Quant Hedge Funds Are Losing Their Edge in China as Models Fail

China’s quantitative hedge funds risk ending years of outperforming the market, after a surge in local stocks spurred by the government’s economic stimulus package last month beat their models and squeezed short positions.

Quants’ long-only strategies trailed mainland Chinese stocks’ 22% jump by 2 percentage points in September, turning their year-to-date so-called excess return into a 0.1% loss. That compared with an outperformance of at least 16 percentage points in the past three years, according to data compiled by Shenzhen PaiPaiWang Investment & Management Co. 

The market-neutral strategy — meant to deliver an absolute return by stripping out volatility — fell 0.8%, extending the year’s loss to 2.5%, after recording positive returns for each of the past four years, according to PaiPaiWang, which tracks hedge funds.

Quants’ failure to catch up with the broad market surge in late September follows record drawdowns in February when their favored small-cap stocks collapsed. The growing setbacks threaten to further tarnish the appeal of a 1.6 trillion yuan industry that touts the ability to generate market-beating returns, just as regulators tighten scrutiny.

The performance showed that “many managers’ excess returns were not pure alpha derived from stock selection capabilities but instead due to market-style exposure to small caps,” said Liu Xuhui, chairman of Hainan Zhengren Quant Private Fund Management Co. “The conventional quant models that have adapted to certain market patterns are struggling in rapid swings this year.”

Chinese quants typically use multi-factor models to identify characteristics of listed companies that can rise. The historical outperformance of small caps then drove an over-concentration in such shares in recent years. Managers tolerated such deviation from benchmarks their index-enhanced products were meant to track.

When small caps crashed in early February and the broad indices jumped amid government support, quants’ excess returns turned negative in the industry’s “Waterloo,” said Edward Liu, chief investment officer at Shanghai Manfeng Asset Management Co. Many quants then reshuffled their holdings to chase the rising benchmarks, which fueled the stampede from small caps, leading to a “perfect storm,” he said. 

And when the market surged in late September, quants’ stock portfolios, which are often more diversified than the benchmarks they seek to beat, struggled to match the indices’ gains. Their market-neutral products, meanwhile, recorded hefty drawdowns as surging index futures imposed losses on their short positions.

While they could have also recorded significant gains, their diversified portfolios suggest quants, especially in their index-enhanced strategies, “may find it hard to achieve the expected excess returns for the short term,” Guotai Junan Futures Co. analysts wrote in a report this month. 

If the drawdowns in February could be partly blamed on quants’ own risk management, the recent wild market swings were more extreme and rare, leaving little trace in statistical patterns for quant models, trained on historical data, to capture, Manfeng’s Liu said. 

“One disadvantage for quants in China is that the stock market is heavily influenced by policy changes, and such fluctuations are not easily captured by statistical patterns,” he said. “A sudden policy shift can be challenging for any genuine quant strategy.”

The benchmark CSI 300 Index surged 27% in late September after the government’s stimulus measures stoked optimism. The gauge jumped a further 6% on the first trading day of October but has since fallen more than 8% as investors wait for clarity on fiscal support.

Still, quants beat discretionary stock hedge funds in September as their positions were kept full while the rivals had to build up their holdings from low levels, according to PaiPaiWang. Some top players’ excess returns recovered in the first two trading weeks of this month as the extreme volatility eased, according to market data seen by Bloomberg. Guotai Junan Futures analysts recommended investors allocate more to enhanced-index products, citing likely improvement.

While the environment for excess returns will likely improve as market liquidity has recovered from very low levels, a “better environment is no guarantee of performance,” Zhengren Quant’s Liu said. “The traditional multi-factor models may face more intense challenges.” 

Liu said his firm’s strategy doesn’t depend on traditional factors but uses more advanced artificial intelligence models to predict stock price movements. Reinforcement learning allowed the company to adapt more quickly to shifting market conditions while maintaining strict risk controls, with about 90% of its stock holdings kept within constituent stocks of the indices being tracked to limit deviation, he said. 

Zhengren’s Stable CSI 300 Index Enhanced Fund beat the gauge by 13.4 percentage points this year through Oct. 11, while the market-neutral strategy based on that index recorded a 10% gain. The firm’s assets under management have jumped more than 60% this year to about 1.5 billion yuan, Liu said. 

Manfeng’s Liu said quants still have a chance to outperform by improving their stock selection outside the benchmarks as strong index gains are hardly the norm. 

“It’s certainly tough” to beat the market this year, he said. And for the long term, “excess returns in China are no doubt on the decline, although I don’t think they will slip to a very deep level so quickly.” 

This article was generated from an automated news agency feed without modifications to text.