Chinese mutual funds suffered a 12.5% decline in assets under management in the first half of 2013, the biggest six-month drop in three years.

Assets fell by Rmb350 billion ($57 billion) as investors’ risk appetite plunged due to volatile equity markets amid a liquidity crunch on the mainland.

Moves by China’s central bank to tighten liquidity in an effort to curb lending sent equity markets in a downward spiral. Shanghai’s benchmark CSI 300 index fell almost 7% in a week in late June and is down 12.8% for the first half.

As such, institutional and retail investors have lost their appetite for equity-focused funds, which has pushed Chinese mutual fund AUM down to Rmb2.44 trillion ($398 billion) from Rmb2.79 trillion at the end of 2012, according to Shanghai-based consultancy Z-Ben Advisors.

While significant, it pales in comparison to the first half of 2008, when Chinese fund houses' AUM plummeted 36% to Rmb2.18 trillion.

The liquidity crisis has also dampened investors’ appetite for fixed income, with bond funds raising only Rmb350 billion at the end of June, down from Rmb408 billion in the first half of 2012.

Even money market funds, traditionally regarded as safe investments, suffered significant redemptions in the first half, with AUM plunging 49% to Rmb304 billion due to Q2 withdrawals.

These outflows, likely a combination of redemptions and poor performance, have led to a reshuffle of the top 10 Chinese fund houses. CCB Principal and Bank of China Investment Management have both dropped out of the top 10, to be replaced by Full Goal and HuaAn.

Funds managed by ABC-CA Fund Management, Minsheng Royal and E-Fund also experienced drops in assets.

Z-Ben says these firms relied too much on short-term bonds, which “tend to draw in significant assets initially, but are typically subject to heavy redemptions”.

Looking to the second half of 2013, the consultancy expects Chinese fund AUM to continue to shrink.

"The entrance of new competitors, in the form of insurers, brokerages and private fund managers, is set to make a material impact on the industry towards the end of the second half,” says Z-Ben.

“Top-tier firms are unlikely to be affected by these new players. However, further down the scale, fund management companies will still need to have their wits about them.”

Despite the risks associated with an over-reliance on short-term bond funds, Z-Ben expects fund managers will continue to issue money market funds in an effort to boost their AUM, as Chinese equity markets will undoubtedly remain volatile.

Money market funds invest in short-term debt securities and commercial paper, and are often regarded as safe investments that provide better returns than bank deposits. But rising interest rates recently caused investors to retreat from such products into bond funds and bank deposits.