Summary of Key Points
In July this year, leading quantitative private equity firms, represented by Huanfang, suffered a major setback: nine of Huanfang’s products experienced a monthly decline of over 20% (with the worst drop being 22%). Other prominent firms such as Jiukun and Mingyun also saw significant drawdowns, even wiping out their gains from the first half of the year. Meanwhile, the excess returns in the quantitative industry plummeted from 14% last year to just 3% this year, widening the gap between the top performers (6.5%) and the bottom performers (0.14%). More critically, Qianhui Asset, a private equity firm with assets of tens of billions, was convicted of illegal operations due to its T+0 portfolio allocation strategy, becoming the first case in China where such behavior resulted in criminal charges. This series of events marks the end of the easy profit-making period for quantitative investment in China, as the industry is transitioning from exploiting market volatility among retail investors to becoming a compliant asset allocation tool.
Why Has Quantitative Investing Suddenly Become Less Attractive? — Six Overlapping Reasons for the July Drawdown
The collective collapse was not caused by a single issue but by a combination of several “black swan” events:
1. Extreme Market Divergence: In the first half of the year, only the top 5% of A-share stocks in the technology sector appreciated, while quantitative funds held a diversified portfolio (including many less popular stocks). As a result, even though the market index rose, the funds’ own stocks declined, making diversification a disadvantage.
2. Collective Failure of Strategy Factors: Quantitative investing relies on multiple factors (such as momentum and reversal) to generate profits. Normally, these factors offset each other’s risks, but in July, they all performed poorly simultaneously, leading to a collapse in the effectiveness of the investment strategy.
3. Homogenization and Herd Behavior: Too many quantitative firms used similar models and data, leading to simultaneous reductions in positions at the slightest market fluctuation, creating a vicious cycle of “decline → reduced positions → further decline”.
4. High Positions Limiting Risk Hedging: Quantitative funds typically operate with full portfolios (holding no short positions), leaving them with no option to hedge against market declines.
5. AI Models Unprepared for Extreme Market Conditions: AI-based quantitative models are trained on historical data and were unprepared for the sudden shift in market trends in July.
6. Excessive Scale Diluting Returns: The scale of quantitative private equity funds increased by 500 billion (to 2.3 trillion yuan) over half a year, squeezing out arbitrage opportunities.
Whose Money Does Quantitative Investing Earn? — Retail Investors’ “Pricing Biases” Are the Key
Quantitative investing has been profitable for years because it exploits the large number of retail investors in the A-share market:
- High Retail Investor Participation: Retail investors account for only 30% of A-share market value but contribute 60%-70% of trading volume, with a higher turnover rate (average holding period of less than 40 days).
- Retail Investors’ Prone to Mistakes: They tend to overreact by buying high and selling low, creating pricing biases that quantitative algorithms can exploit for profit.
- Comparison with the U.S. Market: In the U.S., retail investors account for only 20% of trading volume, giving institutions more control over prices. Quantitative firms must compete with them, thus profiting from their investment flaws rather than those of retail investors.
In simple terms, quantitative investing used to profit from retail investors’ mistakes, but now there are more investors competing in the market, and they have become more sophisticated, making it harder for quantitative funds to make profits.
What Does the Qianhui Case Warn Us About? — Regulatory “Zero Tolerance” for Illegal Activities
Qianhui Asset, a large-scale quantitative firm, was convicted of illegal operations due to its T+0 portfolio allocation strategy. It split fund accounts into virtual sub-accounts for intraday trading (T+0) and charged fees and commissions. This highlights the new regulatory stance: previously, such activities might have resulted in fines, but now they are subject to criminal prosecution, even if the involved amount is small.
- Impact on the Industry: The T+0 portfolio allocation practice is becoming unsustainable, and many related software firms have shifted their business models. Quantitative firms must completely abandon illegal practices to survive.
Differences Between Quantitative Investing in China and the U.S. — China Cannot Copy the “Retail Exploitation” Model
The legendary Renaissance Technologies in the U.S. achieves annual returns of 66%, but this model is not applicable in China:
- U.S. Model: It relies on 30 years of closed data, top-tier talent (mathematicians and physicists), and a small scale (only $10 billion) to exploit differences between institutional investors.
- Chinese Model: In the past, quantitative investing relied on retail investors; however, this route is no longer viable. Chinese retail investors are becoming more cautious, and the market is shifting towards a scenario where institutions compete with each other. Additionally, regulations prevent quantitative firms from exploiting them further (e.g., the Shanghai Stock Exchange has removed exclusive trading channels for quantitative funds).
Where Does Quantitative Investing Go From Here? — A Two- to Three-Year Transition Period
The recent drawdown is not the end but the beginning of a reshuffle in the industry:
1. Reduction in Scale: Firms that rely on homogeneous strategies and illegal practices will be eliminated, with their assets possibly shrinking from 2.3 trillion yuan to around 1.5 trillion yuan.
2. Diversification of Strategies: Leading firms will turn to alternative data sources (e.g., satellite imagery, consumer data) and better portfolio management techniques to maintain returns without increasing scale.
3. Compliance as a Priority: Any illegal activities will face criminal consequences, making compliance a critical requirement for survival.
4. Return to the Essence of Asset Allocation: Quantitative investing will focus on providing risk-diverse, long-term stable investments, such as index-enhanced funds, which, although less profitable, offer better investment discipline compared to subjective management.
For retail investors, remember: quantitative investing is not a money-making machine but a tool for diversifying risks. When choosing quantitative funds, look for those that are compliant, use unique strategies, and have a moderate scale. Stop believing in the “AI myth.”
In Conclusion
The era of easy profits for quantitative investing in China has ended, but this is not necessarily a bad thing. It eliminates poorly performing firms and allows only the truly capable ones to stay in the market, making it more fair and healthy. It’s like a child growing up from relying on quick tricks to earning money to becoming self-sufficient through genuine skills.