Quantitative investors – quant funds – are the earliest and most voracious users of data and artificial intelligence in capital markets. They have become a big business in the US, but their global backers have largely abandoned quants operating in Asia, due to poor performance.
That is now changing, and quant investors in the region say some Asian funds now outperform those in the US and Europe. Those shops best suited to sourcing alternative data, training their algorithms to find the best sources of liquidity, and exploiting Asia’s many market idiosyncrasies, don’t mind if local conditions are bullish (as in Japan and India) or bearish (as in China).
“China sentiment is bad, but we can put money to work where no one else does,” says one quant investor at a private forum attended by DigFin. That’s because quants use their computer-generated algos to find market signals that rely on volatility, not on macro growth. They prosper by exploiting the kind of market frictions that mainstream investors regard as a problem.
From zero to hero
Quant factors in Asia failed to outperform benchmarks for a long spell, from 2015 to 2021, crushed beneath the wheels of zero interest rates. The big asset owners that allocate to quant funds have steadily withdrawn from Asia Pacific: one investor says in 2015 the region’s industry peaked at $7 billion of international assets under management, but today the total is below $500 million.
That’s a brutal indictment; the US space also experienced a ‘quant winter’ from 2018 to 2020, but the industry is large and mature (peaking at $2.5 trillion in 2019, says J.P. Morgan). Quants in Asia, however, say they have been generating alpha (returns in excess of a benchmark) over the past 18 months, starting in Japan. Now quant managers are optimistic that China and India will prove fruitful.
The China industry in particular has taken off over the past two years. It is a large and highly automated market, which makes it perfect for quant players.
Estimates for the size of China’s quant industry vary. Chinese media cite a report by Huatai Securities that puts the domestic industry at Rmb1.08 trillion ($148 billion) as of end 2021, comprising mostly big local firms such as High-Flyer Quant Investment, Yanfu Investments and Shanghai Minghong Investment Management.
In recent years some of the biggest names in quant have set up in China, including Citadel, Bridgewater Associates, Two Sigma and Winton Capital.
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Other reports cite smaller figures, but they agree that 2021 was a watershed year for China, with an explosion in the number of funds and assets under management, as well as the entry of big foreign players.
Quants use algorithms to analyze and trade on vast stores of data. They come in different types, which include high-frequency traders (or HFTs, who need to trade at the speed of nanoseconds), commodities-futures advisors (CTAs, which use futures to chase trends), value investors, market-neutral investors, and statistical arbitrageurs.
The most popular form of quant investing is crunching lots of data to identify a ‘factor’ that informs a portfolio strategy, such as one based on a stock’s value, liquidity, size, momentum, or other characteristic. HFTs aside, quants prefer to find factors that will last in the short- to medium-term (days to months).
These investors then use automated, or systematic, trading strategies to execute on those factors.
Several factors make Asia’s biggest markets a playground for experienced quants. First, volumes in markets such as China, Korea and Taiwan are as much as 50 percent retail, versus only 10 to 12 percent in the US and Europe. “There’s a lot more retail investors to pick off,” says one investor.
Emerging markets are less regulated, which means less compliance and reporting, and it’s easier for quants to fly under the radar – where they prefer to be.
Perhaps the biggest advantage in Asia, especially China, is that local inefficiencies mean quants can find more stocks that don’t correlate to local indexes than in the US. The China market is unusually uncorrelated to global markets, given its large size.
“Asia is the place to make alpha,” the investor says.
Local versus global
For now, global quants enjoy an advantage over most domestic competitors, which are numerous but lack sophistication. One foreign investor reckons only one out of five Chinese firms deploys AI in their trading strategies. These shops usually aim for total returns rather than risk-adjusted returns.
“Local managers mostly ignore Sharpe ratios,” says a global investor in China. (Sharpe ratios measure the relative performance over time of a portfolio against its benchmark.) “They’re charging hedge-fund fees for what’s basically a long-only portfolio.”
Domestic funds also tend to rely on similar trading algorithms, such as volume-weighted adjusted pricing (VWAP), which executes trades steadily throughout the day rather than digging deep to discover reliable blips and other inefficiencies in market patterns. But Asian markets often have idiosyncrasies that quants like to exploit, such as a concentration of volume at the start of the trading day in China.
That adds up to more alpha that savvier players can generate.
Challenges to scale
But quant strategies in Asia face three challenges that don’t exist in the US or Europe. First, there are not many stocks available for borrowing, a critical tool for short trading.
Second, there are few hedging instruments available. A preferred tool elsewhere is a futures index, but outside of Japan these are scarce in Asia. In China, investors have spot market ETFs they can use to manage risk, but there are only a few, such as the China Securities Index 300.
The third and biggest challenge is regulatory. In Asia, the rules often change. For example, earlier this year Korea banned short selling. Chinese regulators haven’t done anything that extreme since a 2015 crash, but they are constantly fiddling with rules such as limits on daily trading volumes or single-stock positions.
The China Securities Regulatory Commission is currently investigating hedge funds and brokerages using quant trading strategies in response to complaints by local rivals and retail investors that these firms are profiting at a time when China’s A Share market is experiencing a prolonged downturn, according to local media.
The CSRC as well as regulators at the Shanghai and Shenzhen stock exchanges are reportedly zeroing in on programmatic trading – the automated trading of baskets of stocks, which is a staple of quants’ execution.
China carried out a similar investigation in the wake of the 2015 crash; that ultimately exonerated short sellers. Quant investors don’t expect the authorities to ban their activity, as Korea has, given China’s desire to attract foreign capital. But the uncertainty raises the costs of doing business. And a US-style flash crash could spook China’s officials, who desire stability.
Return of public-market players
Overall, however, Asia’s quants are bullish on 2024, including in China. But the limitations – less stock borrow, few hedging instruments, regulatory uncertainty – put a cap on how much a quant fund can raise before it loses its edge. Industry executives say a China quant fund starts to underperform if it’s managing $1 billion of assets.
But given the market’s plenitude of inefficiencies, savvy multi-managers can allocate to a variety of boutique managers to create a much bigger portfolio. This multi-manager approach is the norm on Wall Street, but new in China, so there will be opportunities for the pioneers to generate outsized returns for little risk.
The question is whether China and other Asia-focused quants will attract global capital. Local fund managers, citing the general pullout of global asset owners from APAC quant, reckon only the biggest institutions maintain a regional mandate, at probably little more than 5 percent of their global asset allocation.
“Foreign LPs [limited partners] have too much exposure to private capital,” says one quant. “They need to extract alpha from public markets, and that’s easiest to do in Asia. That’s the future.”