Who saw it coming? ChinaÆs markets were down by 8% on Monday. Yet there were those at Morgan StanleyÆs recent hedge fund conference whose powers of prognostication seemed to foresee the market fall.

Reading the pig entrails at a session moderated by Morgan StanleyÆs Kurt Baker was a panel of China hedge fund managers. Confronted with a booming market, one might have expected them to be gleeful, yet they all seemed subdued. An observer might have ascribed this to the fact that the panelists tended to be newer hedge fund managers and so were perhaps ruing that they hadnÆt started their funds a couple of years earlier.

Nevertheless, their implacability has turned out to be correct; at least this week.

China assets in hedge funds grew exponentially in 2006, to $6.46 billion versus $1.54 billion at the end of 2005. That $4.9 billion of growth accounted for 15% of the $32.9 billion in growth in Asian funds overall, says Morgan Stanley.

ôI think investors do want beta in China,ö said Xiong Xiong of new China hedge fund Libra Greater China. ôSo market-neutral strategies are not very attractive, in my view. Ultimately, the management of volatility is most important to a successful China product. Looking round the domestic A-share markets, there arenÆt any more than a handful of stocks that you would say are attractively priced.ö

A relatively small proportion of the Chinese market is free float and that makes liquidity issues important. The current conditions of high liquidity might not last long and then liquidity will revert to becoming a major risk in PRC small-cap stock investing.

ôOur fund tries to accumulate a quality small cap stock before it is widely exposed to institutional interest,ö says Barbara Shaw of event-driven fund Axix Capital. ôOnce the stock catches the eye of the broader investment community, liquidity of the counter should improve as more trading activities take place, and the related risk premium should reduce, thereby allowing early investors, like us, to capture the reward of investing early.ö

Doubts about the quality of corporate information are perennial in China, and some funds are trying to take their own steps to figure out the truth about what Chinese companies are telling them.

ôWe believe a lot of data out there appears to be fake or unsustainable, and so we have been heavily relying on independent in-house research,ö says Craig Chen, head of equity at CICC in Hong Kong. ôThis involves visiting companies, their competitors, industry experts and taking market surveys. We even visit companies that we are thinking about taking short positions on. So even though many companies may look good for a couple of quarters, but weÆre looking for longer term sustainability and earnings trends before we make an investment.ö

Gathering information in China is one challenge, but of course simply assembling it is only half the battle.

ôWhat 360-degree research really does is simply generate information,ö said Xiong Xiong. ôYou have to be able to translate the information into investable ideas to generate alpha.ö

As the karmic wheel spins, so those new hedge funds who wished they had been in the soaring market now receive consolation from knowing they can get in at a lower price.