How China tried to fix the stock market—and broke the quants
China’s biggest quant funds beat the market for years, but didn’t model a key factor—the govt
China’s biggest quant funds beat the market for years by applying complicated statistical models to stock picking. But they didn’t model a key factor—the government. Quantitative funds, which use algorithms to chew masses of data and make trading decisions, have become a powerful force in the U.S., where funds such as AQR Capital Management, Renaissance Technologies and Millennium Management manage huge portfolios and provide an important source of liquidity for small investors. But the industry has at times been controversial, being accused of herd behavior that exacerbates periods of volatility.
China’s $200 billion quant fund industry is facing similar accusations, and the ramifications for the sector could be huge. These funds lost billions of dollars last month when their bets on small companies’ shares went wrong. They have found themselves in the crosshairs of Chinese regulators, which are increasingly determined to end the stock market’s slide—whatever the cost.
The country’s two biggest stock exchanges and its securities regulator launched a widespread clampdown on quants in late February, tightening the rules governing the sector and temporarily banning two funds from trading altogether. But investors and analysts say the chaos in the quant market has its roots in the government itself.
China has a record of attempting to control the stock market, and it doesn’t always go well. In 2015, the intervention of a so-called national team of statelinked firms told to buy stocks created moral hazard and led to allegations of insider trading. The introduction of a circuit-breaker mechanism in January 2016 was designed to stem volatility, but made it even worse when investors rushed to sell after it was introduced. Last August, a ban on selling by many companies’ largest shareholders didn’t stop the benchmark CSI 300 index from sliding for another five months in a row.
The turmoil in China’s quant fund sector last month offered just the latest example of how Beijing’s attempts to fight the market can backfire—with dramatic results.
Made in America
The launch of China’s quant industry goes back to around 2010, when a generation of Chinese-born traders returned home after working for some of the biggest U.S. hedge funds. In the wake of the global financial crisis, when China’s economy was booming while the Western world suffered, setting up a fund in mainland China was a natural choice for these traders.
China’s $200 billion quant fund industry is being accused of herd behavior.
Millennium, a New York-based fund, was a particularly strong breeding ground for talent. Wang Chen and Yao Qicong, who had both worked there, moved to China to help set up Ubiquant Investment in 2012. Ma Zhiyu left to set up Ningbo Lingjun Investment Management Partnership in 2014. The two funds are now among the biggest quants in China, with Ubiquant managing more than $7 billion.
Since early 2023, many of the computer programs deployed by Chinese quant funds identified a relatively simple strategy: buying small and microcap stocks and short selling futures linked to indexes of midcaps and large companies. It was a big earner: a popular index of microcap stocks jumped 50% in
2023, while futures tied to the blue-chip
CSI 300 index fell 12%, according to financial data provider Wind.
But China’s quants had a few problems not shared by their U.S. counterparts. For one thing, the country’s rapid emergence as an economic powerhouse meant these funds didn’t have decades of data to fall back on, a major failing for firms that rely on data mining to identify trades. The even bigger problem was China’s great intangible: the whims of the government.
The algorithms used by quant funds digest large amounts of historical data and take advantage of repeatable patterns. While China’s stock–market interventions have become more frequent in recent months, they are still not regular occurrences.
“Quants are just really bad at coping when something suddenly changes,” said Phillip Wool, head of research at money manager Rayliant Global Advisors. “If you have a policy intervention that changes the rules of the game, these models just aren’t that adaptable.”
That became evident earlier this year
when Beijing finally lost patience with a prolonged slide in stock prices.
In January, China’s Premier Li Qiang became an unusually senior voice calling for more to be done to boost the country’s flagging capital markets. China’s securities regulator changed the rules to make it tougher for shareholders to sell. Yi Huiman, the head of the regulator, was replaced.
Beijing turned once again to the national team, which this time concentrated on buying exchange-traded funds that invest in the stock market. Five major Chinese exchange-traded funds tracking large-cap indexes received $34.8 billion of inflows in the first two months of this year, eclipsing their inflows throughout 2023, data from research firm Z-Ben Advisors shows. That is a sign of national-team buying, say analysts.
But the national team initially focused on funds that invest in the shares of some of China’s biggest companies. Micro- and small-caps stocks were left out of the buying spree, leading to a selloff in these stocks and immediately causing pain for quants.
In the first week of February, the CSI 300 gained 5.8% while a popular index of microcap stocks plummeted 17%.
Quant funds, rushing to sell their holdings of small-cap stocks, had to accept heavy losses. Their need to sell had greater urgency because some of the quant strategies had taken on leverage, borrowing from brokers to increase the amount they could invest.
“Everyone was trying to sell at the same time,” said Hao Hong, chief economist at Grow Investment Group. “The exit door was too small, there was a stampede going on, and the market just collapsed.”
Some quant funds caught in the meltdown saw their year-to-date returns plunge by 30 percentage points, according to Rayliant. Some smaller funds have closed.
Mingxi Capital, a Shanghai-based quant fund, issued a statement on Feb. 8 telling investors that the market data and the patterns it had previously used to trade were no longer a good guide. As a result, many quant funds’ algorithms— including its own—went from “getting it right to being repeatedly wrong.”
Minghong Stock Selection Fund I, a flagship strategy launched by Minghong Investment, is down 8.8% so far this year, according to fund distributor Simuwang. It made a double-digit return last year. High-Flyer Quant, another firm, has lost an average of 9.5% across its funds in 2024. Since it was established in 2016, it has returned an annualized 13%.
The rapid change of fortunes for China’s quant funds led to criticism about their strategies and use of leverage. But the bigger problem for the industry was still to come.
Frozen out
On Feb. 19, the Shanghai and Shenzhen exchanges froze the accounts of Ningbo Lingjun for three days. The reason: The quant fund sold around $360 million of shares in less than a minute, at a time when Beijing expected market participants to play their part in boosting the stock market. The exchanges said they had initiated “public condemnation” of the fund.
“The central government could not tolerate having the national team buying only to find that the quant funds were selling,” said Colin Liang, head of China research at Redwheel, a global asset manager. “That was against the broader market and national interests. That was the red line.”
The next day the two stock exchanges said they would more closely scrutinize quants’ trades, particularly those using leverage. They also tightened reporting rules for foreign funds that apply quant strategies through a trading link with Hong Kong’s stock exchange.
China’s securities regulator later warned quants that it would tighten supervision of direct-market access and other over-the-counter derivatives, and vowed to crack down on lawbreakers. It has also pledged to tighten oversight of high-speed trading.
These moves have ramped up the pressure on China’s fledgling quant fund sector. They have also raised questions about how these funds can prosper in a stock market that is increasingly subject to government interventions, following years of poor performance.
“Will there be more bans, more controls? So long as the quants’ activities go against national interest, sure,” said Liang.