In a Declining A-shares Market, Market Neutral Strategies Are the Last Defender of Liquidity

Small-Cap Stocks Plummet Amid Weak Market Sentiment

Since the beginning of 2024, the Chinese stock market has been particularly brutal to small-cap stocks, with the CSI 1000 and CSI 2000 indices, representing the broader spectrum of smaller companies, leading the decline. As of late July 25, these indices have plummeted by 21.31% and 28.20%, respectively, significantly underperforming the broader market.

The sustained downturn has been exacerbated by a notable reduction in the equity positions of active equity funds, which have experienced two consecutive quarters of decline in holdings, coupled with substantial redemption pressures. This confluence of factors has led to a marked decrease in trading volume since May, triggering a prolonged market downturn.

Source: Choice Data

The Investor's Dilemma: To Sell or Hedge?

Consider the predicament of an investor who, in the face of declining markets, decides to reduce their risk exposure. The simplest approach might be to sell off their holdings. However, such actions contribute to a vicious cycle: selling leads to price drops, which further deteriorates market sentiment, prompting even more selling—thus reinforcing the downward spiral. This phenomenon, known as a “cascade of selling”, forces every remaining bull to reluctantly become a potential bear. As market liquidity dries up, even relatively small sales can significantly impact prices. Breaking this cycle usually requires either a major positive macroeconomic development or the influx of substantial new capital.

But is there an alternative that allows risk reduction without triggering such a destructive feedback loop? The answer is yes.

Hedging: A Smoother Path Through Market Turbulence

Rather than selling off stocks, investors can use derivative instruments like stock index futures to hedge their positions. These instruments track specific indices—such as the CSI 300, CSI 500, and CSI 1000—and can be used to offset risk by shorting futures contracts equivalent to the market value of their stock holdings. For example, on a day when the market falls by 2%, the decline in stock holdings could be offset by a corresponding gain from short positions in index futures, thus significantly mitigating overall risk and allowing investors to hold onto their long positions with greater confidence.

However, this approach is not without its challenges. For hedging to be effective, the composition of the stock holdings and the index futures must be closely aligned. For instance, hedging a portfolio of bank and blue-chip stocks with CSI 1000 futures would be ineffective. Furthermore, hedging comes at a cost, with annualized expenses typically ranging from 5% to 10% or more. As a result, successful hedging strategies require not only careful selection of stocks that outperform the index but also the ability to cover these costs.

The Role of Market Neutral Strategies

In the A-share market, market-neutral strategies play an irreplaceable role in providing liquidity and ensuring deep value discovery, especially during market downturns. These strategies, predominantly offered by quantitative funds, are designed to be insensitive to market movements, focusing on long-term stock selection capabilities and maintaining consistent, superior performance that transcends index benchmarks. By steadfastly holding onto their long positions, irrespective of whether they are large-cap or small-cap, growth or value stocks, these funds ensure a healthier market ecosystem.

Unfortunately, the current scarcity of stock index futures in the A-share market results in prohibitively high hedging costs, which in turn limits the overall capacity of market-neutral strategies. This has contributed to the dominance of long-only products in the asset management market, creating an imbalance that leads to widespread losses and subsequent redemptions during market downturns.

Misunderstanding Derivatives: The Case for Education

There is often a misconception among retail investors that derivatives are the villains in a declining market. However, the reality is that these instruments, when used responsibly, provide essential risk management tools that can prevent the kind of self-reinforcing sell-off cycles witnessed this year. For example, under regulatory guidelines, asset managers are prohibited from holding naked short positions, ensuring that short futures positions do not exceed the market value of long stock positions. The absence of sufficient hedging tools often forces investors to reduce stock holdings collectively, thereby exacerbating the “cascade of selling” that was so vividly demonstrated by the performance of small-cap stocks in 2024.

In conclusion, the responsible and scientific use of hedging tools like stock index futures and diversified strategy offerings within the A-shares market is vital for maintaining market stability. We have long recognized the importance of incorporating these instruments into market-neutral strategies. By doing so, we can not only diversify revenue streams and spread investment risk but also help investors navigate the complex and volatile financial landscape to discover and seize genuinely valuable investment opportunities.