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Inclusions and Exclusions of Stocks in Cross-Border Investments: The Case of Stock Connect

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Abstract

How does the market react when more or fewer investors are allowed to trade certain stocks? Stock Connect, a cross-border investment channel between mainland China and Hong Kong, provides a natural testing ground. Investors are allowed to trade a list of qualified stocks from the stock market on the other side, and when a stock is removed from the list, investors can only sell but cannot buy that stock. We find that the inclusion of stocks is correlated with abnormal returns, implying downward-sloping demand curves for stocks. The effect weakens over time and disappears in about 40 trading days. There are no abnormal returns when stocks are removed from the list. On the other hand, when investors can only sell some stocks, they have a significantly higher propensity to sell. Their trading style becomes more contrarian for such stocks, and they tend to trade in small amounts. After 6 months, their investment behavior returns to that before the removal.

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Notes

  1. Stock supply in these studies is not restricted to increase in a short period of time. For example, the secondary distributions used in Scholes (1972) were initiated by shareholders, while the change of regulation used in Jain et al. (2019) allowed blockholders to reduce their shareholding in three years.

  2. There are studies in behavioural finance that suggest sell-only restrictions matter. For example, neural evidence on regret in investment provided by Frydman et al. (2014) and Frydman and Camerer (2016) imply that not being able to buy will induce anticipated regret, changing the deposition effect of such stocks. Since we do not have investor-level transaction data, we are not able to explore in this direction.

  3. In turn, they are part of a large literature on the co-movement between stock markets in China and Hong Kong, such as Kim and Shin (2000).

  4. The numbers come from The Stock Connect Fact Sheet (November 17, 2014–October 31, 2019) issued by Hong Kong Exchanges and Clearing Limited.

  5. Moreover, the foreign shareholding of a stock listed in Chinese stock markets is subject to a limit of 30%. Excess shares are subject to forced sale. This poses an additional uncertainty for foreign investors to trade securities in Northbound trading and thus makes corresponding abnormal returns less clear evidences on the slope of demand curves.

  6. In particular, under the Shanghai-Hong Kong Connect, eligible securities include all the constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index, and all H-shares that are not included as constituent stocks of the relevant indexes but which have corresponding shares in the form of A-shares listed on SSE (with certain exceptions). The Shenzhen-Hong Kong Connect has nearly the same arrangement, with additional eligible stocks from constituent stocks of the Hang Seng Composite SmallCap Index which have a market capitalization of not less than HK$5 billion (which is roughly US$0.5 billion).

  7. The Shanghai Stock Exchange usually announces changes after the market close on Friday while the Shenzhen Stock Exchange usually announces before the market open on Monday.

  8. In particular, each day’s sell ratio is generated by subtracting the average sell ratio of sell-only stocks with past returns in the winner and loser quartile from the average sell ratio of other stocks with past returns in the winner and loser quartile.

  9. Other control variables are not included in the estimations as it would greatly reduce the number of stock-removal observations from 102 to 48. In regressions with the other control variables, the estimated abnormal returns for pooled and fixed effect models are −0.186 and −0.025, respectively. Both estimated results are statistically insignificant due to the limited number of observations.

  10. Using the whole pre-sell-only period does not affect the comparison for liquidity and market capitalization. However, mainland investors; the holding of the sell-only stocks will be underestimated as pre-sell-only period has a greater weight on the initial inclusion period when the holding is small. We, therefore, prefer using a shorter pre-sell-only period for comparison.

  11. The 100 stocks with the largest market capitalization are grouped as large market capitalization stocks while others are classified as small market capitalization stocks. Liquidity is measured as the average ratio of trading value to market capitalization.

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Acknowledgments

The authors would like to thank Ka Yan Wong for data collection, Connie Tang for research assistance, and Ka Wai Wan and an anonymous referee for useful comments.

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Authors and Affiliations

  1. Department of Economics, Hong Kong Baptist University, Hong Kong, SAR, China

    Kin Ming Wong

  2. Department of Economics, Virginia Tech, Blacksburg, USA

    Kwok Ping Tsang

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Wong, K.M., Tsang, K.P. Inclusions and Exclusions of Stocks in Cross-Border Investments: The Case of Stock Connect. Asia-Pac Financ Markets 30, 701–727 (2023). https://doi.org/10.1007/s10690-022-09395-3

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