Hedge Funds Reassess China After Market Free Fall

http://www.nytimes.com/2015/07/14/business/hedge-funds-reassess-china-after-market-free-fall.html

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It wasn’t long ago that hedge funds were preparing for one of the biggest openings into China in years. In November, foreign investors were for the first time able to buy and sell shares listed in the Shanghai market directly. It was a chance to ride the great China bull run.

How times have changed.

Over the last month, trillions of dollars of value were wiped from the domestic market as stocks plunged by more than a third. The Chinese government has stepped in, issuing a series of increasingly aggressive moves to prop up the market.

Hedge funds are now reassessing their positions and questioning the role of the government in China’s stock market.

O’Connor, a $5.6 billion hedge fund owned by UBS, is one such investor. The Chinese government’s moves have left the firm unsure about how to maneuver.

“The intent is clearly to restore investor confidence and market stability, but this is a huge setback for Chinese capital market liberalization,” Dawn Fitzpatrick, the chief investment officer of O’Connor, said by email. The government’s moves, she added, “will materially impact their ability to attract foreign capital, which has been a key policy initiative.”

Today, a third of the stock market in China remains frozen. (Last week it was half.) Investors holding more than 5 percent of one company’s stock have been prohibited from selling for six months. At the same time, brokerage firms have been given a mandate to pump billions into the market, and large state-owned companies have been ordered to buy back shares.

The Public Security Ministry has promised to investigate “malicious” short-selling, according to state media reports. Short-selling is one strategy that distinguishes hedge fund managers from other investors.

Brokers have told their hedge fund clients to skip the short-selling, which allows them to take a bet against a stock, because it will not be worth the headache when Chinese regulators come knocking on the door.

All these moves, in succession, have left foreign investors simultaneously panicking and scratching their heads. One hedge fund manager based in Hong Kong said he had no idea whether he had made or lost money in the mayhem. He will not know until some of his positions — long and short bets on stocks in Shanghai, Shenzhen and Hong Kong — start to trade again.

For more than a few on Wall Street, the powerful rally and sudden free fall, combined with the Chinese government’s intervention, provided the perfect illustration of why not to buy “A shares” — China’s domestic stocks.

“People thought the A shares was a very speculative market and referred to it as a casino,” said Jorge Mariscal, emerging markets chief investment officer at UBS Wealth Management. But, he added, this is a misleading analogy. “In a casino you know the rules of the game. Here they are shifting, and I think this is going to deter foreign investors in this market,” he said.

Not long ago, things were very different. In a pledge to reduce the government’s role in the economy, President Xi Jinping announced a package of changes that would help to liberalize China’s financial markets in 2013. Soon after, the government allowed a small group of hedge funds from the United States and Britain to raise tens of millions of dollars from Chinese investors as part of a pilot program. Last year, the government opened the Shanghai stock exchange to foreign investors through a program called the Shanghai-Hong Kong Stock Connect, a move that investors hailed as the single most important initiative by the Chinese government.

Even as hedge funds and banks expanded their businesses to take advantage of the Stock Connect and other changes, foreign participation in China’s domestic markets remained minuscule.

For several years, a small group of hedge funds have participated in a special quota program, called the qualified foreign institutional investors program, that has allowed them to trade shares denominated in renminbi and Hong Kong dollars. But even with this trading, together with trading through the Stock Connect, only about 1 percent of China’s $8.5 trillion domestic market value is owned by foreign investors, according to estimates by UBS.

For those foreign investors who got in early, the run-up in share prices in China was remarkable. But there were signs of a bubble early on. Stocks nearly tripled over a 12-month period during which China’s economy and corporate earnings were worsening, said Patrick Chovanec, managing director at Silvercrest Asset Management Group. Valuations of companies skyrocketed and, at the market peak, the median was 85 times earnings, a red flag for most investors.

Yet, the party looked set to continue. Just a month ago, MSCI, which compiles indexes tracked by money managers around the world, said it could soon add Chinese shares to its indexes. But MSCI added that it would put off a decision because of worries about restrictions on capital flows, quotas for investment and how the law applied to foreign shareholders, among other concerns

Then came the market purge, which for seasoned China investors was a long time coming.

“Welcome to Asia. So, the people who bought the market and thought that it was MSCI investment-worthy? It’s not,” said Seth Fischer, chief investment officer at the Oasis Management Company, a hedge fund based in Hong Kong. “They should have known that when it went up 50 percent,” he added.

During the very worst moments of the recent sell-off, Mr. Fischer was among the few investors buying shares that no one else wanted to own. He said that while investors were running for all the exits, pummeling stocks, many companies would still be standing in the years ahead. He pointed to Shenguan Holdings, which makes casings for sausages, as an example.

“It’s a real company, and the Chinese are not going to stop eating sausages,” Mr. Fischer said.

Other investors are optimistic that while this market turmoil has scared off many, it will most likely force China’s leaders to put market changes into effect sooner.

“I don’t think I would be worried yet that the whole party is over for China,” said Richard Johnston, Asia head of Albourne Partners, a British hedge fund and private equity adviser. “I think China will have to come back and lick its wounds and be a bit more careful on regulation, but it will stay on the reform agenda,” he added.

As it is, the market has bounced back. Many investors are still in positive territory for the year. Since a low point in the Shanghai stock market on Wednesday, the index is now up 13 percent. “We’ve turned a good year into an average year if we stop and draw a line here,” Mr. Johnston said about hedge fund performance for China-focused firms.

The decline in Shanghai and Shenzhen stock markets has not erased most of the gains made over the last year. In fact, over a three-year period, the Shanghai market is still ahead of the Standard & Poor’s 500-stock index.

At one point last week, the story was radically different in Hong Kong’s stock market. In a single day, the market reversed all of its gains for the year, the biggest drop in one day since the financial crisis

In all the investor soul-searching, one hedge fund manager’s warnings have been louder than others. James S. Chanos, who has bet on a downturn in China for five years, recently compared China to Greece, another country that has caused some gnashing of teeth in the hedge fund community.

“I joke to my Chinese friends, somewhat half-seriously, another three-four years they are going to be like my homeland, Greece,” Mr. Chanos said in May on “Wall Street Week,” an investing program.

Mr. Chanos was briefly vindicated when Chinese stocks on which he taken short positions plummeted in Hong Kong last week. But, as if on cue from China’s government, the Hang Seng index clawed its way back from a low point. By the end of Monday, it had gained 7 percent from its low point last Wednesday.