Due to Government Crackdown, Chinese Quant Funds Suffer

 For many international investors who are eyeing the Chinese equity markets with suspicion, the recent and sudden trading restrictions is yet another reason to avoid the markets. Indeed, until February 2024, China has endured a record outflow from the equity market, and due to never before seen crackdowns on the property and tech sectors, foreign direct investment is at a thirty year low. Furthermore, as a result of the Chinese government’s efforts to halt a USD$ Trillion sell-off in stocks the Quant industry*, (once a booming and integral part of the equity market) it has suffered losses and is yet another casualty of government policy.

*Quant (Quantitative) Fund – This is a fund that identifies with automated algorithms and advanced quantitative models together with statistical and mathematical techniques to make investment decisions and execute trades. Unlike other funds (e.g., hedge funds) a Quant fund has no human judgement or intellect in investment decisions, and experts argue that the computer based models mitigate losses and risks related to human fund management. 

Market analysts advise that the new restrictions will require Quant funds to be scrutinised and regulators will demand that any new entrants will have to report trading strategies before actually trading. Apart from sweeping regulations that are harming Quant funds, they have been caught off-guard by government intervention. Due to the five year low on the *CSI 300 index, they took very hard and forceful measures to stabilise the markets, with Quant funds firmly in their sights.

*The Shanghai Shenzhen CSI 300 Index is designed to replicate the performance of the top 300 stocks traded in the Shanghai and Shenzhen stock exchanges and is weighted for market capitalization. As such, it is seen as a blue-chip index for mainland Chinese stocks.

First of all, in early February 2024, the head securities regulator was dismissed and replaced by a veteran known as the “Butcher Broker” due to his previous record of hard crackdowns Experts suggest that Quants were targeted as the authorities were concerned that declines in equities were compounded by Quant funds making short bets and unloading large blocks of shares. Therefore some Quant funds were limited in their ability to undertake short trades, which, combined with shifts in the market, inhibited and stifled Quant funds. 

Analysts advise that a favourite trade for Quant funds is purchasing small cap stocks as they are susceptible to mispricing and the quants computer programmes exploits this opportunity to gain profitability, whilst hedging market exposure by shorting index futures. However, declines in small cap stocks made sure that quant funds reduce holdings and the huge selling triggered losses in the derivatives market known as snowballs*. This caused further panic in the market (known as a quant quake) and index futures were dumped by brokerages as well. 

*Snowballs – A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Finally the volatility that was in the equity markets impacted those funds (e.g. hedge funds) who had invested in what is known as market-neutral products* and in many cases had leveraged themselves up to 300%, thus forcing them to unwind their positions creating even more havoc in the market which was already going south. This prompted the authorities to prop up exchange traded funds via government-led funds known as the national team, which resulted in a boost for large caps stocks but ignoring the small caps. Data released showed some of the top Quant funds lagging behind the CSI 500 Index (a well-known indicator of the performance of Chinese mid and small cap companies), by circa 12 points for 2 week’s ending 8th February 2024.

*Market Neutral Products – These funds/investments are designed to target returns that are independent of market directions. This is achieved with equal long and short positions in any industry and by investing in equities where the long positions are expected to outperform their peers and the short equities are expected to underperform. Any losses in the short position are offset by profits in the long position.

Following the crackdown on quants the main equity index has risen in nine straight sessions including every day from 19th -23rd February 2024, the longest run of uninterrupted gains in six years. So for now, the strong arm tactics of the authorities are working to stop the downward spiral of equities, however experts wonder if Quant funds will continue operating where there are such arbitrary market interventions. The question is this: will investors be convinced this a one off intervention? Or will the image the authorities have tried to create over the last thirty years that China is committed to a professional and open market be soured?