China's quantitative hedge funds are admitting to unprecedented failures by their stock-trading models during one of the wildest two-week stretches in the market's history.
One manager described it as the industry's "biggest black swan event." Another said its models "switched from doing it right to getting it wrong repeatedly."
While historical data on China quant returns is limited, all signs point to record underperformance for such funds — a shock that Man Group has compared with the "quant quake" that wreaked havoc on U.S. managers in 2007.
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.
After defying the nation's 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.
A week meant for national celebrations turned into "one sleepless night after another" for quants and their investors, Shanghai-based Hainan Semimartingale Private Fund Management wrote in a Feb. 8 letter seen by Bloomberg that also described the episode as a black swan event.
The debacle highlights how quants' efforts to woo clients — this time by quietly adding better-performing smaller stocks in portfolios tracking benchmarks to boost returns — could 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.
"That was the first ever liquidity crisis triggered by a stampede from crowded quant strategies in China," said Li Minghong, a fund-of hedge-funds manager at Beijing Yikun Asset Management. While such risks were anticipated, "I didn't know it would come so early, so abruptly."
Managers' recounts of this year's tumult have been largely consistent, according to their investor letters. The "fuse" was the "extreme polarization" last year in the valuations of falling large stocks and surging small caps, Li said.
That situation quickly reversed this year when small caps began to slump, 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 "snowballs," causing panic among holders and forcing brokerages to dump stock index futures.
In turn, that pushed up the hedging costs of quants' 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.
As government-led funds stepped 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' 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 — which employ the leveraged market-neutral strategy — pushed managers to cut positions once allowed, according to Shanghai-based Mingxi Capital, which manages more than 1 billion yuan.
"A series of external interventions and changes made it hard for quant models to make predictions, or even adapt," Mingxi wrote in a Feb. 8 article on its WeChat account. "The models switched from doing it right to getting it wrong repeatedly."
