Huge spike in China-related derivative and ETF volumes

China A50 futures up 85%, ETF inflows increase 40% following announcement of Hong Kong Shanghai stock connect and improved investor perception of China

China-related futures, warrants and exchange-traded funds (ETFs) have all seen a massive spike in volumes over the past two months, which market participants say is driven by investors positioning their portfolios ahead of the opening of the Shanghai-Hong Kong stock connect in October, as well as a general increasingly positive view of the China economy.

The Singapore Exchange's (SGX) China A50 futures index – the only offshore contract on the China A-share market – saw 3.2 million contracts traded in July up 85% from a year earlier, which in turn was 47.3% higher than the 2.3 million contracts exchanged in June.

While BlackRock's iShares FTSE A50 China Index ETF (2823) saw inflows of $861 million in July, representing more than 40% of its year-to-date volumes and an 85% increase on the same period in 2013. Similarly, Hong Kong-based asset manager CSOP also reported that 30% of its $1.4 billion year-to-date flows on A-share ETF (2822) have come in the last two months.

Sales of China A-share ETF call warrants have also seen a "huge" increase in volumes since mid-July, according to one Hong Kong-based dealer, with sales of call warrants and bull certificates of 2822 and 2823 ETFs – both of which investors use to express a positive view on market direction – seeing inflows 3.3 times higher during July and August than the monthly average for the rest of the year.

Chinese regulators announced in April the creation of a connection that will allow investors to trade directly between the Shanghai, Shenzhen and Hong Kong stock exchanges, subject to a quota limit. The connection is expected to go live in October. According to the warrants dealer, investor anticipation that the connect will drive up valuations on the China A-share market [renminbi-denominated shares traded on the Shanghai and Shenzhen exchanges] versus H-shares [China firms listed in Hong Kong and denominated in Hong Kong dollars] is behind the spike in derivative volumes.

"We saw lots of hot money buying ETF-related call warrants and bull certificates starting from the middle of July and it has continued in August. Investors are looking towards the Hong Kong-Shanghai stock connect and they believe that after this connection is in place, the A-shares market will outperform the H-shares. The view is that A-shares are trading at a discount to their Hong Kong-based peers."

According to a Hong Kong futures dealer, asset managers with no RQFII quota or ones that have reached their limit have instead been using the SGX A50 contract to express a view on China. He estimates that long-only fund managers have conducted about 70% of recent trades.

"For investors who exceeded their quotas, A50 futures are the most attractive alternative way to access the China story due to their liquidity."

But while the futures dealer says the Hong Kong stock connect is important, he also points to a broader, more positive view of the China economy.

"I agree that the Hong Kong stock connect has had a positive impact on the A50 futures sales but the noise on China has been building since all the discussions over China A-shares' potential inclusion in the MSCI emerging markets index earlier this year. China has been underperforming the rest of the globe for the last six to 12 months and investors have now recognised this."

Jane Leung, Hong Kong-based head of iShares, Asia Pacific at BlackRock, agrees that investor perception of China is improving and that while the stock connect is a positive factor, its significance is more due to being part of a broader policy of China financial liberalisation.

"The increase in volume is very much driven by macro sentiment on China, which has been undervalued for some time but now there has been an increase in interest," Leung says.

"This has been spurred on by the relaxation of the QFII and RQFII schemes earlier this year, and while some of the increase in volumes is a result of the stock connect, this is more in the context of people viewing it as a further relaxation of China regulations, which is viewed positively by investors. The stock connect is significant, but ultimately it's just one additional piece of the broader China story."

Leung also played down the significance of the increase in volumes onto the BlackRock ETF, saying that while the numbers were large it was not a massive outlier for large flows to move through 2823 – for example, the fund traded $600 million in one day in the first quarter of 2013.

"If you look at the 40% figure relative to the year-to-date inflows, it is significant but if you look at the history of the fund there have certainly been periods where you see increased movements in China, caused by macro events, or the potential arbitrage from trading in China versus trading in Hong Kong, that have caused investors to want access to China.

"So it has been significant – but we have seen it before in previous years. Anecdotally we do see several hundred millions of dollars come from single counterparties."

Daniel Weinberg, Sydney-based Asia Pacific director at market maker Optiver, agrees with Leung that it is difficult to isolate the impact of the stock connect from the broader positive market noise about the China economy.

"China is just getting more interesting after being quiet for a while; it's not possible to draw the dots and say the recent upsurge in China interest is function of the stock connect. The only place you can do that is by looking at the Hong Kong Exchange's share price – it's gone up from around HK$120 to HK$180 off the back of the stock connect."