The prospectus for the Tracker Fund is now out and we've read it. In this article we look at the complexities of how and when the discount and pricing will be fixed, the odd lots created by the loyalty bonus, and make an early assessment of the potential public demand.

On TraHK
25 October 1999

The prospectus for the Tracker Fund of Hong Kong (TraHK) was published today, and brings you the key details.

To view the full prospectus, go to the TraHK web site and use the password "TraHK" and city "Hong Kong". Then download the prospectus in PDF format (get the free Acrobat reader first). Strangely, when we checked the site, we found that they've posted the so-called "red herring" document used in the international marketing, which has all sorts of stuff about Hong Kong from an international perspective. This is contained in what professionals call a "wrap-around" - a set of extra pages that go around (or in front of) the Hong Kong prospectus. For example, the wrap-around says:

"an investment in Hong Kong securities may carry the risk of less publicly available information, more market volatility, less strict securities regulation, and greater political uncertainty than investments in securities of other jurisdictions, such as the United States and the United Kingdom."

How refreshingly honest. Hong Kong investors are assumed to know this, since the warning does not appear in their version of the prospectus. If you don't know that by now, you shouldn't be investing.

Loyalty units in Y2K

As expected, the Government is offering you extra units in TraHK for free if you will hold the ones you are allocated for at least one year. You'll get 1 unit for every 20 still held after one year, and 1 for every 15 held (including the first bonus unit) if you hold them for a further year.

The prospectus actually says the first year expires on 12-Nov-2000 (or if not a business day, the next day which is a business day). Perhaps they'll spend some of the issue proceeds on buying a Y2K calendar, because 12-Nov-2000 is a Sunday - there's no speculation about that. So the first bonus will probably be due on Monday 13-Nov-2000.

By the way, if you decide to apply, make sure you use the white application form if you hold a HKID card and Hong Kong address. Those are the two criteria to qualify for the loyalty bonus. A non-Chinese friend of ours queued at the HSBC head office today in Queen's Road to pick up a prospectus, and was given an English document stuffed with a blue form (for those who don't qualify for the bonus). Apparently HSBC thinks that anyone who is not Chinese must be a tourist. Thanks, guys. Why any tourist would want to apply for TraHK is beyond comprehension.

Odd Lots will be a problem

Now because of the strange ratios used for the loyalty shares, it will be very difficult to get whole board lots of loyalty units (each board lot is 500 units). We explained in our previous article how the outdated board lot system works. After the first anniversary, you'll be holding 21 units for every 20 you originally bought. Multiply that by 16/15 for the second bonus, and you end up with 28 units for every 25 you originally bought. Put simply, you get 12% more units than you paid for.

As the prospectus notes, "odd lots usually trade at a discount to the price of board lots". Anyone who has ever tried to sell odd lots of bonus shares will know what they mean. Typically a discount of 5% for blue chips or 10% for second-liners might be in order. The prospectus also states that "no special dealing arrangements will be put in place to facilitate the trading or disposal of loyalty bonus units in odd lots". You're on your own, folks.

In order to get whole board lots of bonus units after 2 years, you need to subscribe for a multiple of 25 board lots (12,500 units, but you can't apply for that number because they only take applications for multiples of 2,000 units in that range).

In addition, if you want to retain the flexibility to get out in whole lots after the first bonus, then you need to buy a multiple of 20 lots (10,000 units). The lowest common multiple of 20 and 25 is 100. So buy 100 lots (50,000 units) and you'll be fine. You'll get 2,500 units in the first bonus and 3,500 in the second bonus. But each unit has a maximum issue price of $13.80, so that means buying $690,000 of units. Most people will not be in this league, so most people will have odd lots. In any case, you might be allotted fewer units than you apply for, ruining that strategy. 

Ironically, one of the benefits being promoted in respect of the TraHK is that "the minimum investment size in the IPO is lower than buying board lots in the HSI constituent companies". That's true, but instead, most participants will get odd lots of loyalty units, something which could have been avoided with smaller board lots.

Discount to what?

The prospectus is, to say the least, cryptic on the method of determining the "reference market price" (RMP) against which the issue discount is given.

If you dig deep enough then you find that the reference market price (RMP) is based on the 3-day average of the EAS price. EAS stands for "Exercise and Alignment Settlement" which uses the same method that the Hong Kong Futures Exchange uses to determine the expiry price of its futures contracts each month. In the case of TraHK, this means that you take the average of the market price of each share at 5-minute intervals, excluding the morning and afternoon opens (at 10:00 and 14:30) and the afternoon close (at 16:00). There are 47 such readings each day, of which 30 are in the morning and 17 in the afternoon. You then take the average EAS price for 3 days (or 141 readings) for each stock, and then use this to calculate the index on the last day.

The 3-day average period in fact ends at 15:55 on Monday 8-Nov-99, 4-days after the retail offer closes (12:00 on Thursday 4-Nov-99). The only part of the averaging period during which you can apply for the offer is between 10:00 and 12:00 on Thursday 4-Nov-99. That's only 17% of the averaging period (even if you are standing outside the bank, form in hand, watching the Hang Seng Index). So in effect, you have no way of knowing what the market reference price will be until after you have applied.

The institutional Offer is a bit better on timing. According to a syndicate briefing seen by, the "book-building period" during which institutions must make their orders (which can be made dependent on pricing) closes at 5pm in each time zone on Friday 5-Nov-99. So they get the last bite at the cherry. If you are a US institution in New York then that's 06:00 on Saturday 6-Nov-99, Hong Kong time. 

The prospectus states that the Retail Issue Price will be "at a discount" to the reference market price, whereas the Institutional Issue Price will be "at or at a discount" to the RMP. That's a subtle but deliberate difference - meaning that there is no minimum discount on the institutional offer, and it could (theoretically) be done at the average EAS.

How big is big?

That's one of the strangest things about this offer - there is no fixed number of units being offered. That's not determined until after the offer is over on 8-Nov-99. "How many do you want?" they ask. "Depends on the price, mate" the institutions will say. The Government cannot (for political reasons) be seen to give a greater discount to institutions than to the retail public. At the same time, institutions don't get the loyalty bonus, and they don't normally buy unit trusts - on the contrary, they run them. So we can't expect great institutional enthusiasm unless they are offered the chance of a seriously quick buck.

We've done our share of government privatisations (Scottish Electricity in 1991 is remembered fondly). Over the weekend of 6-7-Nov-99, with two thirds of the averaging period behind them, the bankers will be tallying all the institutional and retail applications and determining how much demand there has been. There will then be one more day of trading followed by a late night on 8-Nov-99 finalising the issue price and (in this unusual case) the amount of units to be sold. We might see the Government deliberately "scale back" retail applications a little to create the impression of a successful offer.

The greatest fun will be had in the market on 4-Nov, 5-Nov and 8-Nov, while the offer is closed but the pricing is still open. We can expect some interesting arbitrage strategies to play themselves out. People will be selling index futures short in anticipation of allocations, which will have a negative influence on prices (in the absence of other factors, that means they go down).  If the market falls during the pricing period, then the reference market price (averaged over the 3 days) will be higher than the closing price on 8-Nov. That will force the Government to set a larger discount to the RMP in order to make the issue fly. That makes the units cheaper. In some ways, it is the best outcome the government could hope for, because it could create a "feel good" factor about the retail offer if people get it at a lower price.

The Government will bear in mind that the public is locked-in until the units start trading on 12-Nov. They will be keen to build in enough "cushion" to reduce the risk of the units opening at a discount to the issue price, in the event that the market falls in the 3 intervening days. The ghost of an opening discount would be a difficult hurdle to overcome in future Government offerings, and besides the TraHK we still have the planned float of the MTRC. So we expect them to price on the cautious side.

So will the Public buy it?

Despite Hong Kong's image as a speculative nirvana, the latest Secondary Market Survey by the Stock Exchange of Hong Kong in Jan-99 found that only 13% of those adults surveyed owned shares, while a further 3% had dealt in shares in the previous 12 months. Investors made an average of 3 transactions in the previous 12 months. The survey covered 2,154 adults by telephone, and extrapolated from there, concluding that 16% of adults held shares (or had held shares in the last 12 months) or about 841,000 investors.

The average income of these investors was estimated at HK$17,500 per month. In the optimistic case, you might think that around 400,000 people might put an average of $20,000 into the Fund. That's probably at least a year's average savings for someone in that position, and it would create $8bn of public demand. That has to be at the top end of expectations. At the bottom end, bear in mind that only an estimated 3% of adults own unit trusts, because most investors prefer to play individual stocks. Even if the optimistic case is correct, satisfying that level of demand would leave the market to absorb future issues.

Don't be misled by the "indicative size" of the initial offer of $10 billion. There's plenty more where that came from. In Titanic terms, it's the tip of the iceberg. According to the prospectus, the Government portfolio was worth $198bn on 20-Oct-99. For this reason alone, it is politically crucial to the Government that this first offer (of many) goes well. If they price it too tightly and the market falls the following week, then the great public of Hong Kong will not be begging for more.

Some of those public investors that buy the Fund are likely to be selling existing stock to fund their subscription of TraHK. That could pressure the market and make their units cheaper. We find it highly unlikely that many "stock market virgins" will make the TraHK their first investment, due to its complexity and novelty. Individual stocks are far simpler. Just because there is a wide brand recognition of the "Hang Seng Index" does not mean that the general public understands how it works and what a tracker fund is.


If your broker tells you that this is the best thing since sliced bread, take it leavened with a large pinch of salt. Even the lowest broker in the food chain will collect 1.75% from the Government and 1% from you for selling the TraHK. That's a total of 2.75%, 11 times more than they might get by buying blue chips for you in the market (0.25%).

The 3 Global Coordinators get an extra 0.25% of everything, and the 24 Retail Managers (including the Global Coordinators) get another 0.25%. They include several of the brokers who bought stock for the Government during the Aug-98 intervention. In total, the Government will spend up to $250m on commissions, plus advertising, legal, printing and other expenses.

If you are being charged 1% brokerage for the TraHK units, you should mentally deduct 0.75% from the issue discount, bearing in mind that you could pay only 0.25% to buy stocks in the market. Institutional investors will make the same calculation, unless their broker offers to rebate some of this charge.

That's enough for today. In our next article we'll explain the "Tap" structure which allows the Government to create more units after the offer. We'll also take a look at how liquid the secondary market might be, and what factors will affect the market price relative to the Hang Seng Index. And don't worry, we haven't forgotten - before the offer closes we'll look at hedging strategies.

©, 1999

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