Hedge funds are ditching their ambitions of pioneering Western-style high-speed trading strategies in China's fledgling equity derivatives market and are styling themselves as traditional asset managers to weather an intensifying regulatory crackdown.
These aspiring 'Flash Boys' have been hamstrung by short-selling restrictions introduced in the wake of last year's stock market crash which has made it difficult and politically risky to execute their sophisticated trading strategies.
That means quantitative trading - rapid-fire computer driven trading strategies that typically profit from short-term price movements - and short-selling are out for many of the China hedge funds. Instead, mutual fund buy-and-hold and old-fashioned stock-picking strategies are in.
The shift highlights growing fears that China's planned reforms to liberalise the country's listed derivatives market have stalled.
"You have to prepare for the worst," said Rocky Hu, managing director of Olympus Hedge Fund Investments (OHFI), based in Hangzhou. "You cannot rely on the expectation that restrictions will be lifted, otherwise you'll starve."
OHFI, which helps foreign hedge fund managers set up onshore joint ventures, is now advising current and potential hedge fund partners to launch traditional long-only products.
"Now we promote the idea that we do not short any more. We compete with mutual funds," Hu added.
The China Securities Regulatory Commission, the country's securities regulator, did not respond to requests for comment.
Prior to the 2015 stock market crash, the Chinese government had begun to liberalise the country's nascent financial derivatives market, paving the way for the launch of products enabling investors to hedge exposure to risks such as stock price swings and interest rate moves.
Hu and his peers built quantitative trading strategies to capitalise on the reforms, investing heavily in maths whizzes and hardware in order to save precious seconds when dealing in new options and futures contracts.
But post-crash restrictions on short-selling via China's main index futures products has since seen liquidity in these contracts evaporate. This has raised costs for all types of investors to hedge their stock holdings, but it has all but killed the profitability of quant strategies.
"We don't have any kind of meaningful hedging instrument - that's the problem," said Ken Zhu, a former trader at U.S. money manager BlackRock Inc who founded hedge fund LongQi Scientific Investment in 2012.
LongQi Scientific Investment had to return about 5 billion yuan ($749.38 million) of capital to investors amid the crackdown, said Zhu, although he still sees opportunities in the market. The fund manager recently launched a market timing strategy that involves buying or selling stocks based on predicting future price movements.
LAGGING RETURNS
The regulatory crackdown is taking a toll on China's domestic hedge fund industry, which has ballooned in recent years with 7,800 private investment fund managers accounting for $361 billion in assets, according to the Asset Management Association of China.
Many of these managers have had a tough year, with China-domiciled hedge funds posting a 0.36 percent return on average as of August, compared with 6.67 percent for emerging market funds, according to data provider eVestment.
Some funds are now redeploying quantitative analysis to drive old-fashioned stock picking.
Alpha Squared Capital is one such manager. It performs statistical analysis on a large volume of market data to pick stocks that have a high probability of outperforming the market. The fund is targeting annualised returns of 20-30 percent, said co-founder Wang Feng.
"Things changed from the market crash last year," said Wang, who still harbours hopes of moving into high frequency trading if the rules are eventually loosened. "It's a tough moment. We just have to cope with it."