CMC Markets Connect

When the Winds of Change Blow… How LPs Manage Index Rebalancing

Plans are afoot in Hong Kong for what would amount to a major overhaul of the benchmark Hang Seng index. This will see the number of constituents expanded and maximum weighting limits reduced, in a series of reviews which are set to take place on a phased basis through to at least the middle of 2022.

The outcome will deliver an index which should be both more balanced across sectors and as a result better diversified, meaning lower levels of concentration risk for investors. However, arriving at the new index structure will see a series of fundamental changes taking place over a period of at least twelve months, which presents a series of challenges to those parties involved in managing risk exposure to the index.

The changes will increase the Hang Seng’s exposure to new, potentially fast-growth industries, whilst revisions to weighting caps will also initiate a rebalancing of portfolios. Those who have adopted a passive approach to tracking the index will therefore be obliged to adjust their own positions, whilst the prospect of a more dynamic index is likely to increase capital inflows, too. The new index construct will maintain a minimum number of local companies and with global demand for exposure to South East Asia showing no signs of relenting, again this has the scope to add to the popularity of the instrument.

Whilst this is likely to be well received by investors and issuers alike, behind the scenes such moves come with a host of challenges, not least for those acting as counterparties on the assets involved. CMC Markets, which quotes over 660 Hong Kong stocks as CFDs as well as the underlying index, is one company that will need to be ready to accommodate change.

Biyi Cheng
Biyi Cheng

As Biyi Cheng, CMC Markets Connect’ Head of Greater China, explained: “We have teams of risk analysts and quantitative analysts based in our London head office, who are tasked with managing risk profiles for instruments and clients alike. A lot of that work is done on a recurring basis, but this index review will see them having to closely monitor the situation. For obvious reasons, the complier of the index hasn’t provided a detailed timeline as this would present a series of arbitrage opportunities, but our frameworks for managing exposure will be tested through this process and clients should find assurance in the fact our risk teams will be ready with the necessary responses.”

CMC’s risk analysts in London will be looking closely at a number of factors not only in relation to the index but also its current constituents and those companies who may be about to join. The total exposure of CMC Markets to these assets will be under scrutiny along with any signs of concentration risk, whilst margins will be subject to review to ensure any change in volatility can be properly accommodated. This is designed to protect both parties in the trade, with such checks being performed before the event then at regular intervals thereafter to ensure the risk is correctly captured.

Major events which can skew risk profiles are far from unusual for the company, which in recent years has taken proactive steps to manage potentially high impact market instances, examples of which have included the Brexit process and the most recent US Presidential elections.

Cheng added: “Whilst index rebalancing takes place all the time, it is typically designed to maintain a consistent risk profile for the instrument. These more fundamental changes are really more akin to us adding an entirely new product. Both the market risk and counterparty risk components will therefore need to be reviewed on a regular basis.

“This may be no surprise, but sophisticated institutional clients respond well to conversations with brokers when it comes to risk profiling. They are well accustomed to the idea that both sides need to respond to fundamental change in the market, although it’s probably fair to say that some smaller market participants might not share the same view. Regardless, we have to come from the position that exposure limits are likely to be adjusted throughout the Hang Seng’s forthcoming review and as always we will be engaging with clients regarding this.”

The move by the Hong Kong exchange to re-jig the benchmark, rather than creating a parallel index to capture a wider set of constituents is an interesting one. It’s certainly not without precedent – London’s FTSE-100 was built out of the significantly smaller FTSE-30 back in 1984 – but is an astute move to attract more listings to the local market. To some extent this is however a self-serving prophecy which perhaps needs to be addressed with a universal set of rules when it comes to index construction. Until that time arrives, risk managers will keep doing what they’re best at, ensuring that brokers and clients alike remain best placed to contend with – and exploit – the volatility on offer.

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