What are the opportunities and limitations of ETF Connect?

C.Y. Wong CPA, Director, Corporate Finance, OCBC Bank and member of the Institute’s Corporate Finance Committee

In 2014, Stock Connect was introduced to allow eligible Mainland China investors to access the Hong Kong stock market with ease, as well as allowing foreign investors to access the Chinese stock market. Since then, Stock Connect has become a successful investment channel for both domestic investors and foreign investors to access more investment opportunities conveniently. In June, it was announced the Stock Connect would be expanded to include eligible exchange-traded funds (ETFs) for both Northbound trading and Southbound trading on 4 July.

As the China domestic market is a closed market, and domestic investors are restricted from accessing overseas market, the risk and return exposures of the Mainland China market are very different from that of the Hong Kong market. The introduction of ETF Connect provides a very good opportunity for investors to get a foot into a new market. As there are thousands of stocks in each stock market, ETF Connect significantly simplified how an investor could access the other markets without needing to hand pick the stocks to invest in as is the case through Stock Connect. Also, since there is an investment cap for each individual stock in ETF, investors could appraise a new market without needing to worry about how to manage and diversify their risk exposure on a single stock. Different baskets of stock portfolios held by different ETFs could also help investors to diversify their concentration risk into different industry segments.

This could help attract more domestic investors to come invest in Hong Kong markets in order to diversify their concentrated exposure in the China domestic market, as well as give foreign investors an opportunity to understand the Mainland China stock market more by actually participating in it. With an enlarged investor base, this could also potentially entice more asset managers to offer more ETFs with distinctive investment mandates in both the China domestic and Hong Kong markets, facilitating further cross-border investment and creating a virtuous cycle for the ETF market.

“The extremely limited number of ETFs available for Southbound trading has significantly hampered the attractiveness of ETF Connect to domestic investors.”

However, at the initial phase, one of the criteria for an ETF to be admitted into ETF Connect is that most of the stocks in its portfolio must be Stock Connect eligible. As such, investors could already have invested in the underlying stocks directly under Stock Connect, making the ETF Connect less appealing to investors. In addition, unlike the Northbound trading where there are 83 eligible ETFs available for foreign investors to invest in, only four ETFs are admitted into Southbound trading for domestic investors to choose from. The extremely limited number of ETFs available for Southbound trading has significantly hampered the attractiveness of ETF Connect to domestic investors. Without relaxing the admission criteria, the number of ETFs eligible to be included will continue to be limited, and will therefore limit the potential of ETF Connect.

Second opinions

Aron Leung CPA, Director and Independent Advisor, Max Value Partners Limited and member of the Institute’s Corporate Finance Committee

The launch of the long-awaited ETF Connect this year was a remarkable milestone for the already successful Stock Connect, the investment channel that connects the Hong Kong Stock Exchange, Shanghai Stock Exchange and Shenzhen Stock Exchange. A wider range of investment products plays a critical role in investment risk management and ETF products allow investors more choice to tailor for different investment strategies and to diversify their risk.

Only four Hong Kong-listed ETFs are available for Mainland investors initially under ETF Connect but despite this, the trading volume in the Southbound route for ETF surged by about 90 percent in August. Issuers are happy to see the inclusion of Mainland investors from this channel, which proves to be significant under Stock Connect. As an international financial hub with a properly regulated securities market, Hong Kong will continue to attract global financial institutions to issue Hong Kong-listed ETFs with different themes, and to bolster the development of the ETF market.

“Hong Kong will continue to attract global financial institutions to issue Hong Kong-listed ETFs with different themes, and to bolster the development of the ETF market.”

Offshore investors, on the other hand, may not be active comparatively in investing in Shanghai and Shenzhen-listed ETFs under ETF Connect. The standard of corporate governance and disclosure transparency of the underlying equities of these ETFs are areas that offshore investors most probably will need to investigate before making their investment decisions. Considering that ETF Connect had just launched in July, it is inevitable that it will take some time for offshore investors to build confidence in the Northbound route. Some of these ETFs are sector-based or niche products that I believe are good options for offshore investors as they have more options in their investment products for different investment strategies. Professionals in Hong Kong have exceptional opportunities to help market these ETF products to offshore investment funds.

Fear of an upcoming recession driven by recent global economic turmoil has relentlessly shocked the market. It accelerated the need for holistic investment vehicles, such as inversed products, to steer through the pervasive and vibrant market conditions. We expect the exchanges will continue to enhance Stock Connect’s product offering with the addition of more ETFs with different themes and functions in the near future, and with periodic reviews of market demand.

Second opinions

Rebecca Sin, Senior ETF Analyst at Bloomberg Intelligence, and Co-Chair of ASIA’s Women in ETFs

ETF Connect, which investors have been anticipating since 2016, has started to trade earlier this year. ETFs have been added to Stock Connect linking the Hong Kong, Shanghai, and Shenzhen exchanges. Adding ETFs to the product offerings not only provides a low-cost investment option but also helps broaden the investor base for ETFs, spurring the segment’s trading activity, liquidity, and cross-border asset allocations. By bringing onshore Chinese investors to Hong Kong, ETF Connect will diversify the profile of the city’s ETF investors and may provide opposing flows as well as liquidity to Hong Kong-listed ETFs.

The inclusion of ETFs on the Stock Connect may take years before materially contributing to the income of Hong Kong Stock Exchange (HKEX) but investors remain optimistic as there is a need for diversification of products in China. Only those that track Hong Kong-listed stocks with average assets under management (AUM) of more than HK$1.7 billion over the past six months are eligible in the Stock Connect programme. ETFs tracking A-shares are eligible for the first phase of inclusion in the Northbound Stock Connect. This excludes non-Hong Kong equities ETFs tracking overseas, fixed income, currencies, and commodities products. Hong Kong equities ETFs account for 51.1 percent of the market capitalization as of March 2022, while Mainland China A-shares ETFs account for 14.3 percent, followed by fixed income and currencies at 12 percent, according to data compiled by Bloomberg.

A potential key for Mainland investors is non-equity focused ETFs and may be key to the success of the Stock Connect as ETFs listed in Shanghai and Shenzhen are primarily dominated by local indices, accounting for more than two thirds of the country’s total ETF AUM. Another large portion of ETFs in China are money-market funds which account for roughly 25 percent of ETF AUM as investors look for higher yield compared to traditional bank deposit rates. Southbound demand could be muted though due to limited product selection and will be insignificant towards HKEX’s earnings.

“A potential key for Mainland investors is non-equity focused ETFs.”

ETFs in Asia have had a slow adoption rate due to the regulatory framework. In Asia, regulations don’t favour ETFs as many distributors still provide retrocession fees or rebates for mutual funds, thus putting ETFs in a difficult spot. Trading volume on ETF Connect in Japan remains low. Of the five regions that have or will have ETF Connect programmes, Japan ranks top by ETF flows in 2021 at US$23 billion, followed by South Korea at US$13.7 billion, Hong Kong at US$13.4 billion, China at US$12.9 billion and Singapore at US$2.9 billion. The potential is tremendous across Asia as it’s starting from a much lower base, yet regulations would need to support the market to help make ETFs a mainstream product.

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