Industry players have voiced hope that mutual fund recognition and Stock Connect will calm volatilty on the Shanghai Stock Exchange by providing the bourse with urgently needed diversification.

An interest rate cut by the People's Bank of China on November 21 helped to spark a bull-run on the Shanghai Composite, which rose by a quarter to peak at 3,020 points last Monday.

However, the surge came to an abrupt end the following day when the index plunged 5.4%, only to rebound by 2.9% on Wednesday. 

The sell-off was sparked by authorities' clampdown on the use of corporate bonds as collateral for short-term financing, which curbed their ability to trade on margin. 

While this may have been a catalyst for the slump, commentators also observe that the uniform nature of the investor base, which accounts for 80% of domestic transactions, result in a pack mentality on both the sell-side and buy-side.

The combination of margin-trading, which peaked on November 24 with 18.2% of trades on loan from brokerages according to data provider Wind Info, created conditions for a perfect storm last week. 

“What creates the volatility is that it’s the most homogenous market in the world. It’s 97% Chinese owned, 90% urban, 90% digesting all the same state news,” said Aaron Boesky, CEO of hedge fund Marco Polo Pure Asset Management. 

“Why Shanghai has these huge mega runs – it’s a herd. Once they all decide it’s time to go there’s just no sellers, so it goes boom fast and the same thing to the downside. Each time this herd has gotten warmed up, they bust a new high.” 

Boesky noted that intraday volatility of more than 7% last Tuesday was "no joke", with the market initially up 2% only to close down in excess of 5%. Such volatility was even greater than during the dotcom bubble, he said, although he believes the index's long-term upward trend is intact. 

As a result, hopes are being placed on the likes of mutual recognition to tame the volatility by bringing in foreign investors and giving market participants more options to invest abroad and diversify their holdings. 

“One part of mutual recognition is that you’re educating domestic investors to say you don’t just need to have just property, gold or cash. You should have a diversified international portfolio,” said Mark Tinker, head of Axa Framlington Asia. 

Like Shanghai-Hong Kong Stock Connect, mutual recognition would allow international buyers to provide market stability and curb wild price swings if their reputation for having a more long-term investing mentality is borne out, added Tinker. 

However, others caution that the uptake of mutual recognition, allowing Hong Kong-based fund managers to market products into the mainland Chinese market and vice-versa, will be slow. 

Principal Global Investors' Asia COO Frederick Laydon cited that many products under the qualified domestic institutional investor (QDII) scheme have not been popular in recent years. The QDII scheme allows mainland investors to buy securities overseas via fund structures. 

The launch of the QDII initiative proved ill-timed, coming in 2007 at the height of the international market bull-run shortly before the onset of the global financial crisis. The following year mainland funds investing overseas lost an average of 47.8%, according to Morningstar data, leaving mainland Chinese investors disinterested in investing internationally. 

“QDII funds have not received much positive attention for several years, even though folks who have bought units in 2009 would have done remarkably well,” Laydon said.

He noted a mainland Chinese investor could have done well if they had simply bought a US tracker fund, given that the S&P500 Index has risen by 8.5% in dollar terms to date this year. 

But Terry Pan, head of Hong Kong business at JP Morgan Asset Management, noted that Hong Kong managers looking to market products to mainland investors should not confine themselves to the message that other markets are less volatile or offer better risk-adjusted returns. 

He argued that investors also need to understand the basics of investing abroad, such as the dangers that currency fluctuations relative to the renminbi may pose. “There is a lot of [foreign exchange] education that we have to do," he said.

"There are just a lot of things that have to take place before mainland investors can truly understand and appreciate the opportunities behind what mutual recognition can mean for them.” 

The Shanghai Composite closed at 2,938.17 on Friday, up by 0.06% over the course of the week.