Classic Hedge Fund Trade Is a Winner in China’s Two-Speed Market

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(Bloomberg) — Chinese stocks have been among the world’s worst performers over the past year, but they are beating their major peers based on one hedge-fund strategy.

Investing in Chinese equities using the classic long-short trade returned more than 10% through late June this year, according to data compiled by Goldman Sachs Group Inc. That compares with gains of about 7% in the US, and less than 6% in Europe, the data show.

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Among the reasons for the trade’s success in China is the wide divergence in the performance of nation’s shares as state policies favor boosting industrial capacity, while consumer and property stocks struggle amid the stuttering economy. The structure of the mainland’s equity markets also creates fertile ground for the strategy.

“A market where you have reasonably high retail participation, combined with low institutional participation, and also low analyst research coverage, naturally lends itself to creating more structural inefficiencies,” said Bernard Ahkong, CIO for global multi-strategy alpha at UBS O’Connor in London. “China ticks all those boxes.”

Although Beijing’s new curbs on short selling have made it harder for onshore quantitative funds to execute the long-short strategy, analysts say fundamental stock pickers based offshore haven’t so far been affected. They can choose to short American depositary receipts or Hong Kong-listed shares, or use derivatives to bet against mainland equities through trades with global banks.

While the long-short strategy has been successful in China, there are still a relatively small number of practitioners as global interest in the country’s stocks has waned due to the lasting bear market. Among the roughly 600 equity long-short funds globally with assets of at least $50 million and a minimum track record of 18 months, only 35 focus exclusively on China, according to hedge-fund research firm PivotalPath.

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Superior Returns

Among examples of divergence in Chinese stocks this year, the energy sector of the MSCI China Index jumped 27% through July 15, while the health-care sector slid 27%. In contrast, the best sector in the S&P 500 Index is technology which has risen 34%, while even the worst — real estate — has gained 0.1%.

UBS O’Connor’s China long-short fund returned 15% this year through July 12, data compiled by Bloomberg show. The performance was boosted by gains in PetroChina Co. and China Shenhua Energy Co. as Beijing urged state-owned-enterprises to improve shareholder returns, according to a fact sheet from the firm published at the end of May.

The clear signals of intention provided by the authorities also helped underpin gains, UBS O’Connor’s Ahkong said.

Contrary to the widely held belief that Chinese policy making is unpredictable, the government actually tends to map out key initiatives such as SOE reform on a multi-year basis, which makes it easier for long-short investors to bet on sectors likely to win government support, he said.

“It’s almost like you get told ahead of time, and actually in the US and other developed countries, you don’t even have that level of certainty and visibility,” Ahkong said.

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Stricter Regulations

China last week beefed up efforts to combat short selling with some of its strictest measures yet. The China Securities Regulatory Commission approved an increase in margin requirements for short selling starting July 22, while the country’s biggest stock-lending provider suspended its business of lending securities to brokerages from July 11.

Analysts say the latest curbs will hurt quantitative long-short funds that undertake high-frequency trading, but will have less impact on those that hold their positions for longer. Hedge funds that trade on company fundamentals can still short A-shares via over-the-counter derivative contracts with offshore brokers, or bet against futures tied to mainland equity indexes. They can also short ADRs or Hong Kong shares.

“I don’t see any impact on offshore managers running long-short equity strategies” unless there are rules that specifically target short selling in offshore markets, said Benjamin Low, Singapore-based senior investment director at Cambridge Associates, an industry consultant.

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Another challenge facing China-focused long-short funds is how to raise assets from new investors amid dwindling foreign interest in Chinese markets. Despite superior performance this year, many are still struggling to expand, said Gwyn Roberts, head of manager relations at PivotalPath.

Long-short portfolios have fallen out of favor in many countries due to their high fee structures and lackluster returns. Globally, the strategy saw client withdrawals for all but one month since March 2022, according to data from analysis platform Nasdaq eVestment.

Those in the hedge fund industry though say the long-short strategy can continue to perform well in China.

“The China market has its own driving factors, its own characteristics and its correlation with the developed market normally is relatively low,” said Wei Li, multi-asset quant solutions portfolio manager at BNP Paribas Asset Management in Hong Kong. “The low correlation and high dispersion normally indicate a good opportunity to generate alpha.”

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