Arbitrage Alert Triggered as Shanghai-Hong Kong Gap Grows

Arnout van Rijn can’t resist a good arbitrage opportunity.

The chief investment officer in Hong Kong for Robeco, whose Asia-Pacific stock fund beat 92 percent of peers in the past three years, says he’s wagered on narrowing price gaps between dual-listed stocks in Thailand, South Korea and Singapore during a more than 20-year career managing money. He’s now turning to China, where equities traded on the mainland are valued at the biggest discounts since 2006 versus counterparts in Hong Kong.

Robeco is using its quota under China’s Qualified Foreign Institutional Investor program to buy mainland consumer and industrial firms with dual listings in Hong Kong, anticipating the price gaps will narrow as an exchange link with Shanghai makes it easier for money to move between the two bourses. While the mainland discount has grown as local investors exit the Chinese market and international money managers await details of the exchange tie-up, van Rijn says those who buy now and have the resolve to hold their positions will be rewarded.

“I enjoy the discounts trade, because there’s lot of free money as long as there’s the staying power,” van Rijn, who helps Robeco manage about $290 billion worldwide, said in an interview in Hong Kong. “I don’t care if it’s going to happen now or in the next three years, if I just know that I’m on the right side of the equation.”

Exchange Link

China’s benchmark Shanghai Composite Index dropped 3.3 percent this year through July 11, versus a 4 percent retreat in the Hang Seng China Enterprises Index of mainland companies listed in Hong Kong, known as H shares. The Shanghai measure has pared some of its losses in the past two months, rallying 1.8 percent as the government unveiled measures to support economic growth and a gauge of manufacturing industries increased to the highest level this year.

The Shanghai and Hong Kong exchanges agreed on April 10 to allow as much as 23.5 billion yuan ($3.8 billion) of daily cross-border trading, opening up the mainland market further to foreigners while giving wealthy Chinese investors a route to buy Hong Kong stocks. Authorities at the time said the link would start in about six months.

Existing rules restrict overseas money managers seeking investments in China to foreign currency-denominated B shares, while only approved institutional investors can invest in yuan-denominated A shares. There were $56.5 billion of approved quotas under the QFII program as of June 30, including $235 million for Robeco, according to the State Administration of Foreign Exchange.

Discount Deepens

“A-share blue chips at discount to H are set to benefit,” Tony Lau, a Hong Kong-based senior equity specialist at Coutts & Co., which oversees about $49 billion, said in an e-mail on July

11. “In the medium term, we believe fund flows from Hong Kong to Shanghai will dominate.”

While the markets’ valuation difference narrowed more than 4 percent in the first month after the exchanges said they would link trading, the gap has since grown to the widest level since May 2006. The Hang Seng China AH Premium index dropped 0.3 percent to 90.72 on July 11, signaling a 9.3 percent discount for A shares. A reading of 100 would show valuations on the two markets had converged.

The premium index rose 0.1 percent at the close, while the Shanghai Composite jumped 1 percent for the biggest gain in a month. The Hang Seng China Enterprises gauge added 0.8 percent.

Chinese traders have turned more pessimistic on the outlook for stocks in the past three months, liquidating about 700,000 mainland stock accounts since the end of March. That left the number of funded accounts at 53.15 million, a four-year low.

MSCI Decision

Some money managers are still waiting for further details on how the exchange link will work, including whether China’s government will enforce a capital gains tax, said Ryosuke Kawahata, a Tokyo-based money manager at Mizuho Asset Management, which invests in the A share market via the QFII program, said by phone on June 26.

The nation’s personal-income laws stipulate that gains from stock trading are subject to a 20 percent tax, though the finance ministry and taxation bureau have exempted investors from the levy since 1994 to promote the development of the stock market.

If concern over the tax regime still exists by the time the exchange link starts, the valuation gap may persist, Alexandre Werno, a Shanghai-based executive vice general manager of Fortune SG Fund Management Co., which oversees about $11 billion, said by e-mail on July 11. MSCI Inc. cited China’s unclear tax laws as one of the reasons it decided last month to exclude local shares from its global indexes.

Air China

“We need to see the details,” said Gerry Alfonso, a sales trader at Shenyin & Wanguo Securities Co. in Shanghai. “The closer we get to having the program running, and the more information we have, the more likely we are of finding opportunities.”

For Robeco’s van Rijn, who has an overweight position in China, the potential for smaller discounts on A shares just adds to the appeal of a market that’s trading at low valuations versus developing-nation peers.

The Shanghai Composite has a price-to-earnings ratio of 10, a 26 percent discount versus the MSCI Emerging Markets Index, the most since Bloomberg began compiling the weekly data in


Among dual-listed consumer and industrial companies, Air China Ltd., the nation’s largest carrier by market capitalization, trades at an 11 percent discount on the mainland. Tsingtao Brewery Co., the country’s biggest listed brewer, is 18 percent cheaper while Jiangsu Expressway Co., a Nanjing-based operator of toll roads, has a 27 percent discount, according to data compiled by Bloomberg.

“When you sit behind your desk and see all these gaps between these Shanghai-listed stocks and HK-listed stocks, you ask yourself: Why aren’t they closing more rapidly when everyone knows it’s coming?” van Rijn said.

— With assistance by Phani Varahabhotla, Weiyi Lim, and Shidong Zhang

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