The $200b question mark

How to sell $200 billion of stock to an already tremulous market without knocking the stuffing out of it? That is the dilemma faced by the army of investment bankers and senior Hong Kong government officials as they prepare to roadshow what must be the most hyped single-economy fund ever launched.

Having barely hit the ground with the Tracker Fund retail advertising campaign and a global roadshow two weeks away there is already confusion over the short-term impact on share prices and market liquidity.

More worrying is news of sponsoring banks offering leading investors instant exposure to the fund through derivative deals that at the very least smack of a false market in the making.

Uncertainty stems from the fact that the price and number of units to be sold will be decided only at the end of the book building period.

Once completed, the working of the 'tap' mechanism, allowing more stock to be released, remains thoroughly unclear to all but those bankers leading the offering.

The Tracker Fund was designed as a conservative method of beginning the potentially protracted disposal process without destabilising the market. Maximising the return to government coffers was of course paramount.

By offering retail investors only small discounts to buy something they, as taxpayers, already bought far more cheaply a little more than a year ago leaves it highly dependent on institutional investors.

Early indications suggest limited appetite among the main players. That, of course, is hardly surprising since the majority of fund managers are paid to beat the index rather than merely track it.

While index-funds - of which there is a considerable number - are likely buyers, the great rump of institutional fund managers are likely to rely on it for fine-tuning asset allocation.

The point of the global roadshow is to persuade them otherwise. But what officials and their investment bankers can add to sophisticated investors' knowledge about the Hang Seng Index is not clear.

Ultimately, the success or not of the first offering will depend on the price at which it is offered.

While it is still to be decided, investors report that sponsoring banks have made approaches to lock in profits using derivatives.

The difficulty with this is that any bank offering a derivative on the Tracker Fund must have a fairly good idea of the price, which by implication suggests a less than transparent market.

Funds with sizeable amounts of Hang Seng Index holdings have reportedly been approached to sell their underlying stock holdings to a syndicate bank in return for a promised allocation of fund units and put option guaranteeing against a fall in the market.

Why a sponsoring bank would want to purchase large amounts of stock from a fund manager is less clear.

One suggestion being made is that the main banks already are suggesting shorting strategies to their clients.

This would involve the investor buying discounted Tracker Fund units and selling Hang Seng Index futures with the aim of capturing arbitrage profits.

However, perhaps conscious not to repeat the kind of futures trading that caused everyone so much trouble last year, fund managers report that most short positions are being offered not through the futures market, but using offshore over-the-counter products.

As such, the motivation for banks to buy physical stock as hedging cover to manage their positions is clear.

It is these kinds of trading strategies that make the issue of how the tap works for new offerings of Exchange Fund Investment (EFI) stocks important.

While the fund prospectus outlines a programme for selling new units each quarter, the fund managers, State Street, are understood to have told some investors that the tap can effectively be turned on permanently.

The implication is that investors can maintain short-Hang Seng Index positions secure in the knowledge that cheap tracker units can be bought to square off their exposure.

What this boils down to is a highly confused market, with sponsoring banks building large off-balance-sheet and off-exchange positions with detailed knowledge of the likely final pricing.

While this is the normal stuff of banks maximising profits from a capital-raising exercise, the difference in this case is that an entire market is affected.

The irony is that the kind of systemic volatility that raged last year - due, in part, to vast unregulated short selling - could be reintroduced through the back door.

The bigger issue remains the decision to sell back to the people of Hong Kong the proceeds of EFI at only a small discount to the prevailing market price.

Having largely held their nerve and not sold Hong Kong dollar assets during the crisis, the argument for making a windfall distribution to the population was strong.

Moreover, despite the image of an entire city punting on the stock market, the reality is that retail ownership of equities in Hong Kong remains low.

An opportunity to broaden share ownership, such as that achieved by give-away privatisations in Britain during the mid-1980s was missed.

Instead, the biggest winners seem likely to be smart institutional investors who are able to capitalise on a permanent stock overhang, potentially dragging the market lower, and the constant arbitrage opportunities that throws up.

Giving some idea of the new landscape in which brokers and investors will be operating, the advice from one of the sponsoring banks to its clients this week was understood to be: liquidate the fund, keep the big core stocks of the Hang Seng Index, and with the profits from getting Tracker at a discount, sell short the smaller capitalised stocks.

Having made its bed the Government will clearly have to lie in it.

At a price, everything, let alone blue-chip Hong Kong stocks, is for sale.

But the bigger issue is what it does for SAR's development as a leading financial centre and for the retail investors who cough up for a slice in the first round.