China's market intervention has destroyed the nation's hedge fund industry

Photo by Chris Hondros/Newsmakers

The law of unintended consequences. Often mentioned but rarely defined, it is broadly about an action by an individual or group that creates unanticipated effects. It’s also something the Chinese government is quickly learning about from its ongoing sporadic intervention in the nation’s highly volatile stock market.

What they are aiming to achieve through direct market intervention by the so-called “national team” – reducing market volatility and, more than likely, further market gains – is actually discouraging investors from participating in the market.

Last week we brought you the story about the collapse in Chinese stock market futures trading volumes. As a result of banning some investors from selling, reducing trading limits, upping margins and probing those who dare to sell futures rather than buy, the government has single-handedly scuttled investor activity, causing daily traded volumes in CSI 300 and 500 futures to fall by 99% in the space of just three months.

Now we’ve discovered another unintended consequence of government intervention in the stock market, both on the way up and on the way down: they’ve blown up the nation’s once-vibrant hedge fund industry.

According to Bloomberg, the budding sector, short on experience and ways to protect itself from market declines, has seen almost 1,300 funds liquidate amid China’s $US5 trillion, 40% market rout. Now, with the government taking extraordinary measures to prevent investors from profiting from further market downside by limiting or banning stock index futures trading, the future of a similar number of Chinese funds may also be at risk.

Shanghai Composite 1-Year Chart

Despite being regarded as hedge funds, there is one key difference between those residing in China compared to those based in the US, Europe and other developed markets: the majority are long-only funds, meaning they bet solely on rising markets. While that was a brilliant strategy between June 2014 through to June 2015, it’s turned into a nightmare strategy for many funds of late.

Yes, the days of levering up, buying any stock you could get your hands upon (particularly obscure small cap firms that were trading on mammoth multiples) and making ridiculously large paper profits are well and truly in the past.

Now, even for the small percentage who were interested in hedging their long positions, or who looked to profit from falling markets, the government’s decision to tightly control who can trade, and how much can be traded, has put many funds at risk.

“It spells the end, at least temporarily, for China domestic hedge funds,” said Hao Hong, chief China strategist at BOCOM International, in an interview with Bloomberg.

Li Dongjian, chairman of Zhejiang Purple Cloud Investment Management told Bloomberg that he couldn’t believe his ears when a few executives from futures companies called him about the new regulatory restrictions on the stock index futures on a business trip.

“At first, I didn’t believe it was true because restrictions like that would mean this market will be dead”, said Li. “The restrictions have dealt an enormous blow to hedge funds”.

With hedge funds blowing up and restrictions in futures trading remaining in place, many now fear for the future of those who managed to survive the recent market rout.

“If the market drops even further, certainly more private funds will liquidate”, said Guo Tao, director of the Hedge Fund Talents Association.

“If the market goes even lower, it would be because of panic. Not fundamentals, not policy, not margin finance, not leverage. Just fear.”

Late in Wednesday trade China’s benchmark Shanghai Composite index currently sits down 0.50%, taking its losses from the multi-year peak struck on June 12 to in excess of 41%.

You can read more here.

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