Reform One: the Compilation Methodology

The first change applies to the HSI's compilation methodology, which will be switched from a full market capitalization formula to free float adjusted market capitalization weighted formula with a cap of 15% on individual stock weightings. The reform is so thorough that the new methodology will remain viable even in the very long run. Its impacts will also be substantial. Hence it will be implemented in three phases.

Phase one will be implemented in this September and the free float formula will not be applied immediately. Rather, a 25% cap for individual stock weightings will be introduced. Only HSBC will see index funds switching out while the other constituent stocks will benefit to various degrees. Phase two will be scheduled for next March. We will see both the effects of applying 2/3 of the free float adjustment and lowering the cap of individual stock to 20%. Even if constituent stocks are not deemed fully float and have to be adjusted by their respective factors, the impacts may not be all negative. Phase three will be launched next September, those stocks with high original weightings but low free float adjusted factors will be negatively affected.

After the new changes, the weightings of the HSI finance stocks will decline by a third to about 24.60%, while those of utilities, properties and commerce and industry stocks will increase, with utilities and properties stocks become the biggest winners. The HSI will be less dominated by individual large cap companies. Although HSBC and China Mobile will maintain their double digit weightings, their influence will be reduced to only 2/3 of their current combined weightings of 46.68%. As a result, manipulating the broader market and index futures through certain individual stocks becomes more difficult.

In phase one, the adjustments by the index tracking funds may amount to 5.1% of the HSI's total market capitalization on either the buy or sell side. And they will reach 9.7% and 11.1% in phase two and three respectively. It is a much higher record when compared to previous adjustment. This is due to the application of free float formula and the strict definition of free float. Amongst the current 33 constituent stocks, 13 have free float adjusted factors of less than 0.50, 5 have factors of exactly 0.50, and only 3 have factors of 1.00. No wonder the trading triggered by the index adjustments will be extremely active when the time comes.

In return for paying such a high price, the HSI will adopt a compilation methodology preferred by fund managers and prevalent in stock market index community. Hong Kong's stock market is currently ranked the 9th largest in the world by market capitalization. Out of the eight bourses ranked ahead of it, New York, London and Deutsche Stock Exchanges have been calculating their indices using the free float method. And the Morgan Stanley stock market indices family is also known for such practices, suggesting a growing trend in the index community.

Listed companies in matured markets tend to have higher degrees of free float shares. But in Hong Kong, the increasingly dominant red chip and H share companies have not yet caught the trend given the Mainland Government's shareholding practices. Thus the HSI's reform addresses this issue, pushing for the share reforms of Chinese enterprises.

Reform Two: the Inclusion of H Share Companies

In the future, eligible H share companies can be included in the HSI. To be qualified, the H share company must have 100% of its ordinary share capital in the form of H shares which are listed in the Hong Kong Stock Exchange, or it has completed the process of share reform, with the result that there is no unlisted share capital in the company, or if it is new H share IPO, the company has no unlisted share capital. Currently, there are 20 H share companies eligible for consideration in the upcoming August review.

This reform coordinates with the free float adjusted compilation methodology. As a broader market indicator, the HSI should have broader market representation and coverage, with a requirement of representing about 70% of the Main Board's aggregate market capitalization. But with the listings of China Construction Bank and Bank of China, Hong Kong market capitalization rose to around HK$10 trillion. The HSI constituent stocks only account for HK$5.3 trillion or less than 60% of the market capitalization. In view of the prospects that only large H share companies can substantially increase the market capitalization of Hong Kong, excluding them in the HSI will only serve to undermine its representation.

Combined with the free float and 15% cap measure, the inclusion of H shares will have minimal impact on existing constituent stocks. If they still see significant declines in their weightings, it will be mainly due to the 15% cap and the application of the free float adjusted factor, not the inclusion of H shares. It is because H share itself also faces a relatively low free float adjusted factor, such as the 15% of the China Construction Bank.

Reform Three: the Increase in the Number of Constituents

Also, the number of the HSI constituent stocks will gradually increase to 38. As an interim measure, any H share company joining the HSI will result in a net increase in the number of HSI constituents instead of replacing an existing one as before. Once there are 5 H share companies join the HSI, the number of constituents will rose to 38. The HSI Services Limited will then announce the way ahead with regard to the number of index constituents.

This design is believed to have the goal of shielding existing constituent stocks from deletion in mind. After the listing of the China Construction Bank and Bank of China, there are worries that existing banking stocks might have to be replaced by them in order to limit the weightings of banking constituents. This measure dispels such concerns. According to current spectrum, the 5 smallest constituents are all commerce and industry stocks. And the smallest property stock has a market capitalization larger than 10 commerce and industry stocks based on total market capitalization. It will be larger than 14 of those commerce and industry stocks if free float market capitalization method is used. This means even if the Index still stick to the 33 constituents, it will be commerce and industry stocks instead of properties stocks that are in danger of being replaced. Properties stocks have regained their footings due to their substantial price increases in the last two years. Thus the market's speculation of the HSI trying to maintain the properties stocks blue chip status proves to be unfounded.

Judging from current candidates, only China Construction Bank and Bank of China are eligible for immediate entry into the HSI. The other H shares have smaller market caps than even the smallest constituent company.

The reform will completely revamp the HSI. It has its own merits by adopting the internationally popular trend of compiling stock market indices using free float capitalization. The HSI therefore will solidify its benchmark status for fund managers and index tracking investors. It also solves the low tradability issue of H shares, bypasses the excessive dominance by large cap stocks and increases the difficulty of manipulating the index through influencing individual stocks. But the price to pay is the comparability of the HSI's historical performance after the number of constituent stocks increase to 38 instead of the original 33. The capping of individual stock weightings could also make historical comparison invalid. Moreover, the 15% cap imposed is a subjective number, which might distort a gigantic company's representation in the index. Nevertheless, we believe that the pros of the reform will outweigh the cons. Therefore, it will be welcomed by market practitioners and investors and the existing constituent stocks should be able to cope with it.

HSI Constituents and the Hong Kong Economy

Over its 40 plus years of history, the changes in HSI constituent stocks have mirrored Hong Kong economic development. When it was first introduced in the early 60s, there were only 30 constituents, which remained so until 1969 when the number was increased to 33, just as today. Over the HSI's lifetime, eight stocks remain unchanged, including banking, utilities and conglomerate companies, which constitute the backbone of Hong Kong's economy. The economic takeoff in the 1970s witnessed transportation, shipping, garment and hotel companies entering the HSI. They faded away as manufacturing began its decade long relocation to China and service took over the economy. The inclusion of red chip companies since 1994 reinforced the HSI. But its underlying businesses and income sources have expended substantially beyond Hong Kong's border.

The Asian Financial Crisis hammered properties stocks while banking and utilities stocks held relative well. This gave way to the surge in commerce and industry stocks. Nowadays they account for the majority of the HSI in terms of numbers and weightings. Along with red chip companies, they diminish the link between the HSI and the Hong Kong economy. Instead, the HSI serves a new purpose of becoming a comprehensive indicator of both Hong Kong and China's economies. As international investors still cannot freely invest in Chinese stocks, the HSI fills the gap, serves as a proxy and facilitates the transition. Its future changes will take on significantly more meanings.

HSI Constituents and Transformation

Hong Kong economy's has transformed from manufacturing to service, and from production service to consumption service. This is well manifested in the HSI constituents' changes. The decision to include H shares coincides with the concerns about marginalization of Hong Kong economy. It duly reflects the ever growing dominance of China factor in Hong Kong's economy and financial markets, although the real economic activities may not take place within Hong Kong's border. This serves as a good example of how the Government and market interact in a meaningful way.

The HSI's compilation method and the decision to reform lie in the hands of the HSI Services Limited. In recent year when free float has become the trendy thing and competitors are launching new products, the HSI resisted the early temptations. Even the large H share companies, such as PetroChina and Sinopec, could not make themselves into the HSI. It is only when China Construction Bank and Bank of China adopt the full float approach and unload the legacy baggage of state owned enterprises that the procedure is set in motion to include eligible H shares. And the decision comes after extensive consultation, strengthening the case of market force working properly. Moreover, there is no delay in timing as both banks are likely to make their entry into the HSI within 12 months after their IPOs.

The SAR Government does not interfere with the market. But along with the Mainland Government, they help contribute to the successful listings and share reforms of the state owned enterprises. When such listings alter the HSI's broader market representation and coverage, the reform of HSI comes naturally. In this case, the Government and the market interact in a meaningful way. The Government stays away from free market operations, and the market reacts promptly to the changing situation based on its sound systems and mechanisms. By doing so, Hong Kong's finance sector is free from concerns of being marginalized. And it can serve as a useful reference to other sectors and industries on how to cope with China's development and opening. Nonetheless, it must be pointed out that if a sector or industry facing challenges is not as competitive as the finance sector. The Government might have to pay an active role in order to promote transformation.