Hong Kong ranks as one of the world’s freest economies and is often dubbed “big market, small government”, a surprising characterization of a country owned since 1997 by China, a notably interventionist government. Despite its frequent intrusions in the Shenzhen and Shanghai equity markets, the Chinese government has left the Hong Kong market alone. That is, until now.
The Hong Kong Hang Seng Index (HSI) is one of the world’s top performing markets this year, returning 27.7 percent through August 31. And that’s reflected in the performance of the two Hong Kong-focused exchange-traded funds—the iShares MSCI Hong Kong ETF (EWH) and the First Trust Hong Kong AlphaDex Fund (FHK), both of which are up close to 29 percent this year.
The HSI consists of 49 members, including high-profile independent Chinese companies as well as many state-owned enterprises. That is just a small representation of the total Hong Kong stock exchange, where 2,060 companies are listed with more than $30.2 billion in market capitalization.
Chinese companies listed in Hong Kong consist of H shares, which are shares of companies incorporated in mainland China (these companies also have A shares listed on one of the exchanges in China); and red chips, which are Chinese companies incorporated outside of mainland China and controlled by mainland government entities. The HSI also lists Hong Kong-based enterprises. Currently, Chinese companies make up approximately 65 percent of the total Hong Kong market capitalization.
Chinese companies have been available to international investors through the HSI for the past two decades, and that access widened in 2014 when a direct link between the Chinese equity markets and the Hong Kong stock exchange was forged. Unlike Chinese markets that foreigners couldn’t access directly (that will change to a degree after MSCI in June said it would include 222 mainland Chinese companies in some of its global indexes by mid 2018) and which are known for government interference, Hong Kong has been recognized for allowing market forces to control the fate of its member companies, a characteristic that is being challenged.
Communist Party Butting In
In August, the Wall Street Journal reported that since 2016 at least 32 Chinese state-owned companies or units listed in Hong Kong have proposed changes to their corporate structures to install Communist Party committees that advise their boards of directors. This change, the article said, impacts almost one-third of the total value of stocks listed in Hong Kong.
The verdict is still out on the influence the Communist Party will have on the operating decisions of these Hong Kong-listed companies since all but two of the 32 companies added the committees between April and August of this year. But some investors fear this trend will weaken the ability of market forces to dictate the direction of the Hong Kong market, and that shareholder interests could take a backseat at those affected companies.
Jonathan Passmore, former international equity portfolio manager at GE Asset Management, believes the objectives of the Communist Party may be at odds with those of shareholders.
"There's no guarantee that the Party committees will follow proper free market capitalism objectives in the pursuit of business," he commented. "If the Party has to be consulted about business matters, the likelihood that sustainable profit will be the objective seems pretty slim. Most problematic would be that active managers would hardly be likely to invest in companies with hidden agendas and despite the growth of passive investing, active funds are still hugely significant, especially in markets like Hong Kong. Active managers have a choice—why would a long-term manager get into ‘partnership’ with China's Communist Party?"