China’s hedge fund sector has been described as a sleeping giant, and certainly onshore hedge fund managers appear content to have an extended lie-in.

Only a handful plan to branch out overseas in the coming years, say industry executives. The typical route is to set up a Hong Kong office and launch a Caymans-domiciled fund.

Among those taking the step are Shanghai’s Infore Capital, which runs Rmb5 billion ($800 million) and gained a licence from the Hong Kong Securities and Futures Commission earlier this year.  

There are about 2,500 mainland sunshine investment trusts – private, closed-end pool funds – which are thought to comprise mostly hedge fund-type strategies. Property trusts and private equity funds also fall into the classification.

Sunshine funds are estimated to run AUM of Rmb250 billion to Rmb300 billion. The majority of the money is sourced domestically, from high-net-worth individuals and families, say sources.  

Interestingly, they also account for much of capital base of most China offshore hedge funds, albeit limited to mainland investors with overseas-based capital.

“Those investors do not necessarily have the expertise to do due diligence in managers,” says Theodore Qi Shou, chief investment officer at Skybound Capital, a South African-based FoHF. “They may happen to have a [social] relationship with the portfolio manager, and that’s how [managers] raise the capital.”

Raising money from mainland investors is relatively easy, compared with institutional investors in the West. “When I speak to US institutions about macro, it’s great. Fixed income, fantastic. If you want to talk about China, the meeting is over,” says a New York-based executive at a multi-billion-dollar fund of hedge fund manager.  

In the US there are stories of dodgy accounting, says David Walter, a Singapore-based director at Paamco, a global FoHF. “Recently there’s been a lot institutional money for long/short [equity strategies] going into Europe, given its potential for economic recovery,” notes Walter. “They’re still relatively underweight in China.”

The performance of sunshine trusts falls within a broad range. The top performer had a gain of 80% last year, while with the worst-performing fund lost 28%, according to data compiled by Gesafe Wealth Advisory in Beijing. 

While 79.6% of sunshine private trusts had positive returns in 2013, it falls behind the 84.6% for wealth management products by China securities firms and 90.5% for mainland mutual funds, says Gesafe.    

Determining how sunshine managers derive their returns is a concern among the investor community, which cites transparency as an issue. They are not required to disclose allocations to investors, unlike China’s mutual funds.

However, it is known that many sunshine fund managers had invested heavily in technology stocks, which helped some to achieve high returns last year. This approach may have backfired amid a sharp fall in tech stocks worldwide in April.

Furthermore, a number of mainland hedge funds are known to maintain highly concentrated positions, with only a few stocks in the portfolio at any one time. While the approach may lead to a high return, it runs the risk of creating a large loss.

“A lot of the [US] pension funds are a bit nervous of it all,” says Walter at Paamco.

The most successful mainland managers who have expanded to set up offshore funds and attract overseas investors are those that have built their businesses on a US hedge fund framework, he notes. They include Hillhouse Capital, Greenwoods Asset Management and Keywise Capital, which each run more than $1 billion in assets.  

“Managers have got to realise that if they want to get institutional money, they’ve got to start building institutional-quality businesses. The ones that have done so have been successful,” says Walter.

In the meantime, however, it is China’s mutual fund managers that will attempt to make a name for themselves in the offshore hedge fund industry.

Between 20-30% of China’s 91 licensed mutual fund managers have licences in Hong Kong, where they are expected to launch Caymans-domiciled hedge funds, say industry executives.

The largest mutual fund houses believe they will be able to leverage their brand recognition to sell long/short equity strategies.

They also have the capital to build a sophisticated infrastructure that would be of institutional quality – an expense that not all sunshine funds can afford. However, it remains to be seen whether or not they will be able to attract foreign institutional capital.

It may be Chinese institutions – in the form of sovereigns, pensions and insurers – which eventually step up to invest in domestic hedge funds, particularly in the onshore market.

“They’re getting more involved in this [sector] which will create more institutional industry,” says Walter. “That will hopefully create a much better framework for onshore China managers as a result.”

*A full version of this article will run in the May edition of AsianInvestor magazine