The Government has announced plans to sell off its surplus equity holdings as a unit trust, which we recommended in February. The plan is short on detail and fails to commit to a scheduled disposal programme, instead preferring to time the launch based on "prevailing market conditions". Has the motive behind the intervention changed from protecting the currency to one of maximising profit? At current prices, we calculate that the Exchange Fund will have to sell HK$177bn of shares, or 79% of its holdings, to reduce its portfolio to the target 5% weighting.

EFIL Announces Sale Plans
21 June 1999

After several months of inward reflection and advice from Goldman Sachs, ING Barings and Jardine Fleming, the Hong Kong Government today announced that it plans to sell its excess equity portfolio, acquired during last year's intervention, in the form of a unit trust to be listed in Hong Kong.

No Timing

The use of a unit trust, which is accessible to retail investors as well as institutions was something we recommended in an article on back on 8-Feb-99. However, we also said that, in the same way that the Government pre-announces a schedule of land sales, it should also commit to a timetable for the sale of its equities in progressive slices, independent of market conditions. This would provide certainty to the market in terms of future supply of equities, without dumping it all in one go. For example, selling 2.5% of the portfolio per month for 40 months would be easily absorbed.

Instead, Exchange Fund Investment Limited (EFIL) has refused to commit to a timeframe. It states that 4 to 5 months of preparation will be required, but that "the timing of the launch will depend on the prevailing market conditions", thereby leaving uncertainty. This will likely exacerbate volatility in the market as it attempts to decide what level of Hang Seng Index will be acceptable to EFIL. Today's market reaction seems overdone, with the HSI now a whisker below 14,000. A sale is still a sale, and we still have no idea how much the Government will attempt to sell, when, and at what level.

The apparent effort to "time the market" brings into question whether the motives of the original intervention have changed. 10 months ago, the rationale was to protect the Hong Kong dollar against speculators, not to make a killing by cornering the market. Indeed, the only legal basis on which the HKMA felt able to intervene was in its role as guardian of the currency. Have these good (but misguided) intentions now become ones of maximising profit and minimising damage to the share prices of our largest companies? These share prices have out-performed the rest of the market by a large degree since intervention began, as we quantify below, benefiting the fund-raising exercises of several companies and in the process distorting capital allocation within the economy.

The current value of the portfolio is shown in the table below:

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Stock Shares held Price $
% of
1 HSBC 237,275,845 300.00 71.18 31.66 31.66
2 Hutchison Whampoa 342,194,832 72.75 24.89 11.07 42.73
3 HK Telecom 1,080,247,752 20.70 22.36 9.95 52.68
4 Cheung Kong (Holdings) 247,140,470 71.50 17.67 7.86 60.54
5 Sun Hung Kai Properties 216,741,540 71.50 15.50 6.89 67.43
6 Hang Seng Bank 126,067,870 91.50 11.54 5.13 72.56
7 China Telecom (HK) 478,806,000 22.25 10.65 4.74 77.30
8 CLP Holdings 163,623,440 38.40 6.28 2.79 80.09
9 New World Dev. 248,010,824 23.65 5.87 2.61 82.70
10 Swire Pacific 'A' 119,403,000 39.30 4.69 2.09 84.79
11 Henderson Land Dev. 85,349,000 44.40 3.79 1.69 86.48
12 HK & China Gas 326,438,032 11.50 3.75 1.67 88.15
13 CITIC Pacific 146,713,000 24.90 3.65 1.62 89.77
14 Wharf 136,013,000 23.50 3.20 1.42 91.19
15 HK Electric 124,335,500 24.90 3.10 1.38 92.57
16 Bank of East Asia 94,268,110 20.15 1.90 0.84 93.41
17 Cathay Pacific 139,659,000 12.65 1.77 0.79 94.20
18 China Resources Ent. 136,414,000 12.85 1.75 0.78 94.98
19 Cheung Kong Inf. 96,403,000 16.00 1.54 0.69 95.67
20 TVB 38,851,000 37.20 1.45 0.64 96.31
21 Shanghai Industrial 71,413,000 17.40 1.24 0.55 96.86
22 First Pacific 143,864,000 6.65 0.96 0.43 97.29
23 Hopewell 209,323,000 4.38 0.92 0.41 97.69
24 Hysan Dev. 69,732,000 12.35 0.86 0.38 98.08
25 Wheelock 62,391,000 10.60 0.66 0.29 98.37
26 Shangri-la Asia 61,674,000 9.65 0.60 0.26 98.64
27 Amoy Properties 71,135,500 7.45 0.53 0.24 98.87
28 Sino Land 107,238,000 4.90 0.53 0.23 99.11
29 Henderson Inv. 91,308,000 5.75 0.53 0.23 99.34
30 HK & Shanghai Hotels 66,593,666 7.15 0.48 0.21 99.55
31 Great Eagle 27,668,000 15.30 0.42 0.19 99.74
32 Hang Lung Dev. 33,156,000 9.80 0.32 0.14 99.88
33 Guangdong Inv. 157,472,000 1.66 0.26 0.12 100.00
Total 224.83 100.00

The above table is based on today's closing prices and assumes that no changes have taken place since the portfolio was disclosed in an announcement on 15-Dec-98, when it was worth $159bn, including $9bn inherited from the former SAR Land Fund. Since then the value has increased over 41% (excluding dividends) to $225bn. It is notable that the top 13 holdings account for 90% of the portfolio value, and HSBC alone accounts for almost one third. 

The HKMA announced on 3-Mar-99 that the new Asset Allocation strategy for the Exchange Fund would include 20% in the form of equities, of which 5% would be in Hong Kong. In the latest abridged Exchange Fund Balance Sheet as at 30-Apr-99, the fund had assets of $956bn. Therefor the target holding of Hong Kong equities is $48bn, and the Government needs to sell about $177bn (US$22.8bn) of shares, or 79% of its current portfolio.

Unit Trusts

So far, Unit Trusts have not been very popular among the retail public in Hong Kong, as retail investors prefer to make direct investments in individual stocks or warrants. This may stem in part from the heavy charges placed on subscriptions and management fees for investing in something that many investors feel (rightly or wrongly) they understand. Holding stocks directly allows investors to trade in and out of our volatile market without incurring hefty front-end or back-end (redemption) fees.

Hong Kong also has a highly concentrated equity market with the top 10 stocks accounting for some 66% of total market value at 30-Apr-99 and the next 10 accounting for another 12%, so the average investor can broadly track the market without a holding a large number of stocks. The new unit trust will need to be very low on charges and the Government will face a challenge to persuade the public of the perceived benefits of diversification - probably the only way to achieve this is to offer them a decent discount on the units.

The Government announcement was short on details, but the unit trust approach was believed to "cater to the needs of both retail and institutional investors".

What Kind of Unit Trust?

The term "Unit Trust" is normally used to describe an open-ended investment fund. What this means is that holders of units can present them to the manager who will redeem them at the price per unit which reflects the underlying asset value, usually with a spread attached. This is known as the "bid" price. Conversely, those who wish to increase their investment may subscribe for new units, at the "offer" price. A front-end fee, often split between the marketer and manager of the fund is either added to or built into this price. The difference between prices at which units are issued and redeemed is known as the "bid-offer" spread.

In the case of the Government Unit Trust (or GUT for short) it is unclear whether they would allow new subscriptions to the fund, but we would hope not - the last thing we want is more of the market to be locked up in Government hands. Indeed, we presume demand for the Units will be met by sales of existing units by the Government. So the fund should be closed to subscriptions.

The next question is whether redemptions would be possible, that is, will the Government allow Unit holders to convert their holdings to cash? The answer should surely be yes, so as to ensure that the price of the Units will always reflect the underlying value, and the underlying stocks will gradually return to the market as people cash in their Units.

In this way, the GUT will be a gradually diminishing portfolio, allowing only redemptions and not subscriptions. As Units are redeemed, the GUT will sell the underlying securities into the open market to raise funds to pay for the redemption.

If the Units are listed on the Stock Exchange, then investors will be able to choose between selling their Units in the market compared with redeeming them. If the time or charges attached to redemption are more than the costs of selling Units in the market, then it is possible that few of the Units will ever be redeemed and the GUT will end up as a permanent custodian of a big index portfolio. In that case, it is important that the directors of GUT are not appointed by Government but elected by Unit holders. Otherwise, the Government will remain able to exercise the votes and intervene in commercial affairs of the underlying companies.

A Weighty Problem

The GUT is to be "a unit trust product tracking the Hang Seng Index".  Apart from being great publicity for Hang Seng, this also means that the weighting of one stock, HSBC, will be about 3 times the normal 10% limit permitted by the SFC for authorised mutual funds. It is a reflection of how outdated the Hang Seng Index is when it comes to tracking the Hong Kong economy. HSBC is now a UK-headquartered global bank with about half its operations outside Hong Kong. It can't go without mention that Hang Seng Bank, which owns the rights to the index, is a subsidiary of HSBC as well as a member of its own index.

The Perils of Indexation

One hazard of encouraging the investing public to buy Hang Seng Index-linked units is that they end up boosting the demand for those 33 stocks compared with the rest of the market. This in turn increases the disparity in cost of capital between the elite members of the HSI club and those who are not. Since the intervention began last August, the Hang Seng Index has out-performed the Hang Seng Mid-Cap Index (which is basically the 101st to 150th largest companies) by about 44%. That makes it cheaper for the Hang Seng Index members to raise funds than for the rest of the market. It's the thin end of a dangerous wedge when the cost of capital gets distorted in this way. In future, when companies move in and out of the Hang Seng Index, there will be a much more dramatic effect on their prices if the GUT has to dump its holding in the departing stocks and buy a matching holding in the replacement stocks.

The Active Portfolio

With regard to the 5% of the Exchange Fund Assets, or around HK$48bn, which the Government plans to keep in Hong Kong equities, it said today that it plans to divide it into two portions (of unknown sizes). One portion will be passively managed (at low cost) to track the HSI, while the other will be actively managed and "expected to outperform the Hang Seng Index by investing in individual HSI constituent stocks within predefined permissible limits".

This is a great expectation - surely we can't expect them to do much better if they are only investing in the HSI stocks - or do they know something we don't? More importantly, it is alarming to read that the Government will only invest in the HSI constituents. In other words, intervention in the economy will be restricted to the top 33 stocks. If the Government's long term policy is to invest in the Hong Kong equities market, then surely that capital should be made available to the whole market and not allocated exclusively to the biggest companies.

Auction Program

The Government really should come off the fence and announce a schedule for the sale if its portfolio. This would provide the certainty that the market needs. EFIL is unwise to second-guess the market on when "prevailing conditions" will be right, since this is a reflexive question - the prevailing conditions will reflect the market's anticipation  of what the Government will do.

©, 1999

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