China's 'flash boys' hedge funds eye end to hiatus

By Noah Sin and Samuel Shen

HONG KONG/SHANGHAI (Reuters) - China's data-driven "flash boys" - hedge fund managers who for years have been handicapped by government curbs on tools to short-sell stocks - are dusting off high-speed trading products as Beijing revives the country's financial derivatives market.

China's financial futures exchange last month relaxed trading rules on stock index futures and vowed to boost liquidity of that market, while the country's two largest stock exchanges said they aimed to launch new stock index option products this year.

That is music to the ears of a breed of fund managers nicknamed "flash boys", whose quantitative strategies rely on historical data, algorithms and derivatives to profit from short-term price movements, sometimes within a second.

Such techniques differ from conventional strategies, in which portfolio managers make bets based on their views of a company or market.

"The widespread usage of derivatives will make returns more stable ... increase liquidity, and new strategies may emerge," said Wang Feng, a former Wall Street trader and co-founder of Alpha Squared Capital, a Hangzhou-based hedge fund. "The industry will enter era 2.0. The most difficult time may have passed already."

LEAN YEARS

Derivatives could be deployed to insure against unexpected losses or simply to bet on shares to fall, a so-called short strategy. The latter function was blamed for exacerbating the equity rout of 2015 and 2016, leading to more stringent rules. That led to poorer liquidity in such instruments and ultimately higher costs for hedge funds, sharply reducing their popularity.

Shen Yi, a former Goldman Sachs (NYSE:GS) trader who set up his own fund house in Shanghai, saw his assets under management halve from a pinnacle of $1.6 billion around 2015 as government curbs on index futures trading bit.

"In the last two years, you see quant funds shrink and shrink and shrink," he said. But with the rule relaxation, "I would say we will go back to the peak time very soon".

A liquid derivatives market is particularly essential to many quantitative trading strategies. In "market neutral" strategies, for instance, investors match long and short positions in different stocks, seeking to profit from stock selections while maintaining constant, steady returns regardless of whether the overall market is rising or falling.

In China, where shorting individual stocks is highly restricted, hedge funds instead use stock index futures to build short positions.

"The next two to three years will be a bull market for quant funds. We're getting ready for that," said Chen Bin, founding partner of quant fund manager SHQX Asset Management in Shanghai, who increased headcount by a quarter last year to 40 in expectation of business expansion.

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The derivatives defrost is good news even for mutual fund managers, who typically focus on long-only products that bet on rising prices.

"A broadened derivatives market gives fund companies more choices in designing fund products," said, Fang Weili, deputy CEO of Huatai-PineBridge Investments in Shanghai.

(GRAPHIC: Trading Turnover of China's Index Futures Market - https://tmsnrt.rs/2RIp2Xc)

WELCOME CHANGE

There were 8,966 private securities investment fund managers in China as of November 2018, commanding 2.26 trillion yuan ($331.05 billion), according to data published by the Asset Management Association of China.

Amid the Sino-U.S. trade war and softer domestic economic growth, the Chinese stock market shed a quarter of its value last year.

Due to excessive hedging costs, many hedge funds were forced to diversify into long-only quant strategies, which gave them little shield against the market downturn.

Without adequate protection, these funds' ability to deliver positive returns regardless of the wider market's performance - a key selling point for flash boys' clients - was sharply weakened.

Market neutral strategies achieved annualized returns of just 0.6 percent on average since regulators introduced harsh curbs on index futures trading in late 2015, compared with roughly 10 percent in the previous four years, according to an index compiled by fund distributor Shenzhen Qianhai Simuwang.

But the industry sensed hope as regulators stuck to derivatives liberalization throughout 2018 despite slumping share prices, in stark contrast to their response in 2016. Officials started talking up a derivatives reboot when the stock market was in better shape in 2017.

Underscoring authorities' changing attitude toward derivatives' role in market downturns, the securities regulator made the rare move in November of exonerating three brokerages previously accused of funding short-selling activities during the 2015 market crash.)

Over the past year, China also allowed high-profile global hedge funds such as Bridgewater Associates, Man Group and Winton Capital to operate in China's capital markets, where foreign participants are predominately traditional, long-only players.

Shen applauded the moves, relieved that index futures were no longer the scapegoat for market slumps. "Now we find another guy to blame, it's Donald Trump," he said.

For the flash boys to fully blossom again, however, regulators will need to do more.

First, there is the issue of cutting "relatively high" administrative fees for trading index futures, said Alpha Squared Capital's Wang, who expects such reforms to take time.

More broadly, fund managers would be more comfortable in applying short strategies if they did not have to worry about regulatory consequences, said Josh Gu, Chengdu-based director of quant research at the industry tracker HFR.

"Short trading (could be) very costly when your career is also at stake," he said.