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Quant Trades Are Misfiring. Time to Try China (And Ask Mom)

Justina Lee and Gregor Stuart Hunter
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Quant Trades Are Misfiring. Time to Try China (And Ask Mom)

(Bloomberg) -- Jason Hsu co-founded one of the most famous firms in quantitative investing, but when the stock strategies he helped pioneer in America began to falter, he decided to look east. The only problem was they didn’t do what they were supposed to there, either.

That was 2016, and ever since then Hsu has been in the vanguard of quants who are rewiring systematic strategies to conquer the world’s second-biggest equity market. As Chinese stocks near completion of their entry into MSCI Inc. indexes tracked by trillions, U.S. powerhouses like D.E. Shaw & Co LP and Two Sigma Investments LP are among those stepping up their charge.

For equity quants like Hsu, who helped establish Research Affiliates, the stakes are huge. China’s market totals about $6.8 trillion and systematic investors barely have a toehold, meaning there’s no risk of the kind of overcrowding that’s thought to be undermining U.S. returns.

Instead the challenge comes from mom and pop. Retail investors are so dominant in the country that the kind of factor investing strategies championed by Hsu, which slice and dice stocks based on characteristics such as size or volatility, obey different rules. And he’s spent years learning what they are.

“Those markets are where you have opportunities,” said Hsu, who is now chief investment officer of Rayliant Global Advisors. “With more retail, there’s more noise trading, there are more behavioral mistakes.”

Rayliant’s research shows, for example, that the classic value factor -- which has endured a disastrous decade in the U.S. -- is alive and well in China. While returns have deteriorated a little in recent years, its survival highlights the behavioral differences in a market where more than eight in 10 trades are made by a retail investor.

Read more: Quants Think Like Amateurs in World’s Wildest Stock Market

That means momentum -- a strategy of buying recent winners that has been one of the better performing factors on Wall Street in the last few years -- fails in China, since mom and pop react strongly and quickly to news. Meanwhile, the opposite approach of betting on reversals thrives.

“We’ve had to create completely new models for China,” said Marko Schaffrick, managing director of San Jose, California-based True Arrow Capital Management, which runs systematic trading strategies in Asian markets. “You have to localize everything you do.”

Adapt and apply, is the mantra.

At Huatai-Pinebridge Investments, Chief Investment Officer for Quantitative Investment Hanqing Tian discovered that historical earnings growth, which tends to already be discounted in the U.S., can still predict winners in China.

Meanwhile, high levels of capital expenditure -- a red flag in developed markets -- can drive short-term outperformance in China, possibly because investors see that as a sign of corporate strength, she said in an interview.

But using the right signal matters. The strategy of buying high-dividend stocks, for instance, is distorted by local rules that encourage firms to return cash. Some may sell new equity to do so, diluting shareholders and reducing overall returns.

“Dividend yield as a value signal has been commonly used in most other markets,” said David Lai, co-chief investment officer at Premia Partners Co., a Hong Kong-based smart beta ETF company advised by Rayliant. “But in the Chinese market, the policies and regulations of the market make it quite difficult to generate a similar performance.”

A recent paper by three scholars at University of Pennsylvania’s Wharton School suggests that when implementing the size factor -- buying small caps and selling large ones -- investors should ignore the bottom 30% in China. Since many are likely targets of reverse mergers used to skirt rules around initial public offerings, their valuations can be detached from fundamentals.

State-owned enterprises, which have goals other than growing profits, are another distortion. Rayliant’s Hsu recommends neutralizing exposure to regional SOEs in value as well as low-volatility portfolios.

Overlaying all these idiosyncrasies are more functional issues for any quants seeking to get systematic in China. Because of a change in accounting standards in 2007, the availability of consistent equity data is limited. Shorting single stocks is curbed by regulations.

Yet quants oversee just 5.5% of equity and mixed-allocation mutual funds in China, according to Citic Securities, meaning the market is wide open for new systematic entrants. It’s not a direct comparison, but JPMorgan Chase & Co. has estimated that quant strategies account for 20% of assets in U.S. stocks.

For factor investors that means learning the new rules of the game, while for other quants it may mean hunting for signals in a cacophony of social media noise. But for all of them, it means understanding mom and pop. Literally, in Hsu’s case.

“I study my mother and I understand all the things she does that are kind of weird,” he told a conference audience in London this month. She’s U.S.-based, but he believes retail investors are the same the world over.

“All these things we’ve documented in behavioral anomalies you see in China,” Hsu said. “It’s a great laboratory.”

To contact the reporters on this story: Justina Lee in London at jlee1489@bloomberg.net;Gregor Stuart Hunter in Hong Kong at ghunter21@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Yakob Peterseil

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