(Bloomberg) -- It was a good year for hedge funds betting on rising and falling stocks in Greater China. Just not good enough to beat a spectacular market rally.
Long-short equity hedge funds investing in the region returned an average 30 percent through Nov. 30 and notched this year’s biggest gains among global peers. While that puts the funds on track for their best annual performance since 2009, they’re still lagging behind the MSCI China Index by the widest margin on record, according to Eurekahedge data as of Dec. 14.
That’s a big gap, but it hasn’t been enough to scare off clients. Investors poured more than $600 million into China long-short funds this year after pulling money in 2016, according to the data provider.
That said, nobody likes to trail the market, and some managers are disappointed that they didn’t do better. Below are some of the biggest challenges they faced this year.
It’s tough for long-short funds to keep up when the market is surging, and the MSCI China gauge’s almost 50 percent rally in 2017 has been one of its strongest in years.
Long-short strategies tend to result in lower volatility than the index, leading to underperformance during big rallies and outperformance during declines. The only other times hedge funds trailed the MSCI China by around this much, in 2003 and 2006, the index posted gains of about 80 percent.
While Hong Kong stocks have long marched to a different beat than their counterparts in mainland China, that’s changing as cross-border exchange links make it easier for cash to move between the two markets. Some hedge fund managers say their jobs are getting harder as an influx of trend-chasing Chinese individual investors causes Hong Kong share prices to detach from corporate fundamentals for extended periods.
Investors in Hong Kong now have to pay more attention to where the mainland money is flowing, said Huang Rawen, whose Hong Kong-based Petrel Capital Management has a hedge fund betting on rising and falling stocks. “If you are a short seller, you have to take into consideration whether your target is a southbound favorite.”
Market rallies always take a toll on hedge funds’ bearish positions. But this year has been especially tough when it comes to selling stocks short, said Richard Johnston, Asia head of Albourne Partners, which advises institutions and rich families with more than $400 billion in alternative assets globally.
“Shorting has become very challenging in Hong Kong,” he said. “The big real estate shorts killed people.”
More than half of the 868 Hong Kong-listed stocks with outstanding bearish bets tracked by IHS Markit Ltd. gained in value as of Dec. 14. And more than 100 jumped at least 50 percent. Several of those, including property developer Sunac China Holdings Ltd. and China National Building Material Co., were favored holdings of mainland investors.
“The risk-reward to shorting is always more difficult anyway," said Wan Yuet Wei, founder of Hong Kong-based hedge fund firm Wei Capital Management. That’s exacerbated when many short-sellers pile into the same trades, she said.
“When shorts get crowded, that makes it worse.”
Long-short managers have been dialing back their net exposure to the market, in part due to client demand for returns that are less correlated with the index.
The percentage of Greater China equity hedge funds with a net exposure below 50 percent has risen to one-third of those monitored by Albourne Partners, from nearly none five years ago, Johnston said.
That means returns are increasingly tied to managers’ stock-picking skills, rather than broad market swings. Even funds that have the flexibility to increase their net exposure have decided against it. They still have painful memories of 2015, when a 13 percent first-half rally in the MSCI China Index turned into a second-half plunge of 20 percent.
“2017 is the first time in three years that people are finally making good returns,” Petrel’s Huang said. “So naturally, the right thing to do is to protect your winnings."
The region’s managers are becoming more responsible at managing risk, and hedge funds with lower net exposures will prove “more sustainable” over the long term, said Marlon Sanchez, Asia-Pacific head of prime finance sales at Deutsche Bank AG.
“China fund managers have really matured over the last two years,” Sanchez said.
Much of this year’s gain in the MSCI China gauge has been driven by two stocks: Tencent Holdings Ltd. and Alibaba Group Holding Ltd. The Internet giants have outsize weightings in the index and have both jumped more than 100 percent in 2017.
Many hedge funds missed out on those gains because they didn’t want their portfolios to closely mirror the benchmark or have a disproportionate amount of money in big index constituents, said Mohammad Hassan, a senior analyst at Eurekahedge in Singapore.
"I would doubt many investors would be paying 2/20 to a manager to build up exposure to these common names," said Hassan, referring to the 2 percent management and 20 percent performance fees that used to be hedge-fund industry standard.
©2017 Bloomberg L.P.