China’s Quant hedge funds stumble after breakneck growth

These quantitative fund managers use statistical models to select stocks and time trades, relying on machine-developed trading algorithms to filter out human weaknesses and find patterns in the market. The rise of Chinese quant investing mirrors earlier growth on Wall Street, with stock markets in both countries being large and liquid.

Many say the Chinese onshore market has been fertile soil for quants because it is heavily influenced by individual traders, whose behavior can be irrational, often in predictable ways. At the end of 2021, there were nearly 197 million individual stock-trading accounts in China, according to China Securities Depository and Clearing Corp., though the number of active individual investors is likely smaller.

However, recent setbacks suggest competition to exploit inefficiencies is increasing and cutting into returns, while some algorithms may have been caught by an unexpected turn in the market. Some managers are also struggling to maintain their edge as they grow.

China’s domestic quant industry managed assets totaling some 760 billion yuan, equivalent to $119 billion, at the end of 2020, according to the Asset Management Association of China’s most recent data for private securities-investment funds, the country’s closest equivalent to Western hedge funds.

The quant business likely grew substantially further last year, with the number of domestic Chinese managers running more than 10 billion yuan rising to 28 from 10, according to fund distributor Simuwang. Seven of the 28 generated cumulative returns of more than 100% over the past three years, Simuwang says.

Shanghai Mingshi Investment Management Co., one of China’s oldest domestic quant managers, says it now manages more than $2.5 billion, quite a change from the early years after its founding in 2010.

“We developed strategies and trading algorithms but there was no money to run," said Stephan Zhou, a founding partner at the firm.

But the last quarter of 2021 proved painful for the top 28. Only seven generated positive returns, with the worst performer, High-Flyer Quant, losing an average of more than 11% across its funds.

High-Flyer Quant made an unusual public apology to investors, blaming the setback both on its algorithms and the industry’s rapid growth, which it said had made funds managed by different firms increasingly similar.

As China’s stock market matures, and quants increasingly trade against each other, the opportunities to generate excess returns are dwindling, said Bo Hu of Simuwang.

But some of the variety of investment strategies quants employ could continue to perform well. The global quant industry has also seen the performance of various strategies vary over time.

Mr. Hu and others said some quant investors had been wrong-footed by sudden market shifts—driven partly by changes in government policy that an algorithm built around previous market history might not anticipate.

Funds are becoming larger, more alike and more tightly regulated, all factors that help explain the industry’s recent challenges, said Kangting Ye, a senior China analyst at research and consulting firm Cerulli Associates.

Several market participants, including one investor in several Chinese quant funds, said declining returns from initial public offerings had also hit performance.

Until recently, unwritten caps on IPO valuations ensured that shares in most newly listed companies jumped on their debut—a lucrative bet for any investor able to secure an allocation of stock, and a popular trade for quants. But the performance of recent listings on the less-controlled STAR Market hasn’t been as reliable.

Recent rules requiring quant funds to disclose net asset values regularly may have also made them more conservative, this investor added.

A comparatively weak fourth quarter for smaller Chinese shares, the focus of many of the country’s quant investors, was another headwind. China’s small-cap CSI 500 index gained 3.7% on a total-return basis in the quarter, Wind data shows.

If future returns are more modest, that could be a shock for many end-investors.

“In the U.S., if you outperform the index by 5%, you will be better than Warren Buffett and Bill Gross," said Jason Hsu, the chairman and chief investment officer of Rayliant Global Advisors Ltd., which actively manages some $928 million. “But in China, people have been told that outperforming the index by 20% to 30% is normal."