There is some optimism that regulatory relaxations tipped for next year will bolster China’s bleeding sunshine funds market – the private trusts that serve as prototypes of hedge funds.

Countrywide there are now about 1,800 such funds, which enjoy greater flexibility in investment strategy than, say, mutual funds, in that they are not required to have at least 60% of their portfolio invested in their equity strategy and can increase cash positions to evade risk.

The universe is mostly made up of unstructured sunshine fund products, which are actively managed but with a non-guaranteed return.

However, the scope of their remit is clearly far more limited than that of traditional hedge funds and they are not allowed to employ popular strategies such as long/short or market neutral.

The understanding is that they have very limited tools at their disposal to hedge downside risk, which means that in a sluggish market they struggle to make any money.

And 2012 has been a sluggish market. China’s CSI300 Index has been flat for the year to December 19, but has sunk almost 13% since a high in early May.

As a consequence, to date 2012 has seen an increase in sunshine fund liquidations to 117, which is above 111 from 2011, according to simuwang, a Shenzhen-based website covering private equity. This includes 48 unstructured funds, up from 32 last year.

Most liquidations are due to poor fund performance. Usually managers and issuers of these funds agree on a liquidation line of Rmb0.7, or 70% of net asset value (NAV). If the NAV drops below this line, the products are liquidated and the money returned to investors.

However, the liquidation line is negotiable, varying between Rmb0.6 and Rmb0.8, while some finds don’t set a liquidation line at all.

Of funds which liquidated but recorded mild returns (with an NAV slightly above Rmb1), it was largely redemption pressure from nervous investors that forced them to close rather than at the managers' choosing, notes Peng Xiaowu, an analyst at simuwang.

“Sunshine funds beat the market in two ways: good stock-picking that can beat the benchmark, and good timing which can ease downside risk. These help them to generate absolute return,” says Long Fang, managing director of West Brothers Fund Manager Research Centre.

But it is their inability to hedge downside risk which is causing the problems. At present these sunshine funds are under the supervision of both the China Securities Regulatory Commission and the China Banking Regulatory Commission.

But there is some hope that regulations will be eased in 2013, with a new fund law expected to be announced next year.

Cindy Qu, an analyst at Shanghai-based consultancy Z-Ben Advisors, suspects any new law would clarify which regulator sunshine funds come under, and may also allow them to engage in margin financing and futures trading. This could lead to improved performance (aside from a pick-up in the market).