No Escape for China Hedge Funds Overwhelmed by Stocks Crash

  • Almost 1,300 funds closed in China's $5 trillion stock plunge
  • Government restrictions make bear-market bets more difficult

It’s about to get even uglier for China’s hedge funds.

The newfangled industry, short on expertise and ways to protect itself from market declines, has seen almost 1,300 funds liquidate amid China’s $5 trillion stocks selloff, and a similar number may be at risk, according to Howbuy Investment Management Co. Now, a government crackdown on short selling and other hedging strategies have made prospering in a bear market difficult.

It’s an inglorious turn for China’s on-again, off-again love affair with stocks, which saw the number of hedge-fund-like vehicles explode in past years as the government made it easier to register funds and introduced new financial instruments. The market rout -- and the regulatory response to it -- has revealed cracks in the industry that suggest it may need years to recover. In the most devastating blow to domestic hedge funds, China has imposed new restrictions on trading in stock-index futures, a key investment strategy to dampen volatility and avoid big losses.

“It spells the end, at least temporarily, for China domestic hedge funds,” Hao Hong, chief China strategist at BOCOM International Co. in Hong Kong, said in an interview.

CSI 300 Futures

China’s hedge-fund industry has grown rapidly as the nation’s stock market jumped and wealthy individuals and smaller institutions sought to profit from that surge. The number of private placement securities funds, the Chinese equivalent of hedge funds, more than doubled from the beginning of the year, peaking at 11,159 as of Aug. 31, managing 1.62 trillion yuan (about $254 billion) in assets, according to the China Securities Regulatory Commission. Individual investors are required to have at least 5 million yuan in assets to invest in hedge funds, while institutions must have at least 10 million yuan.

Key Difference

While these vehicles in China are broadly categorized as hedge funds, there is one key difference with counterparts in the U.S., Europe and Hong Kong. Most of them are long-only, meaning they bet solely on rising markets. Even before government restrictions on practices such as short-selling, many limited hedging so they maximize benefits from a market that had advanced almost 50 percent in the two years through 2014 and rallied another 60 percent through mid-June. Most China-based managers rarely wager against individual securities because the practice is expensive and many new managers lack the expertise for complex strategies, Alexis He, a Shanghai-based analyst for Z-Ben Advisors, said.

Betting solely on rising markets made China’s domestic hedge funds very vulnerable when stocks fell. William Ma, Hong Kong-based chief investment officer of Gottex Penjing Asset Management (HK Ltd.), said that most of the liquidated funds were launched in April and May when valuations were high, making them the “first and largest wave” of closures. While funds set up late last year or early in 2015 still face liquidation risk if the market drops further, they are fewer in number and have high cash positions, said Ma, whose firm invests in hedge funds.

The "system risk is not very big now," he said.

Large Liquidations

More than 50 percent of long-only new products launched this year have liquidated, according to estimates from Guo Tao, a board member of the Hedge Fund Talents Association, affiliated with the Zhejiang provincial government, whose members collectively manage about 300 billion yuan.

Among domestic hedge funds that suffered losses after the stock rout were Heju Investment, a Beijing-based firm which oversees about 10 billion yuan. Heju said in a statement that some of its funds suffered losses between 5 percent and 15 percent during the stock rout in July.

QingShuiYuan Investment said in July it would set aside 20 percent of its net income in the next three years for a special investor fund after several of its funds were liquidated, as their net asset values dropped below certain predetermined levels after the stock crash.

“The real hedge funds,” which use risk-management tools including stock index futures, recorded mostly positive returns in the June to August period amid the market turmoil, Guo said.

Margin Limits

Those practices, though, have effectively been ended after Chinese regulators raised margin requirements, tightened position limits and started a police probe into bearish wagers to stop the equity rout. Trading in stock-index futures plays a key role in the investment strategies of domestic hedge funds and other investors by helping them to dampen the impact of wild market swings. Selling index futures is also more cost-effective than unloading large blocks of shares and is one of the easiest ways for investors to make bets against stocks.

Li Dongjian, chairman of Zhejiang Purple Cloud Investment Management Co., said he couldn’t believe his ears when a few executives from futures companies called him about the new regulatory restrictions on the stock index futures on a business trip.

‘Dead’ Market

“At first, I didn’t believe it was true,” he said. “Because restrictions like that would mean this market will be dead.”

While its small size and adjustments to trading strategies helped
Hangzhou-based Purple Cloud avoid liquidating its funds, the new rules have
reduced the hedge fund’s returns and cut its exposure in stock index futures to 30 million yuan this week from 600 million yuan previously. The lack of hedging tools now also threatens to widen losses in a 40 million yuan portfolio that already totaled 2 million yuan since inception in mid-June.

The restrictions have dealt “an enormous blow” to hedge funds, Li said on Sept. 12 in Shanghai on the sidelines of 2015 Hedge Fund China Summit organized by Finfo Global.

Apart from restrictions, prominent executives have been caught up in regulatory probes on so-called “malicious” short-selling. Citic Securities Co. President Cheng Boming is being probed as part of a campaign to root out financial wrongdoing, after state-run Xinhua News Agency reported last month that four executives at Citic had admitted to so-called insider trading. Authorities say they want to “purify” the market.

As regulatory moves clamp down on strategies that could help in a down market, what most hedge-fund investors fear most now is another downdraft in shares.

“If the market drops even further, certainly more private funds will
liquidate,’’ Guo of the Hedge Fund Talents Association said. “If the market goes even lower, it would be because of panic. Not fundamentals, not policy, not margin finance, not leverage. Just fear.”

— With assistance by Dingmin Zhang

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