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Shorts and hedge funds, welcome to China!

There are liquidity issues and capital-raising challenges in the Chinese markets, but Zhen Liu hopes to overcome all that with China’s first official hedge fund.

A flurry of bad news this summer in the U.S. hedge fund industry, including the shuttering of big name funds like Stan Druckenmiller’s Duquesne Capital Management, led to more pessimistic predictions about the future of hedge funds. Amidst all the turmoil in the U.S. came the announcement early this month of China’s first domestic hedge fund.

The fund’s splashy media debut probably oversells its ultimate significance — there are already many hedge fund-like structures in China, and countless structural problems limiting the growth potential of the industry. But it’s nevertheless an important event, as it comes as a signal of loosening regulation in the Chinese alternative investment space — and perhaps also as a rejoinder to Wall Street-centric analysts predicting doom for hedge funds.

The market in China is certainly ripe. “If you go to an island where no one wears shoes, there won’t be a shoemaker,” says Zhen Liu, the former DE Shaw vice president who has been tapped to run the new fund, which will be run as a managed account of a bigger Chinese asset manager called E Fund. “Chinese investors have heard about hedge funds, but they’ve never seen one.”

Despite China’s rapid growth, the country’s equity markets have long been one-sided. Local investors could buy stocks, but no one could bet on share prices falling. Since shorting commonly plays a major role in hedge fund strategies — it’s typically how they “hedge” their bets — this regulation severely crimped the market. Just a few months ago, however, short selling, margin trading, and stock index futures were finally introduced to the Chinese market, potentially opening up new realms of investment activity.

Contrary to the recent spate of predictions about the end of the hedge fund era, Sebastian Mallaby, author of “More Money Than God,” a new book on the hedge fund industry, predicts that fund assets will triple in the next decade due in large part to the growth of the sector in emerging markets. China’s hedge fund launch is part of that.

But change is slow. “This is only the first step in what’s going to be a 10- to 20-year financial modernization,” says Michael Kurtz, a China strategist at Macquarie Group in Hong Kong.

Great barriers to execution

For now, that means the odds are stacked against E Fund and the other pioneers. In terms of strategy, the domestic market remains constrained by a limited supply of shortable stocks because there’s no formal stock-borrowing program on the mainland.

There’s also a limit to the number of illiquid investments a hedge fund can buy. Due to China’s relatively closed equity markets — less than 1% of Chinese market capitalization is open to foreign investors — there’s a mismatch between the demand for liquidity and actual liquidity. Similarly, unlike their U.S. counterparts, China’s hedge funds cannot turn to prime brokers to provide packaged assets, further limiting their investment options. There are also issues of corruption and transparency. Some Asia-based equity research firms refuse to cover China, citing a steady stream of bad information.

From a capital-raising perspective, although much is written about China’s new class of millionaires, there are major limitations to the fundraising abilities of Chinese hedge funds. “Hedge funds are difficult to understand for the normal retail investors,” says Andy Mantel, Managing Director of Hong Kong-based Pacific Sun Investment Management. “People are interested right now in real estate or private equity.” Due to the volatility in markets, says Alexander Mearns, CEO of Eurekahedge, a research firm based in Singapore, there aren’t a lot of new investors entering the market right now.

First mover advantage?

Liu’s strategy is to tackle the limited marketplace by trading futures of Chinese market indexes in a way that mimics the effect of shorting market risk. With such market uncertainty, he says this is an attractive environment to market hedge funds. Liquidity, however, will be an ongoing problem, but that there’s not much to be done until rules are further loosened.

He projects the challenge will pay off. “If the deal is easy to do, there wouldn’t be any money to make,” says Liu, ever the optimist. “When I was in New York, everyone was chasing after billions of dollars. The first guy who comes in here gets all the opportunity for himself.”

There are factors working in Liu’s favor. For one, there seems to be a sense among Chinese regulators that hedge funds make markets more efficient by eliminating inefficiencies and pulling skewed prices in the right direction. Interestingly, state media has increasingly echoed this viewpoint.

Further, China’s recent currency easing means that investors will be more keen to convert stockpiles of Hong Kong dollars to RMB, since the Hong Kong dollar is linked to the U.S. dollar, against which many analysts think the RMB will gradually gain value. China is the world’s top IPO market this year, which doesn’t hurt either. Most importantly, there’s still a tremendous amount of money sitting on the sidelines in China, and investors, although wary about their losses in 2008, are searching for new opportunities.

This puts a lot of pressure on the pioneers. If there are a few high-profile hedge fund blow-ups in the press, Mearns says, it could frighten potential investors for years to come. Of course, it could go the other way. “China is really status conscious,” says Melyn Teo, a hedge fund expert at Singapore Management University. “If you see a lot of rich, wealthy individuals start investing in hedge funds, everyone else might pour money into them.”

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