Background
Hong Kong has historically been viewed as a gateway to investing in mainland China, and the country’s international finance centre. The Hong Kong stock exchange is open to trading for all international investors, and trades in Hong Kong dollars, which are pegged to the US dollar and can be easily exchanged. The exchange has over 2,000 companies, with around 350 of these being H-shares, some of the largest companies incorporated in China but listed in Hong Kong. These H-shares make up around 12% of the index (by market cap), though when combined with so-called ‘red chips’, which are companies owned by Chinese individuals or the government, but incorporated outside China, this figure jumps to over 75%, showing how much of the Hong Kong market is dependent on China in one way or another.
By listing in the country, these companies have had to uphold the rule of law in Hong Kong, which operates under a separate legal system from China and is based on the principles of British common law. As such, investors have strong legal protections and property rights when investing in these companies.
However, in the past few years, there have been several new laws that have undermined Hong Kong’s special status. The largest of these has been the implementation of a new national security law, despite huge protests, which has raised concerns over the future of Hong Kong’s democracy. This has curtailed press freedoms, after criminalising material that is considered to promote secession from China. Furthermore, oversight on the implementation of these laws is now in the hands of Beijing, as the national security commissioner is appointed by China rather than Hong Kong. There have also been tweaks to market regulations, primarily around the corporate governance rules of the c. 150 H-shares that are dual-listed in mainland China. This has led to many warnings that the shareholder protections of a listing in Hong Kong have been diminished. This has been borne out in the statistics too, with Hong Kong falling to the 13th best market to IPO in in 2024, according to the London Stock Exchange Group, after being consistently placed in the top three for much of the decade prior, and in first place as recently as 2019.
China’s domestic market growth
Hong Kong’s waning star has come at a time when China’s stock markets have been looking to increase their international standing and representation in global indices. By way of background, there are two major markets in China, the Shenzhen and the Shanghai stock exchanges. The larger of the firms listed here are called A-shares. A-shares are traded in Chinese yuan renminbi (CNY) and are mainly available to citizens of mainland China, although foreign investors are able to invest through a heavily regulated structure. The CNY is subject to capital controls meaning it cannot be exchanged without permission from the government, and the exchange rate is controlled centrally.
Listed companies in China are subject to the Chinese civil law system, which is based on socialist principles. Changes in legislation can be made centrally by the government which oversees the regulator, and these can occur quickly with limited legal recourse. This was the case in 2021 when the government effectively banned for-profit companies in private education, decimating the sector almost overnight. Governance rules are less strict than for H-shares though, which has led to comments that the onshore Chinese market is both overly regulated, due to government restrictions, and not regulated enough due to lower governance standards.
Despite this, the A-share market continues to grow. As the country develops, more companies are looking to public markets as a way to fund their future growth and are choosing the A-share market to do so. The lower regulatory requirements are often cited as a reason behind this, with pressure from the Chinese government also a potential factor as they have historically favoured having oversight of their domestic champions. However, the A-share market is more developed now than it was just a few years ago, meaning raising capital domestically is a much more viable option for Chinese firms, rather than having to tap international investors via the H-shares market or listing on other foreign exchanges.
Chinese equities were first included in the MSCI Emerging Market Index in 2000 at a c. 7% weight. Until 2018, when A Shares were included for the first time, it was mostly H-Shares, Red Chips and companies listed in the US via American Depositary Receipts. The overall Chinese weighting peaked at 41% in 2020. This has since pulled back to around 30% now after the country struggled with headwinds as a result of the extended zero-covid policy, as well as sluggish growth. In contrast, Hong Kong is less than 1% of the MSCI Emerging Markets Index. On a more local basis, Hong Kong makes up just 4.5% of the MSCI Asia Pacific ex Japan Index, compared to China’s 21.2% making it the largest country allocation in the index as of July 2024.
China has a much lower weight in the MSCI AC Asia ex Japan Small Cap Index at only 9.5%, versus an average weight of 26.8% in the other indices. As such, all three smaller companies trusts are overweight China, but not in the context of the wider region. Only one trust, Fidelity Asian Values plc (LON:FAS), is close to the average index weighting in China, with co-managers Nitin Bajaj and Ajinkya Dhavale allocating significantly to the country due to what they believe are compelling valuations. Similarly, the managers of abrdn Asia Focus (AAS) have often varied their allocations between the two depending on their outlook. They acknowledge there is a significant difference in the small-cap versus large-cap market and highlight that this is one of the key attractions of the smaller companies sector.
Fidelity Asian Values Plc (LON:FAS) provides shareholders with a differentiated equity exposure to Asian Markets. Asia is the world’s fastest-growing economic region and the trust looks to capitalise on this by finding good businesses, run by good people and buying them at a good price.
