While last week’s approval of the Shenzhen Connect was long-anticipated, the announcement contained a surprise: the China and Hong Kong securities regulators pledged to extend the Shanghai and Shenzhen trading links to incorporate exchange-traded funds (ETFs) some time in 2017. 

There were no specifics forthcoming about what form this may take. But industry participants hope a number of items will be included in the extension, including wider product eligibility and details of which approvals processes the ETFs will have to follow. Plus they hope the proposed link could prove a boon to Hong Kong's evolving ETF market. 

Product eligibility

Some contacts said they hoped the link could expand the existing market’s narrow landscape, which has a market capitalisation of HK$590 billion ($76 billion) but is dominated by vehicles that track China and Hong Kong assets. A good way to broaden this universe would be to bring in more flows from mainland investors, who increasingly want to make global investments.

“The most obvious question will be around what types of ETFs will be allowed to be included,” said Stewart Aldcroft, Hong Kong-based senior fund adviser at CitiTrust, citing as an example the newly allowed leveraged and inverse ETFs in the city.

Quota questions

Another key issue is the level of independence ETFs receive within the Connect agreements.

Clarence Chan, Hong Kong-based head of ETFs and beta investments at BMO Global Asset Management, said it would also be important to see whether the ETF Connect has a separate programme with its own quotas, distinct from the existing quotas available to investors participating in the Shanghai and Shenzhen Connect.

The advantage of this would be that ETFs trading in the scheme would not risk having their daily liquidity affected by sharing the same quota as the Shanghai and Shenzhen links. 

Connect or MRF rules?

Chan also questioned whether the rules of product eligibility and fund-raising for ETFs under the cross-border link will follow concepts under the Connect schemes or instead adhere closer to the mutual recognition of funds (MRF) scheme, which launched last July. This could have a big impact on their appeal to mainland investors.

Eligible stocks under stock trading links are based on listed companies’ market capitalisation. If the market cap cut-off for each ETF were set at a reasonably low level, such as Rmb200 million ($30.1 million), it would enable many Hong Kong ETFs to be included. 

The MRF’s northbound (Hong Kong to China) leg, however, has a different set of requirements. It requires that Hong Kong-domiciled funds have a minimum one-year track record and have total assets under management of at least Rmb200 million. And, importantly, the funds must not primarily invest in China’s onshore capital markets. Additionally, approved funds cannot raise more than half of their AUM from mainland investors. Such rules would likely heavily restrict Chinese investor interest. 

“If similar [MRF] rules are applied to the ETF Connect, then the money most Hong Kong ETFs can raise [from mainland investors] is not much,” said Chan.

Presently, 33 Hong Kong-listed ETFs have AUM of more than Rmb200 million, but 13 of these mainly invest in China equities and bonds, according to data from Hong Kong Exchange and Clearing (HKEx) as of last Friday.

“An issue that ETFs will want to avoid is for there to be an approval process similar to MRF that in effect prevents funds from access,” said Aldcroft.

ETFs need fast approval

Related to which set of rules is used to monitor the ETFs is how quickly they can be approved into the new Connect scheme.

The funds industry will hope the ETF trading link does not require a duplicate approval process like the MRF scheme, which could substantially lengthen the time it takes to get funds included. Approval from the China Securities Regulatory Commission (CSRC) in particular can be laborious; the regulator has only approved six Hong Kong funds in the past 12 months.

Such slow approvals be particularly detrimental for ETFs, which tend to benefit from and take advantage of new market trends and developments that capture investors' attention. The lengthy duplicate approval process could well mean they miss windows of opportunity, affecting the flows they get from Chinese investors. 

Chan and Aldcroft believe non-China ETFs would appeal to mainland investors, as such products can allow them to access to global markets. ETFs tracking foreign indices such as the S&P 500, FTSE 100, Nikke i225, Eurostoxx, gold and other commodities might be attractive, noted Aldcroft.

Changing Hong Kong’s ETF market

Ultimately, ETF providers hope the increasing interest of mainland investors in foreign assets will offer Hong Kong-listed ETFs a big growth opportunity – and help the market to evolve.

Currently there are 145 Hong Kong-listed ETFs (excluding the renminbi share class). The top five funds of this group in terms of average daily turnover (ADT) are China and Hong Kong equity products. They represent 96.6% of the industry’s ADT this year of July. Meanwhile, the top five funds in terms of AUM represent 41% of the industry total as of July, according to HKEx, which runs Hong Kong’s bourse. In other words, it’s a highly concentrated market.

The hope is that mainland investor money entering Hong Kong’s ETF market in bulk could help broaden the number of products and improve their liquidity, said Aldcroft.