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China investors aiming at arbitrage profits make Hong Kong shares soar

* Funds trying to arbitrage major price differences

* Chinese funds buying HK shares ahead of Shenzhen pilot

* Previous attempts failed on tepid demand for HK shares

* Investors see HK shares as less bubbly than mainland stocks

By Samuel Shen and Pete Sweeney

SHANGHAI, April 8 (Reuters) - Chinese funds are snapping up shares in Hong Kong, betting that a link-up between the Shenzhen and Hong Kong stock exchanges, and easier access for institutional investors, will yield quick double-digit or even triple-digit arbitrage profits.

On Wednesday, Chinese investors used the entire 10.5 billion yuan ($1.69 billion) daily investment quota for buying Hong Kong stocks under the Shanghai-Hong Kong Stock Connect scheme for the first time.

This propelled the Hang Seng China Enterprises Index up 5.8 percent, following a 6.43 percent gain last week, and helped the Hong Kong exchange reach record volume on Wednesday.

Small caps expected to become eligible for mainland investment when the Shenzhen leg of the stock connect opens - anticipation is for this year - benefited even more. Hong Kong’s Growth Enterprise Market(GEM) shot up over 10 percent in the same period, its biggest weekly gain in nearly six years.

Domestic fund managers say they are seeking to exploit a major pricing imbalance between the markets, the result of a mainland rally that until now showed little sign of spilling over into Hong Kong.

Including Wednesday’s gains, China’s CSI300 index has soared 92 percent during the past year while the Hong Kong China Enterprises Index is up 29.8 percent.

As a result, mainland-listed blue chips are now about one-third more expensive than their Hong Kong versions - as measured by the China-Hong Kong price premium index - while Chinese dual listed small-caps trade at a premium of 10 times the cost of the same company’s shares in Hong Kong.

Shanghai-based hedge fund manager Xia Xiaohui thinks such price differences cannot last.

LARGE PRICE GAP

“With such a big price gap, why don’t I buy stocks in Hong Kong, especially if it’s the same company?” said Xia, chairman of Liuhe Capital, which has started buying Hong Kong stocks.

“With the two markets increasingly connected, this is an obvious arbitrage opportunity.”

In the past, arbitrage opportunities proved a mirage. The Shanghai-Hong Kong stock connect not only failed to narrow the premium after its November launch but actually widened it as Chinese retail investors declined to move money south.

But this time may be different. In late March, China’s securities regulator improved access, letting mainland mutual funds invest in Hong Kong shares via the connector. Several days later, China allowed insurers to buy shares listed on GEM.

China’s 5 trillion yuan ($807.36 billion) mutual fund industry is already getting into position.

Invesco Great Wall Fund Management Co is launching China’s first actively-managed mutual fund to invest via the Shanghai-Hong Kong Connect, describing the Hong Kong market as a “gold mine”, and “a low-lying land” in terms of valuation. Borsera Asset Management Co plans to launch a similar fund this month.

PUMPING IN LIQUIDITY?

“Water flows downward. So lowly-valued Hong Kong stocks are becoming increasingly attractive to mainland investors,” Borsera’s fund manager Zhang Xigang said, predicting that China’s mutual fund industry would soon start pumping liquidity into Hong Kong.

David Dai, Shanghai-based investor director at Nanhai Fund Management Co, a hedge fund, said he would buy Hong Kong shares in part because he thinks valuations on mainland exchanges are overheated.

“There are not many good investment opportunities here, so we would naturally want to hunt for new targets elsewhere,” he said.

“The current huge valuation gap and the excessive liquidity in mainland funds is raising interest in Hong Kong stocks,” said UBS strategist Lu Wenjie, noting Chinese small-caps trade at around 100 times earnings on average, compared with just 10 times for Hong Kong peers.

The mainland market is now seen as bubbly without growth, while Hong Kong has value but lacks liquidity, he said.

“Regulators seem to be very supportive for local funds to invest in Hong Kong and ... there’s real demand and real interest from local investors.”

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