Changpeng Wan
The Paradox of Rising Markets and Falling Funds
While China’s major indices celebrated significant gains during the week of August 12-16, 2025, a curious phenomenon unfolded behind the scenes. Quantitative hedge funds specializing in market-neutral strategies reported substantial losses, creating confusion among investors who expected these sophisticated products to thrive in any market condition. This divergence between broad market performance and fund returns reveals critical insights about the limitations and mechanics of quantitative investing strategies in China’s evolving financial landscape.
The situation became public when LeAng Asset Management (青岛垒昂资产管理有限公司), a quantitative private fund based in Qingdao, issued an urgent explanation to investors regarding nearly 3% losses in their market-neutral products during a week when the CSI 1000 index gained over 4%. This disclosure prompted wider investigation into why quantitatively managed funds failed to capitalize on what appeared to be ideal trading conditions.
Key Developments
– Major indices showed strong gains: CSI 300 up 2.37%, CSI 500 up 3.88%
– CSI 1000 index led with 4.09% weekly gain
– Market-neutral products across multiple quant funds reported losses
– LeAng Asset Management published unusual transparency report explaining losses
Understanding Market-Neutral Strategy Mechanics
Market-neutral strategies aim to generate returns regardless of market direction by simultaneously taking long and short positions. In China, these products typically go long a basket of stocks while shorting stock index futures to hedge systemic risk. The theoretical profit comes from the spread between stock selection outperformance (alpha) and the cost of maintaining hedge positions (basis).
LeAng Asset Management clarified that their neutral products’ returns derive from stock selection excess returns minus basis hedging costs. When either component underperforms expectations, the entire strategy suffers. During the week in question, both elements worked against fund managers simultaneously, creating a perfect storm of negative conditions.
The Three Pillars of Market-Neutral Performance
Successful market-neutral investing requires three conditions to align:
– Abundant alpha opportunities from stock selection
– Favorable style factors supporting quantitative models
– Stable or predictable basis relationships for cost-effective hedging
Last week, all three conditions deteriorated unexpectedly despite rising markets.
The Alpha Drought in a Rising Market
Paradoxically, sometimes rising markets provide fewer opportunities for skilled stock pickers. While major indices showed impressive gains, the underlying market structure proved challenging for quantitative strategies. LeAng’s analysis revealed that although the average stock gained 2.0%, the median gain was merely 0.36%, indicating extremely narrow market leadership.
This performance divergence meant money concentrated in a small number of stocks and sectors while most issues languished. Quantitative models typically maintain diversified exposure across hundreds of positions, causing them to underperform when markets become hyper-focused on a narrow set of winners.
The Concentration Problem
– Only 23% of stocks outperformed the CSI 1000 index
– Random stock selection would have produced negative results
– Quantitative models struggled with extreme style concentration
This concentration effect illustrates a critical limitation of quantitative approaches during certain market regimes. When leadership narrows excessively, diversified strategies inherently cannot keep pace with benchmark indices.
The Style Beta Challenge
China’s market exhibited extreme style divergence during the rally period. While the CSI 1000 index (representing small-mid caps) gained 4.09%, the micro-cap index actually declined 0.65%. This created particular problems for funds using CSI 1000 futures as their primary hedging instrument.
Most market-neutral products benchmark against the CSI 1000 index futures (IM contracts) for hedging purposes. When this specific index dramatically outperforms both larger and smaller capitalization segments, it creates a hedging mismatch that damages fund performance. The hedging instrument rises faster than the long portfolio, creating losses on both sides of the trade.
Size Factor Anomalies
The unusual behavior of size factors during this period created exceptional challenges:
– Medium-sized companies (CSI 1000) outperformed both larger and smaller peers
– Micro-cap stocks declined despite broad market advance
– Traditional factor relationships broke down temporarily
These anomalies proved particularly damaging to quant models built on historical relationships between company size and performance.
The Basis Convergence Crisis
Perhaps the most technically complex issue involved basis convergence. The basis represents the difference between futures prices and spot index values. When futures trade at a discount to the spot index (negative basis), hedge funds effectively get paid to maintain short positions. When this discount narrows (convergence), it creates losses for hedgers.
During the week in question, the basis for the IM2509 contract (CSI 1000 futures for September 2025 delivery) converged by over 1%. This rapid convergence directly caused approximately 1% in losses for market-neutral products using this contract for hedging purposes.
Basis Dynamics Explained
Basis behavior remains one of the least understood aspects of quantitative hedging:
– Basis convergence directly reduces fund net asset value
– Rapid convergence can overwhelm positive alpha generation
– Forecasting basis movement proves exceptionally difficult
This episode demonstrates how basis risk represents a fundamental vulnerability in market-neutral approaches, particularly during periods of rapid sentiment shift.
Industry Response and Damage Control
Following LeAng’s disclosure, multiple quantitative funds addressed investor concerns through various channels. The consensus view emerged that last week’s problems represented short-term anomalies rather than structural strategy failures. Most firms expressed confidence that normal conditions would resume and losses would be recovered.
A investment director from a billion-RMB quantitative私募 commented: Last week’s index weight gains were obvious, quantitative strategies due to分散持仓都会跑输很多 (dispersed holdings would significantly underperform), and basis convergence was severe, causing losses on both sides. But this is normal fluctuation—we model for such scenarios and typically don’t intervene.
Portfolio Manager Perspectives
Industry professionals highlighted different aspects of the challenge:
– Most market-neutral strategies lost money last week
– Losses are expected to be temporary and recoverable
– Some firms reduced risk exposure to control losses
The general tone remained cautiously optimistic, with professionals viewing the event as an expected occurrence within normal strategy variance.
Risk Management Variations
Different firms employed varying approaches to navigate the challenging conditions. Some reduced overall risk exposure to protect capital, while others adjusted hedge ratios or shifted contract maturities. A Shanghai-based quantitative私募总经理 revealed: Our超额回撤很小 (excess return drawdown was small) because of strict risk control. We closely monitor basis changes and shift some exposure to nearer-month contracts.
This tactical adjustment highlights how experienced managers use instrument selection to mitigate basis risk. Near-month contracts typically exhibit less basis volatility than distant contracts, potentially reducing convergence-related losses during turbulent periods.
Defensive Maneuvers
Sophisticated funds employed several defensive tactics:
– Reducing overall market exposure
– Shifting hedge contracts to different maturities
– Tilting portfolios toward less volatile factors
– Increasing cash positions temporarily
These maneuvers helped some funds minimize losses while awaiting more favorable conditions.
Historical Context and Precedents
While concerning to investors experiencing losses, such periods of strategy underperformance are not unprecedented in quantitative investing. Similar episodes occurred in global markets during:
– August 2007: Quant quake affected numerous market-neutral funds
– August 2015: China’s market turmoil created basis anomalies
– February 2018: Volatility explosion damaged short-volatility strategies
These historical precedents suggest that while painful, such events are periodic features rather than fatal flaws in quantitative approaches.
The Cyclical Nature of Strategy Performance
All investment strategies experience periods of poor performance when market conditions disfavor their particular approach. For market-neutral quant funds, these conditions include:
– Extremely narrow market leadership
– Rapid factor rotation
– Basis volatility
– Correlation breakdowns
Successful long-term investing requires understanding these cyclical challenges and maintaining perspective during difficult periods.
Regulatory Environment and Disclosure Standards
LeAng’s voluntary disclosure of performance issues represents an interesting development in China’s private fund transparency standards. Traditionally, Chinese私募 have operated with limited public disclosure obligations, particularly regarding short-term performance challenges.
This proactive communication may signal evolving industry standards toward greater transparency, potentially driven by:
– Regulatory pressure for improved investor communication
– Competitive differentiation through transparency
– Learning from global best practices in hedge fund communication
As China’s asset management industry matures, such transparency initiatives likely will become more common.
The Path to Professionalization
China’s quantitative fund industry continues evolving toward global standards:
– Improving risk disclosure practices
– Enhancing investor education
– Developing more sophisticated risk management
– Building longer-term investor relationships
This incident and its communication may represent a positive step in industry development.
Investor Implications and Portfolio Construction
For investors in market-neutral products, this episode offers important lessons about strategy diversification and expectations setting. While market-neutral strategies aim to provide uncorrelated returns, they remain subject to certain systematic risks that can cause short-term losses even during favorable market conditions.
Sophisticated investors should consider:
– Diversifying across multiple quantitative managers
– Understanding specific strategy vulnerabilities
– Maintaining appropriate return expectations
– Accepting periodic drawdowns as normal
These approaches help investors navigate inevitable strategy challenges while capturing long-term benefits.
Building Robust Portfolios
Constructing portfolios that withstand various market conditions requires:
– Understanding different strategy return drivers
– Recognizing that all strategies have challenging environments
– Maintaining diversification across return sources
– Avoiding overconcentration in recently successful approaches
This disciplined approach helps investors avoid panic during difficult periods.
Future Outlook and Strategy Evolution
Most quantitative firms expressed optimism about near-term prospects for market-neutral strategies. LeAng specifically noted that they believe the overall basis environment will become very favorable for market-neutral strategy recovery. This expectation stems from typical mean-reversion patterns in basis behavior following convergence events.
Industry professionals anticipate that normal market conditions will resume, characterized by:
– Broader market participation beyond narrow leadership
– Restoration of traditional factor relationships
– Stabilization of basis relationships
– Improved alpha generation opportunities
These conditions should allow quantitative strategies to recover recent losses and resume normal performance.
Strategy Adaptation and Innovation
The quantitative industry continues evolving to address identified weaknesses:
– Developing more adaptive models responsive to changing regimes
– Enhancing basis risk management capabilities
– Creating more sophisticated factor exposure management
– Improving portfolio construction techniques
These innovations should reduce vulnerability to similar events in the future.
Navigating Quantitative Investing Complexities
The recent divergence between China’s rising stock indices and struggling market-neutral funds provides valuable insights into the complexities of quantitative investing. While these strategies offer attractive features including low correlation to traditional assets and consistent return generation, they remain subject to unique risks including basis volatility, factor rotation, and alpha drought during certain market conditions.
Investors should view this episode as educational rather than alarming—a normal occurrence within the expected variance of sophisticated strategies. By maintaining appropriate diversification, understanding strategy mechanics, and keeping long-term perspective, investors can successfully incorporate quantitative approaches into broader portfolios.
The quantitative industry’s transparent response to these challenges demonstrates maturing professionalism and commitment to investor communication. As China’s financial markets continue developing, such episodes contribute to market sophistication and improved risk management practices across the industry.
For investors concerned about recent performance, the appropriate response is typically patience rather than reaction. Historical evidence suggests that following periods of strategy challenge, normalization often occurs, allowing well-constructed quantitative approaches to resume their expected performance patterns. Those who maintain discipline during difficult periods typically reap rewards when conditions eventually revert to more favorable states.
