For the first time since China established its mutual funds industry in 1998, funds have begun to under-perform their benchmarks. Even in the depths of the four-year bear market from 2001-2005, fund managers could at least boast that their skill provided excess returns.

No one is actually losing money; on the contrary, even relatively poor performers are raking it in. But the frenzy of the bull market has introduced a new differential: can you beat the index? Which leads to the question: are your active-management fees justified?

Last year saw the Shanghai & Shenzhen 300 (SS300) Index of A shares (a blue-chip index compiled by the two bourses representing 60% of their combined market capitalisation) return a whopping 121%. Almost half of æaggressively managedÆ mixed-asset funds failed to beat that mark.

The criterion for a fundÆs inclusion in the list of actively managed mixed asset funds varies depending on the data provider. The result, however, is strikingly similar.

Z-Ben Advisors, a Shanghai-based consultancy, defines this as funds with a minimum equity content of 70%. Using Morningstar data this creates a universe of 65 funds, of which 31, or 48%, failed to outperform the SS300. Lipper prefers a minimum equity content of 80%, and its list of 48 funds has 23 (also 48%) lagging the index.

Liang Zhou, LipperÆs China research manager, says, ôThe first half of the year saw most active managed funds beat the index but it was the second half that saw the index outperform them.ö

The top-performing fund last year was the Invesco Great Wall Domestic Demand Growth fund, which hit a chunky 182%. This underscored the status of funds managed by joint ventures in the Lipper list. Sino-foreign JVs accounted for three other top-five funds. The sole pure local-managed fund in LipperÆs top five is Yinhua Core Value Equity which hit 172.93%.

But it is wrong to assume from this that foreign-invested companies are better at managing mutual funds, because in LipperÆs universe of out-performing portfolios, six of the top 10 are run by domestic players. China Asset, China Universal, Dacheng and E Fund managers all had top performers.

And while most funds at the bottom are local, thereÆs also a relative underperformer managed by ABN Amro Teda. This JV has both top-five and bottom-five funds, which demonstrates more than anything how massive bull markets distort rather than clarify investment skill.

The poor performance of some funds, according to Peter Alexander, principal of Z-Ben, may be caused by an increase in redemptions as mainland Chinese investors see what is on offer elsewhere. ôIt is a vicious cycle,ö he says. ôFunds that perform less well need to increase cash to meet redemptions and then, because of the high level of cash, they continue to under-perform the index.ö

This will prove ChinaÆs investors among the most demanding in the world, it seems, as even those holding the worst performing funds, according to Z-Ben/Morningstar and Lipper, got a healthy 66.4% and 54.25% respectively last year yet are likely to be punished for it.

Lipper notes that 40 funds launched last year and have yet to show a track record. How they will manage to invest all of their newfound assets will be the industryÆs biggest challenge in 2007.

LipperÆs top and bottom five funds with an 80% minimum equity allocation (return)
ò Invesco Great Wall Domestic Demand Growth (182.2%)
ò China International Alpha Equity (172.93%)
ò Fullgoal Tian Yi Value Investment (167.41%)
ò Yinhua Core Value Equity (164.08%)
ò ABN Amro Teda Sector Select A-share (159.89%)
ò China Nature Quality Selected (89.21%)
ò Golden Eagle Mid-small Cap Selected (85.38%)
ò ABN Amro Teda Growth (81.81%)
ò Golden Eagle Select Blue Ribbon (73.18%)
ò Wanjia Utilities Equity (54.25%)

Z-Ben/Morningstar top and bottom five funds with a minimum 70% equity allocation (return)
ò Invesco Great Wall Domestic Demand Growth (182.3%)
ò China International Alpha Equity (173%)
ò China International China Advantage (171.6%)
ò Full Goal Tianyi Value (167.6%)
ò Yinhua Core Value Enhanced Equity (164.4%)
ò China AMC Stable Growth (85.3%)
ò ABN Amro TEDA Growth (81.7%)
ò China Nature Core Growth Equity (75.8%)
ò CCB-Principal Consistent Value Equity (74.2%)
ò Jutian Basic Industry Fund (66.4%)