Increasing Dividend Yield of Hong Kong Stocks by 25%

Investing in the A-share market comes with a unique advantage when examined through a tax lens—specifically, the absence of capital gains tax and a threshold for dividend tax exemption after a year of holdingThis light tax burden often leaves A-share investors largely unconcerned about taxation in their investment strategiesHowever, the narrative shifts dramatically in many developed nations, where taxation forms a critical aspect of personal finance and significantly influences investment behaviorsBenjamin Franklin famously quipped that “the only two certainties in life are death and taxes,” highlighting the inescapability of tax liabilities.

Given the allure of Hong Kong stocks, particularly their high dividend yields, a prudent question arises: how can one relish these benefits while simultaneously mitigating tax burdens to enhance net returns? The good news is that there is indeed a viable solution: leveraging favorable policies and utilizing the Qualified Domestic Institutional Investor (QDII) scheme can effectively augment the perceived dividend yields of Hong Kong stocks by as much as 25%.

To fully comprehend this strategy, it is essential to understand the taxation framework surrounding dividend distribution from Hong Kong-listed stocks

Advertisements

For mainland investors engaging with these stocks, the dividend tax can reach up to 28%. It is a multifaceted scenario characterized by various tax implications depending on the type of stock:

• When purchasing H-shares listed in Hong Kong, a 20% withholding tax is applicable, which is collected by Chinese clearing organizations.
• For Red-chip stocks managed by institutions within China, the tax can rise further to 28%, factoring in a combination of pre-deduction by the distributing company and additional withholding by the clearing entity.
• Conversely, dividends from Red-chip stocks managed by Hong Kong institutions or local enterprises are typically taxed only at 20%.

From a tax optimization standpoint, the benefits of qualifying as a "foreign investor" are pronouncedFor instance, if one were to invest through the Hong Kong Stock Connect in a Red-chip stock recognized as a domestic enterprise, they would incur a hefty 28% tax, meaning a net receipt of merely 0.72 yuan from a 1 yuan dividend

Advertisements

However, adopting the identity of a "foreign investor" via a QDII fund reduces the tax liability to a mere 10%, bringing net receipts up to 0.90 yuanThis shift translates to a remarkable 25% increase in post-tax dividends—similarly applicable to H-shares, where one can reduce the tax from 20% to 10%, translating into a 12.5% enhancement in dividends.

The pathway to qualifying as a "foreign investor" through QDII funds is remarkably straightforward—simply invest in these funds instead of the Hong Kong Stock Connect.

The significance of QDII high-dividend funds cannot be overstatedInvestors should remain vigilant and prioritize the scant offerings available in the marketThe QDII series has garnered substantial popularity, especially evident from the extraordinary premiums observed in certain Nikkei ETFs at the beginning of the year, hinting at their scarcity.

This QDII mechanism operates under specific quotas mandated by the State Administration of Foreign Exchange, and when demand for QDII funds escalates without a corresponding increase in new allocations, it can lead to constraining purchase limits—in many cases resulting in the surge of premium rates for these funds

Advertisements

In contrast, through the Hong Kong Stock Connect, funds are treated to a near "unlimited" quota, thereby enabling a broader array of investments over the yearsMost newly launched Hong Kong mutual funds tend to utilize the Stock Connect pathwayFrom a fund management perspective, the precious QDII quota could likely be more profitably allocated towards NASDAQ or other foreign markets rather than tying them up with Hong Kong stocks.

This dynamic draws respect for any fund management firm willing to utilize their QDII quota for Hong Kong high-dividend funds amidst the broader trend favoring overseas investments.

Historically, several QDII Hong Kong funds tracked the Hang Seng Index or the Hang Seng China Enterprises Index when overseas investment was less constrainedThe Hang Seng China Enterprises Index was particularly known for being undersold, acting as an effective platform for rotation strategies between A-shares and H-shares based on the Hang Seng AH Premium Index

• Tianqi Lithium Faces Potential $1.2 Billion Loss
• Gold Prices Surge to Record Highs in January
• Dual Strategies to Bolster Cross-Border E-Commerce
• France Faces Persistent Economic Risks
• Goldman Sachs Embraces Open-Source AI

However, in recent years, the adjustment of index calculation rules to incorporate more tech stocks has diluted the “value” essence of these indices.

For example, the Hang Seng China Enterprises Index has seen a drastic decline since 2021, with its value trailing even below 2016 levelsDespite this, the index yielded a meager dividend yield of only 3.58%, a stark contrast from yields over 6% seen in previous years—a clear indictment of the influx of tech companies diminishing the index's value allure.

Fortunately, the emergence of several high-dividend QDII funds focusing on central and state-owned enterprises has broadened the investment options availableRecently, on a particular Friday, I made a minor investment in the Hang Seng Central Enterprises ETF (513170), not only attracted by its promising dividend yield but also considering the attractive arbitrage opportunity presented by its recent listing at a discount.

The limited supply of QDII quotas, coupled with the intricate dynamics of requesting and redeeming QDII ETFs, often leads to unpredictable premium distributions of these funds

As a result, even when trading against the same index, premium rates can show significant variationsThus, it is critical for investors to meticulously monitor these premium rates when selecting QDII ETFs.

For ardent followers of high dividend strategies, a meticulous approach is essentialIf a mere 28% versus 10% tax difference warrants your attention, then a glaring 2% premium should raise immediate red flagsThus, it becomes apparent that one should not overlook a striking 1.5% discount on the Hang Seng Central Enterprises ETF (513170). This fund was newly instituted on April 10 and only commenced trading a week later, and early price dips in new ETFs are hardly unusual, particularly in the wake of positive broader market performanceHowever, such discounts are unlikely to persist indefinitely, especially when taking cues from similar funds that usually favor a par value or slight premiums

In light of this, investing at a discount is unquestionably a wise choice, allowing for a head-start in the investment journeyBy Monday’s closing, the discount had shrunk to 0.76%—a testament to its potential.

The Hang Seng Central Enterprises ETF (513170) tracks the Hang Seng China Central Enterprises Index (HSCSOE.HI), introduced just this year in AprilThis gives it a “pseudo” high-dividend index statusUnlike the better-known Hang Seng China Enterprises Index, which has taken a more severe downturn due to its inclusion of trendy internet companies, this central enterprise-focused index has shown markedly more stability over the past five years.

Not classified as a high-dividend index, it nevertheless displayed promising metrics since its establishmentBased on the latest available data, the index offers a rolling 12-month dividend yield of 6.54%, notably superior to similar central enterprise indices found in the A-share market