater China region (i.e., Hong Kong, Mainland China, Macau, and Taiwan), Hang Seng Indexes announced on August 14, 2020, that it would make three constituent changes to the HSI, two of which are WVRs.¹ These revisions will come into effect on September 7, 2020. 

Hang Seng Indexes will also conduct a comprehensive six-month study of the HSI: The review will look at its composition and selection of constituents, the number of constituents, weightings, as well as industry and geographical representation.

The number of constituents in the HSI may increase to more than 50 during this period.

A natural evolution

The addition of WVRs and secondary-listed companies—which are mainly from the new economy sectors—has diverse implications. For one, we believe that the HSI will likely reduce its current skew toward financials and provide a better representation of the market. In that sense, it's a natural evolution, but it won't be an overly drastic one. Investors should note that the rebalancing exercise isn't 100% rule based, but supplemented by a qualitative judgment made by a committee. This approach should reduce the chance of extreme bias toward new economy stocks and ensure a holistic market-wide representation.

From a valuation perspective, we expect that the price-to-earnings multiples as well as earnings-per-share growth of the HSI to be higher after the inclusion, at least in the near to medium term; however, volatility isn't expected to shift in a big way by simply changing a few names.

What it means for investors

The change to the HSI is a continuation of its push toward making Chinese equities a more holistic proposition for foreign investors—a drive initially triggered by MSCI’s inclusion of A-shares, which phased out the segregation between offshore and onshore Chinese stocks. We think the return of American depositary receipts (ADRs) and biotech IPOs will not only further enhance the breadth and depth of the market, but also offer more attractive fast-growing listing candidates to investors. The inclusion of these new sectors and stocks into the HSI, therefore, also makes such a push more official and visible.

Foreign investors aside, the return of these ADRs demonstrates that demand from Asian investors and the regulatory framework has reached a critical point whereby new economy companies can reliably source their equity financing here in Hong Kong. This is likely to also lead to more southbound investment flows. Whether this translates into higher growth of investments and shareholdings by mainland investors will, we believe, ultimately depend on if the China Securities Regulatory Commission is willing to relax southbound investing rules for onshore retail investors, such as by abolishing the minimum RMB 500,000 threshold.²

Trends and opportunities

The combination of a strong policy push and a prolonged low interest-rate outlook can only accelerate investments in innovation sectors in China, especially in the Greater Bay Area. As a renowned service provider with superb infrastructure, we believe the Hong Kong market is one of the top IPO destinations for mega-cap, consumption, financial and professional services-related companies. We believe that HSI composition changes and the type of IPOs it attracts will, therefore, serve as an accurate reflection of Hong Kong’s economic evolution.

Conclusion

Hong Kong's stock market is undergoing a major structural evolution. Some initiatives have already come into play while many others are in the making. For instance, the updated listing guidance for biotech companies3 has also been a success and is expected to continue to attract more biotech companies to the Hong Kong Exchange Main Board. The index rebalancing and the launch of the Hang Seng Tech Index reflect this ongoing trend.

Given that WVR and secondary-listing names tend to come from the high-growth new-economy sectors, we believe investors can take advantage of these new opportunities. In addition, investors can consider the new share classes, such as WVRs, from an environmental, social, and governance perspective to ensure that shareholder rights wouldn't be undermined.

Simple graphic outlining key milestones for the Hang Seng Index. The index was launched in 1969 with 33 constituents. The first red-chip company was added to the index in 1994.  In 2006, HSI calculation methodology was changed to free-float adjusted market capitalization weighted (from full market capitalization weighted). In 20017, the maximum number of constituents for the index was increased to 50. In 2014, the first real estate investment trust was included in the index. In 2020, weighted voting right firms and secondary listed companies are added to the Hang Seng Index universe

 

1 Hang Seng Indexes quarterly index review results, August 14, 2020. The information neither indicates any actual portfolio holdings nor constitutes any investment recommendation or advice. 2 SH-HK Stock Connect Information Book for investors, October 25, 2019 version. Only mainland institutional investors and those individual investors who satisfy the eligibility criteria (i.e., individual investors who hold an aggregate balance of no less than RMB 500,000 in their securities and cash accounts) will be accepted to trade Hong Kong-listed eligible securities in southbound trading. 3 Hong Kong Exchanges and Clearing Limited, April 28, 2018. On April 30, 2018, Hong Kong Exchanges and Clearing Limited added new listing rules, under Chapter 18A, to permit listings of biotech issuers that do not meet any of the Main Board financial eligibility tests.

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Winson Fong, CFA

Winson Fong, CFA, 

Senior Portfolio Manager, Greater China Equity

Manulife Investment Management

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