In November 2012 hedge fund manager Fang Zheng began looking into China Metal Recycling (Holdings) after hearing rumors of questionable financial practices at the company, a Chinese scrap metal recycling outfit. Within weeks Zheng and his team of researchers at Keywise Capital Management (HK) concluded that there was substance to the talk. He began shorting the Hong Kong–listed stock between December 2012 and early January 2013 even as other investors were piling in, bidding up the share price by 26 percent, to a high of HK$10.30 ($1.33) on January 11. The shares sagged over the next two weeks on rumors that regulators had begun an investigation before the company suspended trading at HK$9.43. In July the Securities & Futures Commission of Hong Kong won a court order to wind up China Metal Recycling after citing evidence that the company inflated revenues ahead of its $200 million initial public offering in 2009. Hong Kong police are continuing to investigate allegations of fraud at the company.
Such astute bets have made Zheng a rising star in China’s young and fast-growing hedge fund industry. Since founding Keywise Capital in 2006, he has grown the firm’s assets to $1.4 billion, making it the biggest long-short equity manager in the Chinese market, according to the Absolute Return Investment Management Association of China (Arimac), an industry group for Chinese hedge funds. His fund achieved an annualized return of 21.16 percent from inception in September 2008 to the end of October 2013, well ahead of the 7.57 percent return posted by the MSCI Golden Dragon Index of large- and midcap Chinese stocks listed on the mainland and in Hong Kong and Taiwan. His record has attracted such notable investors as Norway’s giant sovereign wealth fund, Government Pension Fund Global. With China preparing to embark on a new wave of economic reform and continuing to liberalize its markets, Zheng sees enormous potential for growth.
“There will be many long and short opportunities in the years ahead, especially at a time when China is going through fundamental restructuring,” says Zheng, who spent a decade managing money in the U.S., including a stint as an emerging-markets portfolio manager at J.P. Morgan Asset Management, before founding Keywise Capital. “The government will begin to end monopolies for state-owned enterprises. As those enterprises begin to lose their monopolies, they will become our shorting candidates too.”
The success of Zheng and other Chinese hedge fund pioneers, like Beijing-based Hillhouse Capital Management, is rapidly attracting followers. China today has some 700 private fund management firms with a collective 300 billion yuan ($49 billion) in assets under management that are actively exploring alternative strategies, according to Z-Ben Advisors, a Shanghai-based fund research firm. U.S.-based fund research house Morningstar tracks 1,242 separate funds run by these firms, including 122 funds with five-year performance records and 490 with three-year records as of the end of October. Those with five-year records produced an annualized return of 10.61 percent; those with three-year records produced a return of –3.19 percent. By comparison, China’s open-end mutual funds delivered average annualized returns of 10.79 percent over the past five years and –5.4 percent in the past three years.
Many Chinese hedge funds have effectively been operating as active long-only managers because of tight regulatory restrictions on shorting stocks and using leverage. Beijing has allowed those tools, as well as futures on the CSI 300 index of leading Shanghai- and Shenzhen-listed stocks, to be used only since 2010, and only by firms managing private money in segregated accounts. But with the authorities signaling their intent to relax such curbs, hedge fund firms are scrambling to experiment with alternative strategies in anticipation of bigger paydays ahead.
Yi (Sonny) Shen, CEO of Shanghai Shenyi Investment Consulting Co., manages three market-neutral funds with combined assets of 2 billion yuan. He uses futures on the CSI 300 as part of his long-short equity strategies, which have delivered an average annual return of 8.7 percent over the past two years, a period when the index has fallen 27 percent. He is looking forward to having much greater freedom in the near future.
“We are all hopeful the government will deregulate,” says Shen, who returned to China in 2010 after working for more than a decade in the U.S. and Europe, including a four-year spell at Goldman Sachs Group, where he set up the firm’s European exchange-traded funds business, and a year as a portfolio manager at Millennium Partners in New York. “China’s hedge fund market will for sure grow. The moves by regulators are quite quick these days. We have seen government bond futures launched this year. We see options coming in 2014.”
Current regulations allow the shorting of 288 domestically listed stocks, known as A shares, representing only 12 percent of China’s listed universe. Other rules keep the cost of shorting those stocks high — between 8 and 9 percent a year. But officials’ appetite for liberalization is rising. The government has declared its intention to make the renminbi an international currency and establish Shanghai as an international financial center by 2020.
In November, China’s leadership held the Third Plenum of the 18th Party Congress, where 373 of the nation’s top officials, including President Xi Jinping and Premier Li Keqiang, endorsed a broad program of economic reforms that includes a bigger role for the private sector and financial markets. The authorities are expected to flesh out the details of those reforms in the coming months (see “Can China’s Market Reforms Match Investor’s Expectations”).
Officials were pressing ahead with liberalization ahead of the plenum. In September the Chinese Securities Regulatory Commission allowed Shanghai’s China Financial Futures Exchange to begin trading government bond futures. In 2014 the Shanghai Futures Exchange will launch futures on the Shanghai Nonferrous Metals Index, says Zhu Honghai, head of the futures exchange’s derivatives innovation and development unit. “We also are planning to launch options contracts,” Zhu says.
“We will see, increasingly, liberalization of the sector in the coming five years,” says Arimac chairman Jeff Nie. He predicts that the authorities will widen the number of A shares that can be shorted to 700 in the next five years. “Once you get to 700 equities, it won’t be so difficult to jump to many more equities that can be shorted,” Nie says. “We will see the financing charges drop to 3 percent or lower. This will lead to explosive growth of China’s hedge fund industry.”
Nie is also CEO and CIO of Asset Dynamic Management, a Hong Kong–based firm that is seeking to raise $500 million for a fund of funds that will invest in Chinese managers, including those in the alternative space.
Currently, many hedge fund managers are cutting their teeth in Hong Kong, where officials impose few restrictions and prime brokers offer a deep pool of locally listed Chinese stocks, or H shares, that can be shorted for less than a quarter of the rates charged on the mainland. Roughly half of the 1,567 companies listed in Hong Kong have mainland origins, and they have a combined market cap of $1.5 trillion, according to market operator Hong Kong Exchanges and Clearing. By comparison, the 2,400 companies listed on mainland markets, primarily Shanghai and Shenzhen, have a total market cap of $3.2 trillion.
“Without a doubt, there will be many hedge funds coming out of China that will go global,” says Philip Tye, chairman of the Hong Kong chapter of the Alternative Investment Management Association. “You need talent, you need a platform, and you need capital. There certainly is talent in China. There is hunger among the talent. The regulatory framework is being developed, and there is no question in my mind that more and more of these managers will go global.”
Beijing has taken several other steps in recent months to spur the growth of hedge funds. In September the government began a trial program that will allow foreign hedge fund firms to raise renminbi-denominated funds from domestic investors for overseas investment. It granted licenses to six leading firms — Canyon Partners, Citadel, Man Group, Oaktree Capital Management, Och-Ziff Capital Management Group and Winton Capital Management — allowing each of them to raise as much as $50 million from high-net-worth individuals in the greater Shanghai area.
These firms declined to comment because of the sensitivity of the market opening. Industry executives note that speculation swirled in 2013 that the government might abandon plans to welcome foreign hedge funds. The fact that the government went ahead with the initiative sends a strong signal of the authorities’ desire to liberalize the market, says Hubert Tse, a partner with Shanghai-based law firm Boss & Young, which represents some of the new licensees.
Other initiatives have focused on Shanghai. In September officials formally designated an area on the outskirts of the city’s Pudong financial district as the Shanghai Free Trade Zone, where domestic and foreign investors will be permitted to freely invest and trade assets without having to go through the complicated foreign exchange and capital controls imposed by the People’s Bank of China, the central bank. Two months later authorities launched the Shanghai Hedge Fund Zone, housed in Citic Plaza, a 55-story glass tower in the city’s Hongkou district. The zone will provide a range of incubation services, including below-market rental fees, for local hedge fund start-ups. Occupying many of the floors are service providers, including Citic Newedge Futures Co., a joint venture between Citic Group, one of the country’s leading financial conglomerates, and French futures and derivatives house Newedge.
Chinese financial executives welcome these moves. “It is a very positive sign by the central government and the Shanghai government and shows their commitment to building the hedge fund industry and developing Shanghai,” Tse says.
Kenny Li, CEO of Shanghai-based KKM Capital, a financial advisory firm that worked with municipal authorities on the creation of the zone and occupies half of the 30th floor of Citic Plaza, is bullish on the outlook for hedge funds. “In the next five years, I believe the biggest new hedge funds will come from China,” he says.
In November, KKM teamed up with New York–based Global Capital Acquisition to cohost the latter firm’s Battle of the Quants hedge fund conference in the Shanghai zone. The three-day event attracted more than 500 Chinese fund managers.
“Due to the accelerated liberalization of regulations, the increase in growth of millionaires in China and the focus by large Chinese financial institutions to seed hedge funds, I believe the Chinese hedge fund industry is poised for tremendous growth,” says Bartt Kellermann, founder and CEO of Global Capital Acquisition. Kellermann has been hosting annual “Battle” events in New York and London since 2006 and plans to make Shanghai a permanent addition to the mix. “In five years the largest and most successful events of all Battles of the Quants are expected to be in China,” he says.
Citic Securities Co., China’s biggest investment bank, announced at the Shanghai event that it was establishing a 2 billion-yuan fund to seed start-up hedge fund managers. “The fund shows our commitment to nurture China’s domestic hedge fund industry,” says Jackie Fan, general manager of Citic Securities Futures’ innovation department.
Other trends, led by the poor performance of the domestic stock market, are helping to fuel investor interest in hedge funds. In early December the CSI 300 was trading nearly 39 percent below its 2009 peak. More than four years of bear markets have prompted China’s mutual fund houses, all of which are controlled by state-owned entities, to cut back and dismiss hundreds of fund managers. Many of these managers have set up their own private investment management outfits and are beginning to look at alternative strategies.
Ping An Russell Investment Management (Shanghai) Co., a joint venture between Ping An Insurance (Group) Co., the largest private Chinese insurer, and Seattle-based asset manager and advisory firm Russell Investments, has been surveying the field for the past two years in an effort to award mandates to the best talent in the industry. Ping An Russell estimates that about half of the 350 private firms it has reviewed have adapted absolute-return strategies.
“We are seeing many managers who are interested in shorting strategies as a way of hedging risk in their portfolios,” says Brian Ingram, head of investment management and research at the Ping An Russell joint venture. “Some are exploring how to short single securities; others might find it expensive and pursue index futures. Right now it’s only a minority that are applying shorting strategies in their portfolios, but over time you will find many other managers with securities selection skills adopting shorting strategies.”
Ping An Russell has hired about a dozen managers to help it advise on the management of about $480 million in assets. “Thus far we have invested across three strategies: absolute-return equity, absolute-return multiasset and relative-return equity,” says Ingram, who formerly worked in London for Russell Investments. “We expect to expand the variety of strategies next year to include more fixed-income strategies. We have hired both quantitative managers and nonquantitative managers for the same client mandate. Our expectation is that their combined exposures will create the risk-and-return profile our clients want.”
None of Ping An Russell’s managers uses derivatives in its strategies for the firm. Foreign clients, which participate through China’s qualified foreign institutional investor program, as well as the firm’s domestic institutional clients, face regulatory constraints that prohibit them from using derivatives instruments. Recent regulatory changes, including a revised law on fund management that came into effect in June, may allow domestic institutions to begin experimenting more with derivatives or investing in funds that use derivatives. The revised fund law, which requires additional regulatory changes to become effective, also formally recognizes the existence of so-called sunshine funds, or funds run by private asset management firms in which the management team has an ownership stake. Virtually all Chinese hedge funds are sunshine funds; they typically charge a 1 percent annual management fee and 10 to 20 percent of any investment gains.
So far, Chinese hedge funds have sourced virtually all their funding from high-net-worth individuals in a throwback to the hedge fund industry’s origins. Typically, their clients are referred by Chinese private banks or wealth managers, which require a minimum deposit of 10 million yuan to open an account. Boston-based consulting firm Bain & Co. estimates that in 2012 China had 700,000 individuals with 10 million yuan or more in investable assets, more than double the number of just four years earlier.
Analysts say that as part of the new fund law the CSRC is preparing regulations that will allow hedge funds to bypass the current system and market directly to wealthy individuals and institutional investors.
One of the firms eager to do that is Venus Investment Management Co. In October the Shenzhen-based firm was honored as one of China’s top 100 hedge funds at industry association Arimac’s third annual meeting. More than 700 participants attended the one-day event, which was held in the 1,000-seat auditorium of the Shanghai Cadre Training Center, a campuslike facility where the Communist Party trains its top local officials.
Chairman and CIO Daniel Zeng Zhaoxiong founded Venus in early 2012, but he and his team of seven analysts and assistants have managed third-party money since the end of 2008. Venus now manages close to 2 billion yuan and offers five funds with strategies that run the gamut from arbitraging volatility among the various Chinese markets to focusing on growth stocks in the consumer and Internet sectors. In the past four and a half years, Zeng’s funds have delivered a compound annual return of 14 percent, compared with –5.6 percent for the overall market during that period.
“In the coming ten years, China will become the world’s biggest consumer market, and the service and IT sectors will be booming as well,” Zeng says. “There will be winners and losers in this process.”
So far, Zeng hasn’t used derivatives in his mainland investing because regulators allowed their use only by firms managing funds for wealthy clients in segregated accounts. Regulators still haven’t released the regulations for the revised fund law, but it is widely expected that they will allow private funds to actively adopt the use of equity futures as hedging tools. Though Zeng can use CSI 300 futures, he hasn’t found the right timing and instead has been using a hybrid strategy that combines fundamental investing, bottom-up stock picking and value investing.
Zeng also has a $10 million fund in Hong Kong that combines his own money and that of a few clients; he intends to begin marketing this fund actively to outside investors in 2014. He has already shorted a variety of H shares, including those of Gome Electrical Appliances Holding and Anhui Conch Cement Co., both of which suffered from difficult market conditions in 2011.
“The financing cost of borrowing stocks from primary brokers is much cheaper in Hong Kong — around 2 to 3 percent,” says Zeng. Although the Hong Kong fund is biased toward long positions, Zeng says he sees “many shorting opportunities in the financial and real estate sectors, in construction, cement, infrastructure, electricity, utilities and coal.”
Other hedge fund managers, such as Beijing StarRock Investment Management Co., have dealt with China’s restrictions on shorting by using a quantitative approach. StarRock, which has 4 billion yuan in assets under management, uses a quantitative model developed by founder Jiang Hui, a former director of China Asset Management Co., the country’s largest mutual fund manager. The model breaks the Chinese market into more than 30 major sectors and analyzes a variety of factors, including quality of management, earnings, valuation, share price volatility and macroeconomic trends.
“Using an absolute-return approach, we look at how government policies will impact the markets and select the firms that most likely will benefit from those policies,” says Yang Ling, president and chief strategist. “We invest in baskets of stocks, typically the top performers of each sector. We hold 20 to 30 stocks per basket at any one time.”
That approach has been wildly successful so far. In 2008, when the CSI 300 fell 70 percent, StarRock — founded a year earlier — delivered a 4 percent return. Since inception the firm has delivered an average annual return of 10 percent, and assets under management have grown 20 times from an original 200 million yuan.
Yang says the firm will not change its existing approach and does not plan to use equity derivatives for hedging even if the authorities permit wider use of such tools. The best way to hedge against rising inflation is not to use interest rate derivatives but to buy gold, she says, and the best hedge against rising oil prices is to buy shares in oil companies, not oil futures. The firm’s approach reflects more than just market factors, she suggests.
“The government, as a matter of principle, dislikes shorting,” says Yang, 36, who worked as a strategist at several mutual funds, including ICBC Credit Suisse Asset Management (International) Co., before joining StarRock in 2007. “You have to remember, the Chinese government focuses on stability. The government wants to form a multitier financial sector that diversifies risk to many tiers. Officials realize if they don’t allow margin trading and shorting, they cannot develop a truly competitive financial sector, but at the same time, they want to diversify slowly so systemic stability can be maintained.”
Other investors, such as Shanghai Shenyi’s Shen, are embracing derivatives. “Stocks are natural long positions, and in China they are difficult to short because there are limited supplies on what can be borrowed,” Shen says. “Thus we use index futures to short, to get rid of systemic risk, and to catch the alpha in our stock selections.”
Alfred Samson Hou, a U.S.-born hedge fund manager who once worked as head of quantitative trading at SAC Capital Advisors, founded True Arrow Capital Management in San Jose, California, in 2010 and set up trading operations in Shanghai in 2013. The firm manages a roughly $100 million market-neutral China fund that hedges by shorting the CSI 300 as well as a few select equities and ETFs. The fund will take long positions in as many as 80 equities, which it balances with a position on the CSI 300 and short positions of as much as 5 percent on a few individual stocks.
“We are very careful about selling short stock,” notes Hou, who says he has shorted many stocks in the CSI 300 over the past year. The timing and composition of his short book depend on each stock’s relative value according to the fund’s quantitative models. The handful of shorts is typically evenly distributed across sectors and includes both small-cap and large-cap stocks.
“We primarily use index futures for hedging our portfolios,” Hou says. “But being able to short additional stocks directly can give us finer control over the book’s risk characteristics and yield higher average returns.” Hou has found a few brokers who have offered him borrowing rates as low as 5 to 6 percent, well below prevailing market levels. “So it is getting to a point where it is getting more economically attractive,” he says. “But the challenge is how scalable it can be. We must go through a few select brokers, and inventory isn’t big enough to rely solely on individual stock-shorting yet.”
Most Chinese hedge fund managers are still learning about the use of derivatives and must be careful not to adopt shorting techniques too quickly at a time when the market appears to have bottomed out, says Sidney Ma, Hong Kong–based head of investor relations for Springs Capital. The Beijing-based hedge fund firm manages about $900 million, two thirds of it in onshore funds that use a contrarian stock-picking strategy and one third in Hong Kong, employing long-short strategies. “The index may rise going forward,” Ma says. “Why would we short the index? If the manager is not careful in shorting the index, they can get it wrong on both sides.”
According to Ping An Russell, many Chinese hedge fund managers still lack the knowledge and technical expertise to use derivatives well in their portfolios. “What we’re finding is that many Chinese absolute-return managers, when they initially consider shorting strategies, automatically look at the hedging risk side. Only a few managers are looking at using shorting strategies for generating returns,” investment management chief Ingram says. “Yes, there are only a limited number of securities available for shorting, and the cost is typically high, but these are not the most important factors. The bigger factor is the discipline of the manager’s investment approach: Only a minority of managers have the research and valuation ability to use security selection on both the long and short sides.”
Keywise Capital’s Zheng is one such manager. He enjoys deep connections with Chinese officialdom by virtue of his government experience: He was an official at the Ministry of Machinery and Electronics industry in the 1980s, when Rong Yiren, the then-head of Citic who later became China’s vice president under Jiang Zemin in the ’90s, picked him as his personal aide. Zheng employs a team of nine researchers at Keywise, which operates out of Beijing and Hong Kong, and sees plenty of shorting opportunities in state-controlled companies.
But Zheng, who earned an MBA from Harvard Business School in the ’90s, is a bull at heart. His firm’s top ten positions are all publicly traded private Chinese companies. Chief among them is Tencent Holdings, one of China’s leading Internet service providers, run by a group of private entrepreneurs. The company’s stock hit an all-time high of HK$460 on December 6.
“Sure, China has some poor-performing state-owned companies, but China also has many highly competitive corporations and a lot of entrepreneurial spirit,” says Zheng. “The top leadership in China just vowed to give more room to the private sector. I’m very optimistic about the future. We should be longing a lot more than shorting.” • •
