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’re outperforming their major peers based on one hedge fund strategy.

Investing in Chinese stocks using classic long-short trades has 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 United States and less than 6% in Europe, the data show.

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One reason for the success of the trade in China is the wide variation in the performance of state stocks, as state policies favor industrial capacity, while consumer and property stocks struggle in a faltering economy. The structure of the mainland’s stock markets also creates fertile ground for this strategy.

“A market with reasonably high retail participation, low institutional participation and low analyst research coverage is naturally going to create more structural inefficiencies,” said Bernard Ahkong, chief investment officer of global multi-strategy alpha at UBS O’Connor in London. “China ticks all the boxes.”

While Beijing’s new restrictions on short selling have made it harder for domestic quant funds to implement short-selling strategies, analysts say overseas primary stock pickers have so far been unaffected. They can choose to short American depositary receipts or Hong Kong-listed stocks, or use derivatives to bet against mainland stocks through trading with global banks.

Despite the success of the China buy-and-hold strategy, the number of practitioners of the strategy remains relatively small, as global interest in the country’s stocks has waned amid the market’s continued slide. Of the roughly 600 buy-and-hold funds worldwide with at least $50 million in assets and an 18-month track record, only 35 focus exclusively on China, according to hedge fund research firm Pivotal Path.

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Superior returns

An example of divergence in Chinese stocks this year is the MSCI China Energy Index, which has jumped 27% through July 15, while the health care sector has fallen 27%. By contrast, the best performing sector in the S&P 500 is technology, which has gained 34%, while the worst performing sector — real estate — has gained 0.1%.

The UBS O’Connor China Long-Term Fund returned 15% this year through July 12, data compiled by Bloomberg showed. The performance was boosted by gains in PetroChina and China Shenhua Energy Co. as Beijing urged state-owned companies to improve shareholder returns, according to a fact sheet from the company published in late May.

Clear signals of intent from authorities also helped boost gains, said UBS O’Connor’s Akong.

Contrary to popular belief that Chinese policymaking is unpredictable, the government actually tends to chart out major initiatives such as state-owned enterprise reform on a multi-year basis, making it easier for long-term investors to bet on sectors likely to win government support, he said.

“It feels like you get information in advance, and in fact in the United States and other developed countries, you don’t even have that level of certainty and visibility,” Akong said.

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Stricter regulations

Last week, China stepped up its efforts to combat short selling with some of its toughest measures yet. The China Securities Regulatory Commission approved higher margin requirements for short selling starting July 22, while the country’s largest stock lender halted its securities lending business to brokerage firms starting July 11.

Analysts say the latest restrictions will hurt long-short quant funds that engage in high-frequency trading, but will have less of an impact on those that hold positions for longer. Hedge funds that trade on corporate fundamentals can still short A-shares through over-the-counter derivatives contracts with overseas brokers, or bet against futures contracts tied to mainland stock indexes. They can also short American depositary receipts or Hong Kong stocks.

“I don’t see any impact on offshore investment managers who run long-short equity strategies” unless there are rules specifically targeting short selling in offshore markets, said Benjamin Lo, senior investment manager at Cambridge Associates, a Singapore-based industry consultancy.

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Another challenge facing China-focused long- and short-term funds is how to raise assets from new investors amid waning foreign interest in Chinese markets. Despite outperformance this year, many are still struggling to scale, says Gwyn Roberts, head of manager relationships at Pivotal Path.

Long-short portfolios have fallen out of favor in many countries due to high fee structures and lackluster returns. Globally, the strategy has seen clients withdraw for a single month since March 2022, according to data from analytics platform Nasdaq eVestment.

But hedge fund industry insiders say a long-term investment strategy could continue to perform well in China.

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

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