S&P and HKEx have joined together to form a new series of Hong Kong stock indices. There will be four new indices of large, medium and small cap stocks as well as one composite index based on all three other indices. All the stocks represented in the indices will from the main board of the Stock Exchange of Hong Kong.

The first new index is the S&P/HKEx 25 made up of 25 large cap stocks, which comprises almost 75% of the main board's market cap. The S&P/HKEx MidCap 25 will be made up of 25 mid cap stocks and the S&P/HKEx SmallCap 50 will comprise 50 small cap stocks. In addition the three indices will be combined to form a new all over index called the S&P/HKEx Composite.

According to Harold McGraw III, Chairman and CEO of McGraw-Hill, the parent of S&P, HKEx and S&P have been in discussions for two years over the move, aimed to provide Hong Kong with a better benchmark index than it currently enjoys.

"Hong Kong needs a benchmark that more clearly represents the activity that is taking place here. That's why we have developed it in terms of large caps, mid caps, small caps and the composite. It will put a spotlight on the best companies in each size category and be representative of all the sectors here," says McGraw.

HKEx denies that the move is because the company is unhappy with the current array of index providers in the Hong Kong market, rather it is about increasing business partnerships with market participants. A spokesman for the firm points out that HKEx has recently signed index partnership agreements with MSCI and Dow Jones as well as furthering the long-term relationship it has with Hang Seng Index on the derivatives side.

Key to the move is that both companies - S&P and HKEx - will be set to make money out of the derivative products that these new indices spawn. First off will be futures and options contracts based on the indices, which both companies confirm will be structured soon. "Introduction of the S&P/HKEx index series will facilitate the development of derivative products," says Kwong Ki Chi, CEO of HKEx. "Developing business partnerships like this one is an integral part of our strategy to improve our service to meet market needs and to expand our business opportunities."

In particular, the two companies are keen to attract the fund management community to the indices. Over the past year, HKEx has introduced the market infrastructure needed for Exchange Traded Funds (ETFs). These are funds that can be traded like a normal stocks and include passive investment vehicles derived from indices.

Barclays Global Investors already has one ETF in Hong Kong based on the MSCI China free index. The Tracker Fund, created by Exchange Fund Investments, State Street and the Hang Seng Index, is perhaps the biggest and most successful ETF to date in Hong Kong. HKEx and S&P will be hoping to attract more ETFs based on their new indices, from which the two companies will earn royalties.

The two companies could, however, decide to launch their own ETFs. S&P has done so with its successful US focused SPDRs product, which is based on its own S&P 500 index in the US. "We might do it very much like we did it with SPDRs with our partner HKEx," confirms McGraw. However any future ETFs are structured, they will be in good company as S&P indices are the basis for half of the $100 billion global ETF market.

The big question now is which companies will make it into the indices. The eventual decision is likely to be made by the end of the year, according to an HKEx spokesman. The criteria for inclusion will be set by S&P, although it has already confirmed that all Hong Kong shares will be eligible, including those of mainland companies.

The other criteria on which each stock will be judged include: float and liquidity; financial viability; market cap; and sectoral representation. It is unclear at this stage if the perennial question of 'is HSBC a Hong Kong or a British stock?' will be answered once and for all by its inclusion or exclusion form the index.

As the deadline looms towards the announcement, it should provide Hong Kong's army of speculators and hedge fund neophytes with ample trading opportunities. Coordinating the inclusion process will be David Collins of S&P Japan. He will be relocating to Hong Kong at the beginning of August to be managing director of the new Asia Pacific Index Services business.

Overall the move should provide another raft of professionalism and liquidity to the Hong Kong market. According to S&P, their stamp of approval on a company's stock is a big drawcard for investors and when it is applied to a market as a whole, everyone benefits. "The new index series will bring to investors an ability to participate in a benchmark for Hong Kong," says McGraw. "It is a very important step and will sit out there as a calling card for investors into Hong Kong. It will change behaviour and allow investors to have more confidence in the system."