How Not to Short China Stocks

Michael Toma, director of risk management at TWC Futures Group, recently told me, "I have come across individual traders mistaken that the FXP is shorting the China CSI300 index. They don't realize they are shorting Hong Kong shares. The concern I have as a risk manager is sometimes the trade works, giving them an even greater false sense of security."

Shorting Hong Kong-listed equities is a far cry from shorting mainland equities. The Hang Seng index is up 35% year to date vs. the SSE Composite, which is up 55%. The Hang Seng trades on a P/E of approximately 15 times forward earnings vs. Shanghai, which is trading at approximately 25 times forward earnings.

Running a simple regression of changes of daily closing prices shows that changes in the SSE explain only about 20% of the variance in the Hang Seng. This divergence also can be seen more clearly by noting that since January 2008, there have been more than 100 trading days on which the FXP traded in the same direction as the SSE. In other words, the SSE falls, and yet this intended double-short position actually loses money.

Thinking academically, the only entities capable of "arbitraging" this market are companies already listed on overseas markets that are rushing to list A shares to China to take advantage of this valuation differential. Given the rush of companies seeking to list A shares, the value proposition must be compelling.

On a separate note, while the mainland Chinese equity market looks very expensive by most metrics, there continue to be many bargains in U.S.-listed China stocks. It is very possible that future corrections in the overvalued mainland market could scare off some investors who hold undervalued, U.S.-listed China stocks, creating significant bargains for those investors are savvy enough to differentiate between the two markets.

>To order reprints of this article, click here: Reprints