China stocks face big risks as thousands of hedge funds close to the point where they are

(Bloomberg) – China’s nearly trillion-dollar hedge fund industry risks worsening volatility in its stock market as the depth of portfolio losses are forced to sell by some managers.

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Last month, about 2,350 stock-related hedge funds fell below a threshold that typically activates clauses that require them to reduce their exposure, with many moving to a level that makes liquidation mandatory, according to an industry data provider. Signs of such pressure are “near historic highs,” China Merchants Securities Co. analysts said in a report this month.

Unusual elsewhere, sales rules are common in China, where they were introduced to protect hedge fund investors from outside losses. Although many funds are forced to reduce their stock holdings, they may backfire in a declining market. At a sign, regulators are taking notice, with stock exchanges asking for some funds to assess the pressure on their portfolios since March, according to people familiar with the matter, who have asked not to be named because the discussions are private.

“After the rapid expansion of the industry last year, the pressure on the market could be fairly large, especially if the volume of funds is concentrated,” said Ian Hong, director of the China Hedge Fund Research Center at the Shanghai Advanced Institute of Finance. While not a common problem, these measures are forcing many hedge funds to sell in this year’s “extremely volatile market”, he said.

Despite the short break, China’s benchmark CSI 300 index had its worst January-April period since 2008. It has fallen nearly 19% so far this year, with a strict Covid Zero policy and a crackdown on private enterprise to undermine investor confidence. A number of disappointing economic data from China this month also highlighted the growing toll of lockdown-dependent approaches, raising concerns that markets would be under pressure if China did not change its outlook.

Trigger

For a hedge fund industry that grew 66% last year and ended up with operating assets of 6.1 trillion yuan ($ 903 billion), this is a sharp change of fortune. As of March 31, the sector was operating at 6.35 trillion yuan.

Each strategy booked losses in the first quarter, except for product-focused funds. The need to sell when certain triggers are injured puts pressure on the struggling fund, leaving little room for recovery.

Until April 22, Shenzhen PaiPaiWang Investment & Management Co. About 10% of the more than 24,500 stock-related hedge funds tracked by have fallen below 0.8 yuan per unit in net worth, a general warning line that often requires a fund to reduce its stock position below 50%.

They were above 0.7 yuan, a so-called stop-loss line that makes liquidation mandatory. About 7% of tracked funds exceeded that threshold. According to the Merchants Securities report, more than 1,000 funds have already expired prematurely this year.

Consultancy Geshang Wealth’s data contained more than a quarter of the 1,153 long-only funds that tracked below 0.8 yuan as of May 5, a jump from 16% in mid-March.

Terms, agreed between funds and their investors, may vary.

Xie Shiqi, an analyst at hedge funds affiliated with Geshang Wealth, an analyst at Beijing Xinjiang Investment Management Ltd., says that forcing a sell-off in a market downturn not only fuels stock declines, but also forces managers to capture any possible rebound.

The market crash has hit companies both large and small.

If poor fund management could have contributed to the downturn of smaller firms, the reason behind the rapid launch of top-tier new products from last year could be why they are now facing a “relatively large liquidation risk,” wrote Tong, led by Ren, an analyst at Merchants Securities.

This includes the Beijing-based quantitative fund Lingjun Investment, which was one of the most active fundraisers last year and managed more than 70 billion yuan as of March. Some of its funds fell below the 0.85 yuan warning line companies used last month, and Lingjun said it would strictly follow the requirements in its contract to adjust the investment, Chinafund.com reported. A spokesman for Lingjun told Bloomberg News that the company would do its best to optimize its model and urged clients to adhere to long-term value investments.

Discussion

Although hedge funds in the Western market employ stop-loss levels for risk management, the industry-wide austerity measures adopted in China are unique. The practice was introduced by trust firms that first distributed personal securities funds or equivalent hedge funds to protect Chinese clients, according to consultant Hubei Wealth Management Co.

While the flaws in the approach are becoming more apparent, eliminating or reducing triggers is “a huge challenge” because it requires consultation with all investors, says Ian of the China Hedge Fund Research Center. Regulators will likely focus on ensuring fairness of the contract and preventing systemic risks, he said.

With the current turmoil, officials at the country’s stock exchanges have reached out to the fund to assess the pressure they are facing, as well as discuss their approach to the exercise, although it is unclear whether any action will be taken, say people familiar with the discussion. The Shanghai and Shenzhen stock exchanges did not immediately respond to requests for comment.

According to Shanghai Minhong Investment Management Co., a top quantum firm, long-only quant funds, which typically operate with full stock positions, should avoid mandatory selling requirements. A 0.7 yuan warning line and a 0.65 yuan stop-loss line are more appropriate where needed, a company spokesman said.

Although some funds are trying to reduce trigger points, the deal is difficult to amend. “Amendments to contracts after reading through caution and stop-loss lines can actually damage investor confidence,” Xie said. “Managers should check their stress and fluidity well and manage positions in advance.”

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