China has a quant quake because there’s no citadel

Shuli Ren, Bloomberg

China is tightening the grip over quantitative trading after experiencing its own version of a “quant quake,” a reference to the summer of 2007 when a number of high-profile and successful US-based hedge funds suffered outsized losses.

The Shanghai and Shenzhen bourses froze the accounts of Ningbo Lingjun Investment Management Partnership for three days after the hedge fund dumped 2.57 billion yuan ($360 million) in shares at the open on [Feb. 19]. That morning, just as traders returned from a week-long Lunar New Year holiday to a jittery market that had barely recovered from a major rout earlier in the month, the blue-chip CSI 300 Index slipped as much as 0.9%.

China’s quant funds are faltering this year. A flagship product at Lingjun tumbled 11.75% in January, wiping out 2023’s 9.21% gain. Some of its peers fared even worse, losing as much as 30%. It was a humbling experience for a sector that outperformed the market last year with a solid 6.4% average gain.

Clearly wary of selloff pressure, the government has since banned major institutional investors from net selling at the open and close of each trading day. Separately, the exchanges said they would monitor more closely leveraged quant products and algorithmic trading.

Fingers were pointed at quants’ outsized exposure to small-cap stocks, the epicenter of this year’s rout. Barely covered by sell-side analysts, these companies may offer excess returns. But given they are also thin in liquidity and trading volume, one manager’s selling can cause an avalanche.

Naturally, market watchers are asking if these quant funds have proper risk management, and if they know what they are doing. Lingjun, for one, chaotically went back and forth in style in a matter of days.

Now, some may blame Beijing and argue that quant trading can’t flourish in a market where the government exerts a forceful hand. In the past, when the national team decided to intervene, they mostly bought blue-chip indices via exchange traded funds. So it was natural that Lingjun increased exposure to large-cap and did not anticipate Beijing’s unusual move.

That’s not the full picture. From Brexit to the Federal Reserve’s quantitative easing, government entities around the world have made surprise policy decisions that changed the trajectory of asset prices. In fact, these dislocations can be the best opportunities to make big profits.

Rather, this episode shows how inexperienced the Chinese quants are. They have not been forced to exit, or to improve, because the nation has largely blocked out the world’s best hedge funds. In other words, they were not baptized by the likes of Citadel, which relentlessly sifts out untalented traders and portfolio managers and speeds up industry consolidation in whichever markets they operate.

When there’s a stock rout, Beijing likes to blame the quants and their computer-driven trading strategies. In 2015, an account operated by Citadel Securities, the brokerage arm that operates separately from its hedge funds, was suspended for trading violations.

Miraculously, Citadel’s Ken Griffin is still keen on China. In 2020, his brokerage unit agreed to pay almost $100 million to settle the 2015 allegation. In recent months, its hedge fund obtained a Qualified Foreign Institutional Investor license and its brokerage made a bid for Credit Suisse’s China securities business.

For years, China has been talking about opening up its financial markets, although the actual progress is at a snail’s pace. That Citadel is finally making inroads is an encouraging sign. By allowing in the best, Beijing can ensure the bad ones can’t thrive and create havoc. Let this quant quake be a lasting lesson.

[Abridged]

Courtesy Bloomberg/Shuli Ren