Quants Corner

The best strategy for navigating Hong Kong’s pro-democracy protests

Hong Kong is experiencing the biggest political disturbances in over two decades. Initially peaceful protests in March against a proposed extradition law have escalated, with hundreds of thousands of demonstrators periodically marching through the Chinese special administrative region. Fears of further turmoil and violence tied to differing interpretations of the ‘one country, two systems’ framework that the global financial center is ruled under are weighing on Hong Kong and its markets.

A clear example of this impact is the accelerating pace of redemptions from the dedicated Hong Kong Equity Funds tracked by Informa’s EPFR (see Chart 1 below). The month the protests started investors pulled US$350 million out of these funds. By early April Hong Kong dedicated mutual funds and exchange-traded funds were hemorrhaging money: since the start of 2Q19 a net $3.91 billion has flowed out of Hong Kong MFs and ETFs.

During the first month of 2Q19 Hong Kong Equity Funds recorded a collective outflow of $2.15 billion while the territory’s benchmark Hang Seng Index (HSI) stayed relatively flat. Over the next two months, however, the HSI dropped over 11%. Overall, since April 1 Hong Kong Equity Funds have surrendered 35.6% of the assets they managed.

For investors the question is, as ever, how best to respond. To answer that from a fund flow perspective, we are looking at both the raw data (Chart 1) and at the recent performance of two EPFR/Trimtabs strategies, illustrated in Chart 2 below, for clues.

The two strategies whose performance is plotted in Chart 2 are based on the rolling one-month average for relevant fund flows. The strategies, and underlying methodologies, are as follows:

The long/short strategy - We are 100% long the Hang Seng Index if fund flows in the past 20 days fund are positive and 100% short the Hang Seng Index fund flows in the past 20 days are negative.

The long/cash strategy we are 100% long the Hang Seng Index if fund flows in the past 20 days are positive and 100% in cash if flows in the past 20 days are negative.

Table 1, below, shows the annual return of the two strategies and the Hang Seng Index from 2015 to date. We also showed the average annual return, the annualized risk (standard deviation) of the daily return, and the average annual return/annualized risk of the two strategies and the HSI.

Between 2015 and the end of 2Q19 the long/short strategy generated a risk adjusted return that was double the HSI’s while the risk adjusted returns for the long/cash strategy have been nearly three times those of the HSI.

It is worth noting that both have underperformed the Hang Seng year-to-date. The Hang Seng enjoyed a blistering start to the year, up some 20% by the end of April. Beating that requires leverage, with the obvious risk implications, and matching it required being fully long the HIS during the same period. Given that Hong Kong Equity Funds suffered periods of significant outflows during 4Q18, the long/cash strategy was 100% cash during early 2019 when the HSI was racking up the bulk of its year-to-date gains.

If the strategies have not delivered outperformance so far this year, what have they done for investors? The short answer is that, over time, investors have a bigger performance buffer to navigate the inevitable downturns that come with any equity market.

In terms of crafting a short-term response to current events, it appears that fund flows are a good predictor of volatility of the Hong Kong stock market. Supporting this simple observation is the fact that flows turned negative well ahead of the protest-driven volatility seen in 2Q19.

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