The Dilemma of Quantitative Strategies in Chinese Equity Markets - What happened in 2024 Rally?

Allen Zhou, Cosmos Quant Investment, nzhou@cosmosquant.com

Chinese version 中文版: https://mp.weixin.qq.com/s/qBrcFgOcgWxKxpjNpfaHfw

What Happened?

The chart below shows the latest 12‑month performance of market‑neutral strategies from several leading quantitative hedge funds in mainland China. These examples are not intended as praise or criticism - rather, they were chosen because these top‑tier funds publicly update their returns in a timely manner and serve as industry benchmarks.

Yet, a natural question arises: why did many market‑neutral products suffer sizable drawdowns in a period when the broader market was rallying strongly?

Market‑neutral strategies from several leading quantitative hedge funds in mainland China sufferred from massive drawdowns in early 2024

Special Structural Features of the Chinese Market

Compared with U.S. and European markets, China’s market structure exhibits several key characteristics that are double‑edged swords - sources of alpha in normal times but also amplifiers of risk in extreme conditions:

• Segregated margin systems: Margin requirements for stock and futures accounts are calculated separately, whereas in the U.S., they can be netted across instruments.

• Shorting constraints: Stock borrowing and direct shorting are relatively difficult and costly.

• T+1 settlement rule: Stocks can only be sold the next trading day after purchase.

As a result, many market‑neutral funds in China typically construct two legs:

• Leg 1: Long individual stocks with positive alpha (stock selection).

• Leg 2: Short stock index futures to neutralize overall beta exposure.

This setup introduces exposure to basis risk, a key concept we must understand.

Understanding Basis and Its Impact

The basis (often described as contango or backwardation) is defined as:

Basis = Price of active stock index futures − Spot index level

Historically, before 2018, the Chinese futures market often traded at a persistent discount (negative basis), with annualized spreads commonly around 10% to 20%. In other words, index futures were priced significantly below the spot index. This was largely due to strong demand from mutual funds and hedge funds shorting index futures to hedge portfolio beta.

As futures approach expiration, their prices converge toward the underlying spot index. The following chart would illustrate this convergence process.

Futures prices converge to spot prices

In theory, if you short a basket of stocks replicating the index and simultaneously go long the corresponding futures, rolling positions periodically, you could earn an annualized return of 10–20%. This situation can be interpreted from two perspectives:

1. Risk‑free arbitrage (in principle): If true stock shorting were fully feasible, index‑enhancement products could exploit this spread.

2. Hedging cost: For market‑neutral funds shorting index futures, persistent negative basis represents an embedded cost of hedging.

The September Shock

During the recent market surge, the short‑futures leg (Leg 2) of market‑neutral portfolios suffered rapid losses. Although their long‑stock leg (Leg 1) likely generated gains, the problem lies in the segregated margin system: since stock and futures margins are calculated independently, losses on the futures side trigger margin calls that cannot be offset by gains in the stock account.

If a fund cannot meet these margin calls in time, it may be forced to liquidate futures positions, which in turn can fuel further market rallies as shorts are covered. This dynamic partially explains the extraordinary market spike observed in the last two trading days before the holiday.

How severe is it? It is difficult to assess the exact magnitude of these dislocations or how much of the stress has already been resolved. Historical comparisons, however, offer some perspective.

Basis in China Market: A Memory from 10 Years Ago

During the 2014–2015 bull market and subsequent crash, the basis once widened to over 140 points, or roughly 5%, annualizing above 50%.

As of Friday’s close (Sept 27, 2024), the basis had again expanded to around 105 points, approximately 2.6%.

"History doesn’t repeat perfectly, but it often rhymes" - The holiday week provides a brief window for portfolio adjustments and liquidity management. Hopefully, investors can navigate this turbulence safely. More importantly.