Chinese Hedge Funds at Risk for Forced Selling

As losses mount this year in global equity markets, China’s hedge fund industry could cause worsening market turmoil due to the possibility that additional losses could trigger forced selling by some of China’s fund managers.  China’s Shanghai Composite Index ($CHSC) is down -17% this year, its worst Jan-Apr period since 2008, as a strict Covid Zero policy and crackdowns on private enterprise weigh on the market.

In April, industry data showed about 2,350 stock-related hedge funds fell below a threshold that typically activates clauses requiring them to reduce exposure, with many falling toward a level that mandates liquidation.  China Merchants Securities said in a report that signs of stress in Chinese funds were “close to the historical high.”

The selling rules are uncommon in other global markets but are common in China, where they were introduced to protect hedge fund investors from outsized losses.  However, they can backfire in a falling market when many funds are forced to cut their stock holdings.  The China Hedge Fund Research Center said given the similarities of the funds’ trading strategies, these measures are “forcing many hedge funds to sell” in this year’s “highly volatile market.”

As of April 22, almost 10% of over 24,500 stock-related Chinese funds tracked by Shenzhen PaiPaiWang Investment & Management had fallen below 0.8 yuan in net value per unit, a warning line that often requires a fund to cut its stock position below 50%. The funds must remain above 0.7 yuan in net value per unit to avoid forced liquidation.  According to a report from Merchants Securities, about 7% of the funds tracked have breached that 0.7 yuan level and about 1,000 funds have already been liquidated this year.

Forced selling at market lows not only fuels fresh stock market declines but also prevents fund managers from adding positions to capture any potential rebound.  While hedge funds in western markets employ stop-loss levels to manage risk, the approach adopted in China is unique.  Some Chinese funds have been seeking to reduce the trigger points, but any contract amendments that occur after falling below warning lines could damage investor confidence.  Moreover, scrapping or reducing the triggers requires negotiations with all investors and would be a massive challenge for regulators.