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China\u2019s quantitative hedge funds are admitting to unprecedented failures by their stock-trading models during one of the wildest two-week stretches in the market\u2019s history.<\/p>\n
One manager described it as the industry\u2019s \u201cbiggest black swan event.\u201d Another said its models \u201cswitched from doing it right to getting it wrong repeatedly.\u201d<\/p>\n
While historical data on China quant returns is limited, all signs point to record underperformance for such funds\u2014a shock that Man Group has compared with the\u00a0\u201cquant quake\u201d<\/a>\u00a0that wreaked havoc on US managers in 2007.<\/p>\n Leading quants each managing more than 10 billion yuan ($1.4 billion) lagged the CSI 500 Index by an average 12 percentage points in the two weeks ended Feb. 8 for the strategy tracking the stock gauge, bringing the year-to-date excess return to a negative 11.3%, according to industry data cited in a Huatai Securities Co. report.<\/p>\n After defying the nation\u2019s stock slump in the past three years, quants were caught off guard by rapid market shifts and government intervention in the lead-up to the Lunar New Year holiday.\u00a0<\/p>\n A week meant for national celebrations turned into \u201cone sleepless night after another\u201d for quants and their investors, Shanghai-based Hainan Semimartingale Private Fund Management LP wrote in a Feb. 8 letter seen by Bloomberg that also described the episode as a black swan event.<\/p>\n The\u00a0debacle<\/a>\u00a0highlights how quants\u2019 efforts to woo clients\u2014this time by quietly adding better-performing smaller stocks in portfolios tracking benchmarks to boost returns\u2014could backfire when going too far. While many of the managers expect their returns to improve as the market swings normalize, the industry is also facing its toughest-ever regulatory scrutiny and weaker players may struggle to recover.<\/p>\n \u201cThat was the first ever liquidity crisis triggered by a stampede from crowded quant strategies in China,\u201d said Li Minghong, a fund-of hedge-funds manager at Beijing Yikun Asset Management LP. While such risks were anticipated, \u201cI didn\u2019t know it would come so early, so abruptly.\u201d\u00a0<\/p>\n Managers\u2019 recounts of this year\u2019s tumult have been largely consistent, according to their investor letters. The \u201cfuse\u201d was the \u201cextreme polarization\u201d last year in the valuations of falling large stocks and surging small caps, Li said.<\/p>\n That situation quickly reversed this year when small caps began to\u00a0slump<\/a>, prompting quant products with heavy exposure to trim holdings as some investors redeemed. The steep declines reached levels that triggered losses in derivatives known as \u201csnowballs<\/a>,\u201d causing panic among holders and forcing brokerages to dump stock index futures.\u00a0<\/p>\n In turn, that pushed up the hedging costs of quants\u2019 market-neutral products, some of which were leveraged up as much as 300%, prompting them to unwind positions. Meanwhile, some so-called index-enhanced products chose to use index futures to replace stocks. Such moves all led to further selling in small caps, fueling a downward spiral in the market.\u00a0<\/p>\n As\u00a0government-led funds<\/a>\u00a0stepped in later, propping up exchange-traded funds tracking different indexes along the way, the market became more unpredictable to computer models trained with historical data. Regulators\u2019 move to curb securities lending pushed up prices of stocks that some managers were shorting, imposing losses. Selling restrictions on so-called Direct Market Access products\u2014which employ the leveraged market-neutral strategy\u2014pushed managers to cut positions once allowed, according to Shanghai-based\u00a0Mingxi Capital<\/a>, which manages more than 1 billion yuan.\u00a0<\/p>\n \u201cA series of external interventions and changes made it hard for quant models to make predictions, or even adapt,\u201d Mingxi wrote in a Feb. 8\u00a0article<\/a>\u00a0on its WeChat account. \u201cThe models switched from doing it right to getting it wrong repeatedly.\u201d<\/p>\n Quants struggled to adjust because the market rally centered on certain indexes and their portfolios are spread more widely, according to\u00a0Zhejiang High-Flyer Asset Management<\/a>. In the week ended Feb. 8, just 11% of mainland-listed stocks gained more than the CSI 500 Index, which surged almost 13%, and only about a fifth of A-shares outperformed the 9.2% rally in the CSI 1000 Index.\u00a0<\/p>\n Zhejiang High-Flyer\u2019s products often hold more than 2,000 stocks each, suggesting they would \u201close by a wide margin\u201d to the indexes in such extreme conditions, it wrote in a letter to investors.\u00a0<\/p>\nUpgraded Models<\/h3>\n