Hang Seng Index released its regular quarterly index adjustment results on Friday (February 26) evening (price data as of December 31, 2020, usually eight weeks later). It covers major flagship indices such as Hang Seng Index, Hang Seng China Enterprises Index and Hang Seng Technology Index.[1]。

In addition, the Hang Seng Composite Index, which is the basis of the investment scope of Hong Kong Stock Connect, has also released semi-annual adjustment results, so it is worth paying attention to. On the whole, this adjustment involves a wide range of areas and has a greater impact. After a comprehensive analysis of the impact, we release this report for investors' reference.

Hang Seng, State-owned Enterprises and Technology Index: expansion of Hang Seng Index, increase in New economy share of State-owned Enterprises Index

Adjustment and weight change of ► constituent stocks: Alibaba Health Information Technology, Longhu, Haidilao International Holding, Country Garden Services Holdings and NONGFU SPRING CO., LTD. were included in the Hang Seng Index and State-owned Enterprise Index.

1) Hang Seng Index: Alibaba Health Information Technology, Longfor Group and Haidilao International Holding are included this time, with weights of 0.89%, 0.62% and 0.58%, respectively. Non-constituent stocks are excluded. After adjustment, the number of constituent stocks increased from 52 to 55.

2) Hang Seng state-owned enterprises: this time, two companies, Country Garden Services Holdings and NONGFU SPRING CO., LTD., are included, with weights ranging from 1.3% to 1.2% respectively. In addition, there is a big change in the weight of JD.com (an increase of 0.5%). At the same time, the adjustment excluded four companies, including China Conch Venture, Petrochina, Hengan Internationgal Group and China Resources Gas, with weights of 0.75%, 0.72%, 0.48% and 0.45%, respectively. After adjustment, the number of constituent stocks has been reset from 52 to 50.

3) Hang Seng Technology: include Haier Smart Home and GDS Holdings Limited, excluding Qiu Tai Technology, Maoyan Entertainment, Xinxin Company and Yixin Group. The number of constituent shares has been reset from 32 to 30. Among them, Haier Smart Home, JD.com and GDS Holdings Limited, whose weights have changed greatly, increased by 2.7%, 1.6% and 0.7% respectively; on the contrary, the weights of Xin Xin Company, Maoyan Entertainment and Qiu Tai Technology decreased to 0 from 0.79%, 0.37% and 0.34% respectively.

► potential passive capital flow impact: pay attention to Alibaba Health Information Technology, Longhu and Haidilao International Holding and other potential positive impact; China Conch Venture, China Resources Gas and other possible negative impact.

Based on the current Bloomberg statistics, the amount of ETF funds tracking the Hang Seng Index is about $21.7 billion, while the ETF funds tracking the State-owned Enterprises Index and the Hang Seng Technology Index are about $4.9 billion and $300m, respectively. Then, combined with the change in the weight of constituent stocks, we measure their potential passive capital flows, and combined with the average daily trading amount of individual stocks in the past three months, we measure the possible impact of passive capital changes:

1) Hang Seng Index:Alibaba Health Information Technology, Longfor Group, Haidilao International Holding and BABA, which have the largest passive capital inflows, are expected to take 2.3,1.4 and 1.3 days respectively. Among the passive capital outflows needed for transactions, CLP Holdings Limited, trial Group and CKI are expected to have the longest outflow of transaction funds, with an average of about 0.4 days.

2) State-owned enterprise index:NONGFU SPRING CO., LTD. and Country Garden Services Holdings, who have the largest inflow of passive funds, expect the transaction time to be within one day; among the passive capital outflows of the required transactions, China Conch Venture and China Resources Gas need the longest transaction funds outflow time, both of which are more than one day.

3) Hang Seng Technology: Haier Smart Home, JD.com and GDS Holdings Limited, which have the largest passive capital inflows, are expected to see inflows of US $9.16 million, 5.27 million, 2.31 million and 2.18 million US dollars; the heart group with the largest passive capital outflows is expected to see an outflow of US $2.65 million. The average transaction required for the above potential inflows and outflows is about 0.1 days.

Chart: ETF fund size tracking Hang Seng Index, Hang Seng China Enterprises Index and Hang Seng Technology Index

Chart: hang Seng Index Adjustment and potential passive Capital flow Measurement

Chart: hang Seng State Enterprises Index Adjustment and Capital flow

Chart: hang Seng Technology Index Adjustment and Capital flow

Chart: the weight change of the state-owned enterprise index before and after this adjustment, the proportion of the new economy sector has reached 57%.

Follow the consultation results of the Hang Seng Index to be released on March 1.

On March 1, the Hang Seng Index Company will announce the proposal to optimize the Hang Seng Index to continue to be the most representative and important market benchmark in the Hong Kong market.[2]The result of consultation[3]We believe that it may be a very important reform in the history of the Hang Seng Index. The specific optimization suggestions in this consultation include:

► recommendation 1: expand the representativeness of the industry; select individual stocks by industry, and ensure the coverage of each industry (market capitalization and turnover).

At present, the stock selection criteria of the Hang Seng Index are still mainly based on market capitalization and trading volume, supplemented by the subjective considerations of the industry representation, financial performance and other advisory committees, although this can enable the index to include almost all the blue chips with the largest market capitalization, however, problems in the market structure will also lead to insufficient coverage of some "unpopular" or "weak" industries. Therefore, if adjusted in accordance with this proposal, it is possible to sacrifice individual large market capitalization companies, but can make the coverage of the industry more balanced.

► recommendation 2: increase the number of constituent stocks to 6580.

The Hang Seng Index had only 33 stocks when it was launched in 1969 and increased to 38 when the index began to include H-share companies in 2007. It was expanded to 50 constituent stocks in 2012 and maintained at that level for the next eight years until December 2020 to 52. With the increasing number of IPO coming to Hong Kong, the 50 or so fixed constituent stocks of the Hang Seng Index have become somewhat "stretched". By December 2020, their market value coverage of the overall market has dropped to 57.6%, and trading volume coverage has even dropped to 50.5%, which can no longer match the status of its market flagship index.

► recommendation 3: quickly include large-scale listed new shares; remove the minimum listing time requirement for eligible candidates.

The Hang Seng Index has relatively stringent fast-track inclusion criteria for new stocks. For example, super-large new stocks with the top five market capitalization in the whole market also need three months to list, while those below the 25th place need to be listed for 24 months. The requirements of this pair of large new shares are much stricter than the major international indexes such as MSCI and even the Hang Seng Composite Index. The current fast track is often that after the market value meets a certain threshold, it can be included within 10 working days after listing, which can ensure that the index can capture the leading new shares to the maximum extent, and then better represent the market appearance.

► recommendation 4: maintain the representativeness of Hong Kong companies; maintain a certain number of constituent stocks classified as Hong Kong companies (currently about 25) to support the representativeness of the Hong Kong portion in the index.

With the continued return of large Chinese companies, especially leading Chinese stocks, the weight of Hong Kong local companies in the Hang Seng Index has gradually dropped from 45.3% at the end of 2016 to 42.2% in December 2020, and we expect it to decline further in the future. Therefore, Hang Seng Index companies have asked whether to guarantee a fixed number of local companies in Hong Kong in order to maintain their representativeness to Hong Kong.

► recommendation 5: improve component equity redistribution; reduce the upper limit of component equity weight from the current 10% to 8%; and raise the upper limit of equity weight of different rights / secondary listed components of the same share from the current 5% to 8%.

In order to prevent the dominance of leading companies, the Hang Seng Index recommends that the limit of a single share be lowered to 8% from the current 10%, similar to the Hang Seng Technology Index. At the same time, when the same shares with different rights and secondary listed companies are allowed to be included this year, in order to prevent an one-time excessive impact, the upper limit is not more than 5%, but this time it is also proposed to be unified to 8%. At present, the cumulative weight of the top 10 stocks in the Hang Seng Index has reached 61.4%. Therefore, if it can be improved, on the one hand, it is expected to increase the weight of "tail" companies in the index, and at the same time, the proportion of companies with different rights and secondary listed companies is also expected to rise significantly.

In terms of specific implementation, the Hang Seng Index Company suggests that if the above optimization proposals are adopted, the transition time should be adjusted to one year. In this quarterly adjustment, the expansion of the Hang Seng Index to 55 stocks may have conveyed the intention and efforts of Hang Seng Index companies to optimize the index and enhance the representativeness of the Hang Seng Index. We believe that the optimization of the Hang Seng Index is not only expected to attract more investors as a benchmark or passive capital tracking, but also to further enhance the long-term attractiveness of the Hong Kong market as an international financial centre, especially as a "bridgehead" for investing in China's new economy.

Chart: market capitalization and turnover coverage of Hang Seng Index

Potential adjustment of Hong Kong Stock Connect: 30 companies may meet the inclusion criteria of Shanghai-Hong Kong Stock Connect

The index review also coincides with the semi-annual index review of the Hang Seng Composite Index (adjusted twice a year, with deadlines at the end of June and December, respectively), which will be the main basis for the Shanghai and Shenzhen exchanges to determine the investment scope of the Hong Kong Stock Connect. According to the adjustment of the Hang Seng Composite Index announced by the index companies, and combined with the additional requirements included by the Hong Kong Stock Connect (including the eligible scope of companies with different rights of the same shares and unprofitable biotechnology companies (- B) in 2020), we have made the following analysis on the adjustment of the potential Hong Kong stock market.

Specifically, this timeThere are 30 companies that may meet the requirements of the investment scope of the Hong Kong Stock Exchange., including Blue Moon, Pop Mart International, Evergrande Property Services, China Resources Mixc Lifestyle Services, ESR Cayman Limited, VESYNC, Sunac Services, Rongchang Bio-B, etc. Seven of these unprofitable biological companies (- B -) may benefit from the expansion of the Shanghai-Shenzhen-Hong Kong Stock Connect at the end of 2020, while GDS Holdings Limited-SW and Baozun Inc-SW are secondary listed companies that do not meet the inclusion criteria for Hong Kong Stock Connect. On the contrary, nine companies may be excluded from the Hong Kong Stock Connect.

Since the beginning of this year, southward funds from Hong Kong stocks have continued to flow into mainland China through the Shanghai-Shenzhen-Hong Kong Stock Connect, with a scale of more than 320 billion yuan, with daily inflows reaching record highs. Judging from the flow of funds to the south, the new economy sectors such as information technology, telecommunications services and consumption have all attracted a large amount of capital.Based on historical experience, we believe that the above-mentioned targets, which are expected to be newly included in the Hong Kong Stock Connect, may benefit from capital inflows and improved liquidity.

Chart: the southbound net purchase of the Shanghai-Shenzhen-Hong Kong Stock Connect has exceeded HK $385 billion since the beginning of the year, close to 50% of the net inflow in 2020.

Chart: 83% of southward funds have flowed into the new economy sector since the beginning of 2021, much higher than when insurance and bank wealth management funds were dominant in previous years.

Chart: adjustment of the investment scope of Hong Kong Stock Connect due to the adjustment of the Hang Seng Composite Index

Timetable: the index and Shanghai-Hong Kong Stock Connect adjustment will take effect on March 15.

In terms of timing, the above index adjustment results will be officially implemented on Monday, March 15. During this period, some active funds still do not rule out taking certain arbitrage operations according to the results of the adjustment announcement, but the passive funds will choose to adjust their positions on the trading day before they take effect (that is, March 12) in order to minimize the tracking error. At that time, the trading of relevant stocks will be much larger than the usual "abnormal volume" situation, especially in late trading.

Similarly, the Shanghai Stock Exchange and the Shenzhen Stock Exchange will adjust the investment range of the Shanghai-Shenzhen-Hong Kong Stock Connect on March 15 based on the Hang Seng Composite Index.