(Bloomberg) — Chinese stocks have been among the world’s worst-performing over the past year, but one hedge fund’s strategy is helping them outperform major peers.
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Investors in Chinese stocks using traditional long/short trades made more than 10% this year through late June, according to data compiled by Goldman Sachs Group Inc. Compared with gains of about 7% in the United States and less than 6% in Europe, the data showed.
The deal has been successful in China in part because of the wide disparity in stock performance across the country, with national policies prioritizing expanding industrial capacity while consumer goods and real estate stocks have struggled in the economic downturn. The structure of the mainland Chinese stock market also creates fertile ground for the strategy.
“Anytime you have a market with relatively high retail participation, low institutional participation and limited analyst coverage, it’s natural that structural inefficiencies are likely to grow,” said Bernard Akon, chief investment officer for global multi-strategy alpha at UBS O’Connor in London. “China checks all of these boxes.”
While China’s short-selling restrictions have made it harder for domestic quantitative funds to execute long-short strategies, analysts say they have so far not affected fundamental stock pickers based overseas, who can choose to short American depositary receipts or Hong Kong-listed stocks or use derivatives to bet on mainland Chinese stocks through transactions with international banks.
Although the long-short strategy has been successful in China, the number of practitioners remains relatively small as a prolonged bear market has dented global interest in the country’s stocks. Of roughly 600 global long-short equity funds with at least $50 million in assets and at least 18 months of track record, only 35 are China-focused, according to PivotalPath, a hedge-fund research firm.
Excellent returns
As an example of the divergence in Chinese stocks this year, the energy sector of the MSCI China Index was up 27% through July 15, while the health care sector was down 27%. By contrast, the best-performing sector in the S&P 500 was technology, up 34%, while even the worst-performing real estate sector was up 0.1%.
The story continues
UBS O’Connor’s China Long/Short fund returned 15% this year through July 12, according to data compiled by Bloomberg. Rising shares in PetroChina and China Shenhua Energy helped boost performance as the Chinese government pushed state-owned enterprises to improve shareholder returns, according to a fact sheet the firm published in late May.
UBS O’Connor’s Akon said clear signals of intent from authorities also helped support the rally in stocks.
Contrary to the widely held belief that Chinese policymaking is unpredictable, the government actually tends to plan major initiatives such as state-owned enterprise reform over multiple years, making it easier for long-short investors to bet on sectors that are more likely to get government support, he said.
“It’s almost like you’re being told in advance, whereas the reality is that in the U.S. and other developed countries you don’t even get that level of certainty or visibility,” Akon said.
Tighter regulations
China stepped up its crackdown on short selling last week, taking its toughest steps yet. The China Securities Regulatory Commission approved raising margin requirements for short selling from July 22, and the country’s largest stock lender stopped lending securities to brokerages from July 11.
Analysts say the restrictions will hit quantitative long-short funds, which trade at high frequency, but have less of an impact on funds that hold positions for longer. Hedge funds that trade based on company fundamentals can still short A-shares through over-the-counter derivatives contracts with offshore brokers or bet on futures linked to mainland China stock indexes. They can also short ADRs and Hong Kong stocks.
“As long as there are no rules specifically targeting short selling in offshore markets, I don’t see it impacting offshore managers running long-short equity strategies,” said Benjamin Lo, Singapore-based senior investment director at industry consultancy Cambridge Associates.
Another challenge facing China-focused long-short funds is how to raise assets from new investors as overseas interest in the market wanes. Despite strong performance this year, many funds are still struggling to expand, said Gwynne Roberts, head of manager relations at Pivotal Path.
Long-short portfolios have fallen out of favor in many countries due to high fees and low returns, and globally, the strategy has seen clients pull out of funds in all but one month since March 2022, according to data from analytics platform Nasdaq Evestment.
But hedge fund industry insiders say long-short strategies can continue to perform well in China.
“The Chinese market has its own drivers and characteristics, and correlations with developed markets are usually relatively low,” said Wei Li, multi-asset quantitative solutions portfolio manager at BNP Paribas Asset Management in Hong Kong. “Low correlation and high variance usually indicate good opportunities to generate alpha.”
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