After Friday, February 18, 2022, Beijing time, the Hang Seng Index Company will announce the results of the semi-annual review of the Hang Seng Index (the deadline for the review is December 31, 2021). These include major flagship indices such as the Hang Seng Index, the State-owned Enterprises Index and the Hang Seng Technology Index, as well as the Hang Seng Composite Index, which serves as the basis for the Hong Kong Stock Connect sample.

As this is a semi-annual adjustment and the systematic optimization of the Hang Seng Index is on its way, the adjustment is expected to be large. At the same time, considering the large scale of passive funds tracking some flagship indexes (according to Bloomberg, the ETF funds tracking the Hang Seng Index and the State-owned Enterprise Index are about $21.9 billion and $4.65 billion, respectively), we believe that the changes in potential constituent stocks and the corresponding changes in capital flows deserve investors' attention. Based on the available public data, we preview the potential index adjustments as follows for investors' reference.

Semi-annual adjustment of Hang Seng Index: the pace of index expansion may be accelerated, focusing on some of the new economic leaders

Preview of possible changes this time.Based on the available data and index adjustment methods, especially through the understanding and verification of the systemically optimized compilation method through the previous adjustment results, we believe that the eight companies at the top of the Hang Seng Index are likely to be included potential candidates. Our calculation gives priority to the order of market capitalization, combined with the comprehensive consideration of the representative of various industries. However, in the actual adjustment process, the indicators such as industry representativeness, listing place representativeness and financial performance, which are the basis for the decision-making of the index advisory committee, do not have a detailed explanation or quantitative basis, not to mention the compilation method itself, because the systematic adjustment of the index is still in the process of continuous optimization, so the above prediction can not be completely accurate, and can only be delineated as a reference.

The pace of expansion of constituent stocks may be more significant.By the third quarter of 2021, the number of constituent stocks of the Hang Seng Index had increased from 50 in the first quarter of 2021 to 64. According to the optimization proposal issued by Hang Seng Index in March 2021, the constituent stocks of the Hang Seng Index willIncrease to 80 by mid-2022Finally, it was fixed at 100. Considering that there is only this semi-annual adjustment before the middle of 2022, and there are two adjustments with March 31 and June 30 as the deadlines for the study.Therefore, we expect that the pace of capacity expansion may be more significant than the previous ones.(3 in the first quarter of 2021, 2 in the second quarter and 4 in the third quarter of 2021). With the expansion of constituent stocks, the coverage of some industries will also be expanded.

Semi-annual adjustment of Hang Seng Composite Index: affecting the investment scope of Hong Kong Stock Connect, 15 stocks may be eligible for inclusion

This periodic adjustment also involves the biannual index review of the Hang Seng Composite Index (twice a year, with deadlines of June 30 and December 31). As the Hang Seng Composite Index is the sample space for Hong Kong Stock Connect investment, its changes will also directly affect the investment scope of Hong Kong Stock Connect, which is worth paying attention to.

Based on the adjustment method of the Hang Seng Composite Index, combined with the need to meet the additional criteria for inclusion in the Hong Kong Stock Connect (for example, the Shenzhen-Hong Kong Stock Connect can include stocks worth more than HK $5 billion in the small-cap stock market of the Hang Seng Composite Index, remove the risk warning implemented by the exchange, be suspended or enter the delisting period of individual stocks. Companies with different rights in the same shares also need to meet the additional conditions such as listing for 6 months and 20 days, as well as market value and transaction, etc.), we estimate that this time, a total of 15 stocks may meet the criteria for inclusion in the Hong Kong Stock Connect. In addition, due to some limitations in the accuracy of the publicly available data, we accept a fault tolerance rate of 1%, that is, the threshold for the inclusion of 94% coverage required by the Hang Seng Composite Index is relaxed to 95%. In this context, eight companies may also meet the criteria for the inclusion of the Hang Seng Composite Index and be included in the scope of Hong Kong stocks, but we have a low ranking of confidence for the latter. Please refer to the report for details.

Chart: semi-annual composition adjustment rules for Hang Seng Composite Index

Chart: screening process and rules of Hong Kong Stock Exchange

Timetable: announced at the close of trading on February 18; implemented on March 7, with the corresponding adjustment of the Hong Kong Stock Exchange Standard.

In terms of timing, Hang Seng Index will announce the results of the formal review of the adjustment of the Hang Seng Index after the close on Friday, February 18, 2022, which will be implemented on Monday, March 7. After the index adjustment takes effect on March 7, the Shanghai and Shenzhen exchanges will then (depending on the announcement of the exchange) adjust the scope of investment targets of the Shanghai-Shenzhen-Hong Kong Stock Connect accordingly.

During this period, similar to the MSCI index adjustment, some active funds still do not rule out the possibility that some arbitrage operations will be taken according to the results of the adjustment, but the passive funds will choose to adjust their positions on the trading day before the effective date (that is, March 4) in order to minimize the tracking error, when the relevant stock transactions will be much larger than the usual "abnormal volume" situation, especially in late trading. In addition, according to historical experience,The small and medium-sized companies newly included in the Shanghai-Hong Kong Stock Connect or those that have been re-included because of the resumption of trading after a long period of suspension may have a relatively significant increase in transaction activity.It's worth watching.

Southward trend and market outlook: steady inflow of mainland funds; gradual turnaround of Hong Kong stocks, mean return in 2022

Since the beginning of 2022, southward capital inflows from Shanghai, Shenzhen and Hong Kong have averaged 2 billion yuan a day, continuing the steady inflow trend since December last year, or even accelerating.Since the beginning of 2022, southward funds from Hong Kong stocks have continued to flow into Hong Kong stocks. as of January 20, 2022, mainland capital inflows into Hong Kong stocks totaled 26.2 billion yuan, with an average daily net inflow of 2.02 billion yuan, with only outflows recorded on the first day of January 4. it has continued the strong inflow momentum since December last year, and has further accelerated. The strong southbound capital reflects that Hong Kong stocks remain attractive to mainland investors, not to mention that the existing reasonable valuation advantage of Hong Kong stocks will further attract more southbound capital inflows. this can also be reflected in the recent trend that Hong Kong stocks have outperformed A-shares and other global markets.

Recently, we have pointed out more than once (see "the turnaround of Hong Kong stocks" and "expected mean return in 2022"). The environment facing the Hong Kong market today is similar to that in early 2016 and early 2019 (for example, the market has experienced a sharp correction, valuations are historically low, investor sentiment is low and wait-and-see sentiment is strong, lack of capital inflows for a period of time, but policy has entered a loosening period, etc.) Southward capital inflows are similar to those at that time. We expect that the already relaxed liquidity environment and the superimposed obvious valuation advantages will be sufficient to attract more domestic capital inflows at this stage, which in turn will promote valuation repair in the Hong Kong stock market.

We reiterate the point made in the 2022 outlook report "mean regression":Given the favourable liquidity and policy environment, as well as low valuations, the Hong Kong stock market in 2022 is likely to be a year of mean regression.In the short term, new changes in the epidemic at home and abroad, the approach of the Spring Festival holiday and the Federal Reserve's January FOMC meeting and other factors may make some internal and external disturbances and uncertainties may still exist, but as the steady growth policy continues to promote growth repair at the beginning of this year, especially the gradual dissipation of some uncertain factors, we believe that the overseas Chinese stock market is expected to gradually rebound, thus attracting more capital inflows.

Chart: tracking the size of ETF funds in the Hang Seng Index and Hang Seng China Enterprises Index