<h2>Introduction</h2>
As of June 10, 2025, the Hang Seng Index has risen by 20.45%, and the CSI 2000 Index has increased by 11.47%.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/95e195e0-ad95-40f9-9d9f-7686fb33deae.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/95e195e0-ad95-40f9-9d9f-7686fb33deae.png"/>
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/81ef1d93-f084-4768-a4b9-ed10ccc314b5.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/81ef1d93-f084-4768-a4b9-ed10ccc314b5.png"/>
However, the CSI 300 Index has fallen by 1.76%.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/3150d6b9-ea05-47a8-be8d-adb7f2468db9.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/3150d6b9-ea05-47a8-be8d-adb7f2468db9.png"/>
This indicates that, so far, the market is mainly focused on Hong Kong stocks and small-cap stocks, while large-cap stocks lack incremental funds.
We have the following two questions regarding this phenomenon:
<ol>
<li>Why has incremental capital bypassed large-cap stocks?</li>
<li>When will the large-cap stock market begin?</li>
</ol>
In this article, we will answer these two questions from the perspective of liquidity.
<h2>Liquidity Characteristics of Index Enhanced Funds and A-shares</h2>
Recently, quantitative funds have replaced active equity funds as the main capital in A-shares. Therefore, analyzing the strategies of quantitative funds is crucial for understanding the liquidity structure of A-shares.
Currently, the incremental capital in A-shares consists of various index enhanced funds; however, the main driving force behind their scale expansion is excess performance. For example, if a fund's performance benchmark is the xx index, the fund company will select a basket of stocks based on this benchmark. The greater the excess performance of the fund compared to the CSI 300 Index, the more incremental capital it will attract.
Therefore, if a certain index enhanced fund is very popular, the incremental capital in A-shares must possess a corresponding special structure.
So, what does this structure look like? We need to clarify how index enhanced funds achieve excess returns.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5d130cb8-3474-42f1-b61f-aca4b2bebee4.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5d130cb8-3474-42f1-b61f-aca4b2bebee4.png"/>
As shown in the figure above, the core difference between the Chinese and American stock markets lies in the different levels of average implied volatility. The U.S. has a very low average implied volatility, while China's average implied volatility is quite high. This leads to an inevitable result: small-cap stocks have a higher PE level, while large-cap stocks have a lower PE level.
Since A-shares exhibit a significant valuation difference between large and small caps, the strategies of index enhanced funds primarily revolve around this point.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/bc5ff075-2e5d-427c-98e4-2f42462900d7.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/bc5ff075-2e5d-427c-98e4-2f42462900d7.png"/>
As shown in the figure above, a classic strategy is to remove unwanted constituent stocks from the benchmark and replace them with preferred small-cap stocks. Thus, with the inflow of incremental funds, the valuation difference between large and small caps will widen, ultimately leading to an excess return relative to the benchmark.
<h2>How to Amplify Excess Returns and the Limits of Valuation Differences Between Large and Small Caps</h2>
However, for many managers, the basic strategy does not satisfy their pursuit of excess performance.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/55490f1e-e5e4-44a2-ac8a-b226ff326608.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/55490f1e-e5e4-44a2-ac8a-b226ff326608.png"/>
Therefore, to amplify returns, they will play the &#34;remove-insert&#34; operation twice, that is, leverage to buy a basket of stocks from the basic strategy and hedge with stock index futures. When leverage and futures hedging are introduced, the flexibility of the strategy is greatly enhanced, allowing managers to adjust their algorithms based on market conditions to achieve higher excess returns.
Furthermore, we can use the discount of IM forward contracts to characterize the degree of crowding in index enhancement strategies, as the more intense the market's pursuit of excess performance, the deeper the discount of the futures contracts.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/0e9e30ba-5895-4eb4-8c36-e68556945bf9.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/0e9e30ba-5895-4eb4-8c36-e68556945bf9.png"/>
As shown in the figure above, the current discount of the forward contracts corresponding to the CSI 1000 Index is around 280 points, with a discount magnitude of approximately 4.7%. This means that obtaining excess returns is becoming increasingly difficult, forcing managers to upgrade their strategies, and if one upgrade doesn't work, they will try twice until the discount level erodes the excess brought by the marginal upgrade, bringing the system to a balanced state.
<h2>The Upper Limit of the Difference Between CSI 2000 and CSI 300</h2>
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/56b98b60-0dd8-492d-845d-7081e80a11b4.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/56b98b60-0dd8-492d-845d-7081e80a11b4.png"/>
As shown in the figure above, a series of institutional arrangements in China determine the absolute level of average implied volatility; however, this level will not rise indefinitely.
This also means that there is an upper limit to the valuation difference between large and small caps. In other words, within a certain time window, the difference between CSI 2000 and CSI 300 also has an upper limit—around 20%.
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/12157217-40cd-4e7e-9afa-d43cd735e6fd.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/12157217-40cd-4e7e-9afa-d43cd735e6fd.png"/>
In recent years, quantitative strategies have been the main force in the A-share market; therefore, the upper limit of the valuation difference between large and small caps is an extremely critical variable. The figure above shows four instances of reaching the upper limit, but in reality, there have only been two. One was at the end of 2023, and the other was during the repeated touches since the &#34;924 market.&#34;
In fact, there is a fundamental difference between these two touches—whether there is incremental capital. The first time there was no incremental capital, and quantitative funds systematically reshuffled; the second time there was incremental capital, and the event shock caused the size premium to repeatedly deviate from its upper limit.
Moreover, based on the previous discussion, when the size premium touches the upper limit, we should also observe that the basis of IM reaches an extreme, but this does not mean that there is a risk of system collapse; on the contrary, it simply means that the space for index-enhanced excess extraction is gone.
<h2>Conclusion</h2>
In summary, we have clarified the liquidity structure of A-shares. The high volatility characteristic of A-shares determines that incremental capital prioritizes entering small-cap stocks until the incremental capital causes the valuation difference between small and large caps to reach the upper limit—constituting an overflow—before large-cap stocks can possibly receive incremental capital. The metaphor in the figure below illustrates the liquidity structure of A-shares:
<img src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5cc94450-9f99-47ea-9be6-7f39ec691bd6.png?x-oss-process=image/auto-orient,1/interlace,1/resize,w_1440,h_1440/quality,q_95/format,jpg" alt="" original-src="https://imageproxy.pbkrs.com/https://wpimg-wscn.awtmt.com/5cc94450-9f99-47ea-9be6-7f39ec691bd6.png"/>
Therefore, the necessary conditions for the initiation of a large-cap stock market are: 1. Continuous incremental liquidity; 2. The valuation difference between small and large caps reaches the upper limit.
Of course, with the continuous inflow of funds, large-cap stocks will rise further, which will in turn affect the average implied volatility level of the entire A-share market, thereby lowering the upper limit of the valuation difference between small and large caps. However, that is a discussion for another time.
ps: Data from Wind, images from the internet
Author of this article: Cang Hai Yi Tu Gou, Source: Cang Hai Yi Tu Gou, Original title: &#34;Necessary Conditions for the Initiation of the Large-Cap Stock Market&#34;
Risk Warning and Disclaimer
The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investing based on this is at your own risk

00HSI

As of June 10, 2025, the Hang Seng Index has risen by 20.45%, the CSI 2000 Index has increased by 11.47%, while the CSI 300 Index has fallen by 1.76%. This indicates that the current market is primarily focused on Hong Kong stocks and small-cap stocks, with large-cap stocks lacking incremental capital. The article explores why incremental capital is bypassing large-cap stocks and the necessary conditions for its initiation, analyzes the impact of quantitative capital on the liquidity of A-shares, and points out that the strategies of enhanced index funds mainly revolve around the valuation differences between large and small-cap stocks

- As of June 10, 2025, the Hang Seng Index rose by 20.45%, while the CSI 2000 Index increased by 11.47%, but the CSI 300 Index fell by 1.76%.  
- The article discusses the liquidity structure of A-shares, highlighting that increased funds are primarily flowing into small-cap stocks due to high volatility and valuation differences between large and small caps.  
- It concludes that for large-cap stocks to attract new funds, there must be sustained liquidity and a peak in the valuation gap between large and small caps.

Necessary Conditions for the Opening of Large-Cap Stock Market