‘Quant Quake’: China Imposes Restrictions on Quant Funds to Boost Market Confidence

‘Quant Quake’: China Imposes Restrictions on Quant Funds to Boost Market Confidence
A security man stands in a local securities in Shanghai, China, on April 30, 2004. (Liu Jin/AFP via Getty Images)
Indrajit Basu
News Analysis

The three-day ban on a large computer-driven hedge fund slapped by China’s main stock exchanges late on Tuesday may be yet another attempt by Beijing to stabilize stock markets. But it also highlights the tension between aggressive trading strategies and the regulators’ efforts to ensure market stability.

Besides, it underscores the fact that Chinese hedge funds are also falling victim to China’s market rout and faltering economy.

As part of wider regulatory attempts to restore confidence in the markets and revamp China’s fast-growing quant trading players, the Shanghai and Shenzhen bourses placed an unprecedented trading shutdown—until Feb. 22—on Ningbo Lingjun Investment (Lingjun), a major quant fund manager.

According to the stock exchanges, Lingjun’s orders to dump equities in early trade on Monday violated orderly trading regulations and coincided with rapid declines in the major Chinese stock indices on Tuesday.

Quant or quantitative funds rely on countless trading signals, such as economic data, global asset values, and real-time corporate news. They use proprietary algorithms to create complex models based on momentum, quality, value, and financial strength.

Quantitative techniques have gained popularity as asset managers aim to outperform market benchmarks over time. However, as such funds expand, they lose their capacity to react quickly and exploit market inefficiencies.

Quant funds may also be dangerous if they are touted as bear-proof or use short-term strategies. One poor turn might result in explosions, which frequently make headlines.

Lingjun, which manages more than 60 billion yuan (about $8.3 billion), dumped a total of 2.57 billion yuan (about $357.4 million) in A-shares between 9:30 a.m. and 9:31 a.m. on Monday, according to the exchanges. The fund’s selling orders constituted “abnormal trading behavior,” and the firm was cautioned many times for the same reason this year, according to the Shenzhen statement.

The bourse needed to enhance monitoring and maintain “zero tolerance” for any practices that violate investors’ lawful rights, it stated.

In addition, the stock exchanges have announced that they and the China Securities Regulatory Commission, the securities watchdog, will be implementing a new surveillance system to closely examine all market activity by computer-driven quant funds using complex automated trading strategies.

‘Quant Quake’

This week, experts at the biggest publicly traded hedge fund, Man Group, compared the current turmoil in the Chinese quant sector to a “quant quake” similar to the 2007 meltdown in the United States when portfolios that were constructed utilizing quantitative models encountered exceptional losses between Aug. 7 and Aug. 9 that year.

“This crisis unfolded in a sequence reminiscent of falling dominoes, each event triggering the next,” Man Group wrote in a note viewed by The Epoch Times.

There is a broader worry about the state of China’s financial markets, and the trading ban on Lingjun Investment is only one example of that. The recent five-year low of the Chinese blue-chip index—the CSI—has stoked concerns about the market’s potential for protracted instability, the risk posed by the quant and hedge funds, as well as the fact that Chinese hedge funds are also facing the heat of China’s faltering economy.

The initial tremor was prompted by the sustained market collapse during the previous three years as the world’s second-largest economy dealt with the fallout from the COVID-19 pandemic.

As of Jan. 31, Chinese equities were significantly discounted, with a forward price-earnings ratio below 10 times—the largest discount to the MSCI World Index since 2006.

The lackluster economic recovery has weakened Chinese corporations’ earnings, lowering their return on equity to the lowest level in 20 years, starkly contrasting the robust profitability witnessed in developed economies, notably the United States.

Consequently, investor sentiment in China has deteriorated significantly; for example, Man Group noted that one index based on sell-side analyst revisions has reached its lowest level ever recorded.

Early in February, a new wave of selloffs and long-term bearish trends turned on the “knock-in” feature of quant’s structured products. These products were made to make money when major stock indexes moved within a certain range.

However, they had to short-sell index futures because the market dropped more quickly and for a longer time than expected, which caused significant instability and issues with the futures market.

According to Bloomberg numbers, compared to the benchmark CSI 300 stock index, which fell 6.3 percent in January, private quant funds lost an average of 7.2 percent.

Quants are also facing new problems due to the recent decline in small-cap stocks and recently enforced restrictions on short selling.

“The escalation of [the recent] volatility increased the hedging costs of [the quants’] market-neutral strategies, which typically maintain long positions in select cash equities—often in small-caps—while shorting index futures. The high degree of leverage, sometimes more than 3x, led to inflated hedging costs, necessitating a massive unwinding of both long and short positions,” the Man Group note said.

Hence, the market crashed Tuesday after Lingjun’s Monday selling, so CSI gained on Wednesday after the ban.

Intensified Market Intervention

Following last year’s criticism—from smaller investors and long-only funds—that quant and hedge funds are turning in huge profits from share price collapses and volatility, Chinese authorities began paying more attention to quantitative funds.

As regulators seek to revive market confidence in the recent market rout, the newly appointed chairman, Wu Qing of China Securities Regulatory Commission, met with market participants over the weekend to discuss more oversight in an effort to restore investor trust.

The nation’s $8.6 trillion stock market has tanked 1 percent so far in 2024 after dropping for three straight years.

Before starting to trade, new quantitative funds will have to disclose their investment plans to authorities, said the Shanghai and Shenzhen stock exchanges on Tuesday. Offshore quants that trade stocks through the Stock Connect program in Hong Kong will also be subjected to the regulation.

The most recent official statistics show that by the end of 2021, the total value of China’s quant hedge funds reached 1.26 trillion yuan (about $179.4 billion). The sector’s fast growth has also attracted foreign quant firms like Two Sigma and Winton in recent years.

Meanwhile, while Lingjun apologized for its Monday actions and the onshore benchmark CSI 300 gained 1.3 percent (3456.87) at Wednesday’s close, Man Group wonders whether these measures can rebuild investor confidence and the duration of their effectiveness.

“Similar efforts in 2016 did not lead to a pronounced V-shaped recovery,” the Man Group note said. “Ultimately, a revival in the Chinese economy and an upturn in corporate earnings are essential for overcoming this crisis.”