'China Index of Hong Kong Market'

Proposal to Enhance the Hang Seng China Enterprises Index As Regards Providing a Representative

‘China Index of Hong Kong Market’

March 2017

Note: The proposal contained in this document is for the purpose of holding discussions with market participants and various stakeholders. It may or may not lead to changes to the Hang Seng China Enterprises Index (“HSCEI”).

A. Summary and Background - A proposal to enhance the HSCEI as regards providing a representative ‘China index of Hong Kong market’

Highlights:  For historical reasons, the HSCEI only covers H-shares.  However, by the end of 2016, H-shares only accounted for around one-third of the total market capitalisation of Chinese enterprises (including H-shares, Red- chips and P-chips) listed in Hong Kong.  The existing HSCEI is highly concentrated in the Financials and Energy industries.  Hang Seng Indexes Company Limited (‘Hang Seng Indexes’) proposes to expand the coverage of the HSCEI by adding Red-chips and P-chips to the index to make it a representative ‘China index of Hong Kong market’.  Hang Seng Indexes will ensure that changes, if any, to the HSCEI will be gradual to minimise any potential impact on the market.

1.1 The HSCEI was created in 1994 with constituents comprising H-shares of Chinese enterprises listed in Hong Kong. Over the years, it has become a leading market benchmark for the performance of China sector listed in the Hong Kong market. Funds and derivatives tracking the HSCEI have grown in size over the years. Exhibit 1 shows that some of the products are comparable with or even exceed those of the Hang Seng Index (‘HSI’).

Exhibit 1. Exchange-traded Products / Derivatives Tracking HSI & HSCEI in 2016 Products HSI HSCEI Exchange-traded Products Number of ETP* 13 14 (‘ETP’) AUM* (USD Mn) 17,026 9,132 Average Daily Volume 140,928 137,673 Futures Open Interest* 124,918 322,904 Average Daily Volume 39,025 76,712 Options Open Interest* 252,082 2,078,923 Average Daily Turnover (HKD Mn) 2,106 226 Warrants % of Total Warrants 23% 2% Callable Bull/Bear Contracts Average Daily Turnover (HKD Mn) 5,260 125 (‘CBBCs’) % of Total CBBCs 94% 2% *As at the end of Dec 2016

1.2 However, the China sector of the Hong Kong market has undergone substantial changes in the past 10 years. A large number of Chinese private companies have been listed in Hong Kong (commonly called private enterprises or P-chips) in a broad range of industries such as Information Technology, Consumer Goods and Properties & Construction. The H-share sector has been dominated by Mainland banks, insurance companies, and oil and gas companies. The HSCEI, which does not have P-chips or Red-chips as constituents, has therefore become less representative of the China sector of the Hong Kong market.

(a) Market capitalisation – By the end of 2016, H-shares only accounted for 21%, in terms of market capitalisation, of the Hong Kong market and 32% of Chinese enterprises listed in Hong Kong.

Exhibit 2. Market Capitalisation Distribution by Share Class

% proportion of total market capitalisation

(b) Turnover - H-shares accounted for nearly half of Hong Kong market turnover in 2007 but dropped to less than 36% in 2016, while trading of P-chips increased significantly from 7.7% of the Hong Kong market in 2004 to 23.2% by the end of 2016.

Exhibit 3. Turnover Distribution by Share Class

% proportion of total market turnover

(c) Number of HK-listed companies - In terms of number of stocks, the importance of P- chips in the Hong Kong market has increased significantly when compared with other share classes.

Exhibit 4. Number of HK-listed Companies by Share Class

1.3 In recent years, some market participants have begun calling for a more representative China index that reflects the entire China sector in the Hong Kong market (i.e. an index that includes H-shares, Red-chips and P-chips) to serve as a market benchmark and an underlying index for the development of index funds and derivative products for hedging purposes. Compared with the existing HSCEI, it is envisaged that such an index will have the following characteristics:

(a) Broader coverage of Chinese enterprises listed in Hong Kong – The HSCEI currently only covers H-shares. The market capitalisation and turnover coverage of Chinese enterprises listed in Hong Kong would be enhanced if Red-chips and P-chips were included in the index.

(b) Lower concentration in Financials with addition of more ‘new economy’ companies – Including Red-chips and P-chips (which cover more ‘new economy’ companies) in the index would broaden the diversity of industries covered and would likely lead to exposure in Financials dropping from its existing HSCEI weighting of around 71%.

Exhibit 5. Industry Distribution of HSCEI (end-2016)

ENG Energy CSG Consumer Goods UTI Utilities IT Information Technology MAT Materials SER Consumer Services FIN Financials CGM Conglomerates IND Industrials TEL Telecommunications P&C Properties & Construction

1.4 Hang Seng Indexes believes the best strategy to achieve the twin objectives of having a representative ‘China index of Hong Kong market’ and a liquid and established market infrastructure for index funds and derivatives products is to enhance the HSCEI.

Proposal – Hang Seng Indexes proposes to enhance the HSCEI as regards providing a representative ‘China Index of Hong Kong market’ by gradually adding Red-chips and P-chips into the index as constituents.

If any changes to the HSCEI are implemented, Hang Seng Indexes will ensure that this is done gradually to minimise any potential impact on the market.

B. Preliminary Ideas

2.1 Hang Seng Indexes has the following initial ideas regarding the enhancement of HSCEI to become a representative ‘China index of Hong Kong market’.

 At the initial stage, the selection mechanism for H-shares will remain unchanged and the number of H-shares constituents will be kept constant (i.e. 40).

 On top of these 40 H-shares constituents, Hang Seng Indexes intends to add Red- chips and P-chips gradually to the index during the regular quarterly review.

2.2 Hang Seng Indexes will need to determine the following implementation details.

 The number of Red-chips and P-chips that should be added to the HSCEI

 The criteria for selecting Red-chips and P-chips for inclusion in the HSCEI

 The definition of a P-chip

 The process for adding Red-chips and P-chips to the HSCEI

The number of Red-chips and P-chips that should be added to the HSCEI

2.3 In deciding the appropriate number of Red-chips and P-chips to be added to the HSCEI, the following factors should be taken into consideration:

 weighting of Red-chips and P-chips in the HSCEI;  market capitalisation and turnover coverage of the HSCEI; and  industry distribution of the HSCEI.

Weighting of Red-chips and P-chips in the HSCEI

2.4 If Red-chips and P-chips are added to the HSCEI, the two largest market capitalisation Red-chips / P-chips would each account for 9 to 10% in the index. Another three to six Red-chips / P-chips would have individual index weighting of greater than 1% depending on the number of constituents to be added. For the rest of the Red-chips and P-chips, they would each account for less than 1% in terms of index weighting and a significant portion of them would have an index weighting of less than 0.5%.

Exhibit 6: Index Weighting of Red-chips and P-chips in the HSCEI

Number of Red-chip / P-chips Added Weighting in the HSCEI 10 20 30 40 50 60 >9.0% to <= 10.0% 2 2 2 2 2 2 >5.0% to <= 9.0% 0 0 0 0 0 0 >2.0% to <= 5.0% 1 1 1 1 1 1 >1.0% to <= 2.0% 5 5 4 3 2 2 >0.5% to <= 1.0% 2 12 17 15 16 16 <= 0.5% 0 0 6 19 29 39

* Simulated figures; assume different number of Red-chips and P-chips are added to the HSCEI

Market Capitalisation and Turnover Coverage of the HSCEI

2.5 The existing HSCEI includes 40 H-shares, covering about 26%, in terms of market capitalisation, of all Hong Kong-listed Chinese enterprises. The coverage would greatly be enhanced to over 58% after adding, for example, the biggest top 10 (in terms of market capitalisation) Red-chips and P-Chips to the index. Meanwhile, the marginal increase in market capitalisation coverage decreases as the number of constituents added increases. Similar statements can be made regarding index turnover coverage.

Exhibit 7. Market Capitalisation (left) and Turnover Coverage (right) of the HSCEI

* Simulated figures based on 12-month average market capitalisation and annual turnover of 2016 6

Industry Distribution of the HSCEI

2.6 The weighting of Financials in the HSCEI would be diluted to below 50% after adding the top 10 (in terms of market capitalisation) Red-chips and P-chips to the index. Further addition of Red-chips and P-chips is unlikely to have a significant impact on the industry distribution of the index.

Exhibit 8. Weighting of Financials in the HSCEI

* Simulated figures

2.7 Hang Seng Indexes intends to add a small number of Red-chips and P-chips to the HSCEI at the initial stage.

The criteria for selecting Red-chips and P-chips for inclusion in the HSCEI

2.8 HSCEI follows a pure rules-driven mechanism in its quarterly constituent reviews. Whether a company is eligible for index inclusion is determined solely by its listing history, turnover and market capitalisation as detailed in the index methodology. No quality screening is applied to constituents.

Exhibit 9. Current Selection Mechanism for HSCEI Constituents

2.9 In considering the addition of Red-chips and P-chips, which have very different risk profiles from H-shares, to the HSCEI, it appears that just focusing on the market capitalisation of a company to determine the priority for joining the index may not be the best approach.

2.10 In addition to the standard selection criteria that currently apply to the HSCEI, Hang Seng Indexes intends to also take into consideration the following factors in selecting Red-chips and P-chips:  risk-related parameters, e.g. financial performance of the company, price performance, volatility of share price, etc;  the representation of the industry within the HSCEI directly reflecting that of the market; and  other applicable factors.

The definition of a P-chip

2.11 P-chips are generally defined as private Chinese enterprises controlled by mainland Chinese individuals. According to Hang Seng Indexes’ current method of classifying companies listed in Hong Kong, companies with over 50% of their sales revenue (or profits, or assets if more appropriate) derived from the Mainland will be classified as Mainland companies (equivalent to Chinese enterprises). Mainland companies will further be classified as H-shares, Red-chips and Other Mainland companies. P-chips (as commonly defined by the market) would normally fall into the Other Mainland companies category.

Exhibit 10. Existing Classification of Mainland Companies

* Including state-owned organisations, provincial or municipal authorities of the Mainland

2.12 Hang Seng Indexes’ classification of Other Mainland companies is well defined. It is classified according to the figures disclosed in the annual report of the company.

2.13 As there exists no precise way to determine whether a person is a mainland Chinese individual, the classification of a company as a P-chip according to the current general definition, - i.e. a private Chinese enterprise controlled by mainland Chinese individual – could end up being a judgment call.

2.14 Hang Seng Indexes intends to determine whether or not a company is a P-chip by considering its business exposure, i.e. by using the process that is currently used to identify Other Mainland companies.

The process for adding Red-chips and P-chips to the HSCEI

2.15 The HSCEI is widely used by various product issuers as the underlying index for funds and derivatives. As shown in Exhibit 1, the AUM for funds reached USD 9 billion by the end of 2016, while the average daily traded volumes of futures and options in 2016 were over 137,000 and 76,000 respectively. The open interest of HSCEI options reached 2 million – more than eight times that of the HSI.

2.16 In adding new constituents to the HSCEI, particularly those that could take up large index weightings, Hang Seng Indexes will consider how best to ensure that the potential rebalancing impact on the index and on the market will be minimised. To achieve this, Hang Seng Indexes may consider:

i. adding constituents one by one, or limiting the number of constituents to be added in each review; or ii. limiting the maximum weighting of the constituent(s) to be added in each review; or iii. limiting both the number of constituents and maximum weighting of the constituent(s) to be added in each review.

2.17 Hang Seng Indexes currently favours option iii, i.e. to limit both the number of constituents and maximum weighting of constituent(s) to be added in each review.

Consultation with Market Participants and Various Stakeholders

2.18 Hang Seng Indexes will consult market participants and various stakeholders on the following implementation details.

 How many Red-chips and P-chips should be added to the HSCEI in order make it a representative ‘China index of Hong Kong market’?

 What criteria should be used for selecting Red-chips and P-chips for inclusion in the HSCEI?

 How should ‘P-chip’ be defined? (e.g. by ownership or by business exposure of the company)

 How should Red-chips and P-chips be added to the HSCEI in order to minimise the market impact?

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