Feb 21 (Reuters) - Chinese hedge fund managers are scrambling to soothe investors after a rout in small-value stocks, even as regulators step up scrutiny of major market players' activities as they try to revive the country's ailing stock markets.
Firms such as High-Flyer Quant Investment and Baiont Quant, which are hedge funds that deploy quantitative strategies using mathematical and statistical techniques, wrote to investors this week explaining their recent glaring underperformance and promising to beef up risk management, according to letters seen and verified by Reuters.
Chinese quant funds - which trade using data-driven computer models - are highly exposed to small-cap stocks which started plunging in early February, triggering panic-selling. Many quant products lost more than 15% of their value in just a week.
Meanwhile, the sector -- worth $260 billion by UBS estimates --- faces tighter regulatory scrutiny. China's stock exchanges said this week that quant fund giant Lingjun Investment had broken rules on orderly trading and barred it from buying and selling for three days.
"Onshore quant funds are facing severe losses and liquidation pressure, apart from stricter regulatory scrutiny," UBS said in note. "If they reduce fund size and decrease trading activities, it may affect market liquidity, especially for small caps."
China's mid- and big-cap stocks rebounded sharply earlier this month on suspected state support but that accelerated a sell-off in small-caps, deepening a liquidity crisis in a corner of the market quant funds are heavily exposed to.
In a letter to investors, quant fund giant High-Flyer attributed its recent setback to strategies that failed to adapt to "extreme" market conditions.
"The drawdown shows that our strategy needs improving," High-Flyer said, adding that it has already tightened risk management.
MARKET TSUNAMI
An index tracking "micro-cap stocks", or China's 400 smallest listed companies, plunged 31% during the first five trading days in February, far underperforming the blue-chip index and dealing a blow to hedge funds that favour them.
Baiont Quant, which employs artificial intelligence (AI) in investment, said its strategies suffered record drawdowns, despite the market "tsunami" triggering red alerts and stop-loss orders. It also said its exposure to micro-caps is limited.
But Baiont said in a letter to clients: "Our strategy remains effective. When the tsunami is over, quant strategies will shine again."
Liangdao Fund, another quant fund manager, said AI-driven models played a role in creating the boom-and-bust cycle in China's small- and tiny-caps over the past year. The money manager said it has adopted a dynamic system to identify risks more proactively.
Quant funds also face regulatory headwinds. Shanghai and Shenzhen exchanges said on Tuesday that they would step up monitoring quant funds and high-frequency traders, who enjoy an edge over small investors.
Authorities will roll out a series of measures to better regulate quant trading, the China Securities Journal reported on Thursday.
"China's recent 'quant quake' has revealed systemic financial risks ... and highlights the perils of crowding and leverage," global hedge fund firm Man Group said in a report.
Tang Yu, a former partner of a major Chinese quant fund, said some leading quant players are too big, so an industry shakeout could help disperse market risks.
"In the short term, some investors may withdraw money from quant funds and wait to see what's the next step of the regulator." ($1 = 7.1869 Chinese yuan renminbi) (Reporting by Samuel Shen and Jason Xue in Shanghai; Summer Zhen in Hong Kong; Additional reporting by Li Gu Editing by Vidya Ranganathan and Kim Coghill)
