China Hedge Funds to Blossom Under New Rules

China’s hedge funds, which for years have operated in a legal gray area, are moving into the mainstream as regulators roll out laws and measures to manage the fast-growing industry.

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The official recognition of this corner of the fund-management industry is likely to propel its expansion and lead to more-sophisticated trading strategies.

Hedge funds offer wealthy individuals an alternative for their cash—away from high-yielding trust products that have been popular, but also widely blamed for contributing to excessive investment in sectors such as real estate and infrastructure.

Hedge funds in China manage 539.4 billion yuan (US$88.2 billion), according to Shanghai-based consultancy Z-Ben Advisors, which forecasts the sector doubling to 1.1 trillion yuan under management by the end of 2018.

The original law overseeing the fund industry, introduced a decade ago, applied only to publicly offered mutual funds, leaving private funds such as hedge funds without a set of guidelines delineating the dos and the don’ts for fund managers.

Last year, new laws that recognize the existence of hedge funds as a legal entity were introduced. Then in August this year, the China Securities Regulatory Commission announced a range of rules for private funds, covering areas such as registration and filing, fundraising, and fund operations.“For the first time, in rather a comprehensive fashion, they have put in place the regulatory regime for private funds in China, and this is fairly groundbreaking,” said Joseph Chan, a lawyer who advises funds for law firm Sidley Austin LLP in Shanghai.

The industry remains in its infancy, and largely closed to foreign investors without a license to invest in China’s domestic capital markets. There are many tiny funds, each with a small market share, and many managers bet only on individual stocks to go higher, rather than using more- sophisticated strategies such as betting on declines or using derivatives for leveraged bets.

While it is possible to take a short position on the broad stock index, it is prohibitively expensive to do so with individual stocks. Investors are still waiting for the introduction of options, which would allow even more-complex strategies.

For some fund managers, however, the relative simplicity of the hedge fund industry presents opportunities to grow.“If you look at the hedge-fund industry, there isn’t already a dominant player in the market,” said Zhou Xin, who recently returned to China after 14 years working and studying in the U.S. She is setting up a hedge fund that employs quantitative analysis—using complex mathematical models to pick stocks. Investors have committed 500 million yuan in capital to her fund, XY Investments, she said.

One of the main outcomes of the industry’s official recognition is that hedge funds can abandon the restrictive structures they were doing business under. For example, a typical structure would be for a fund manager to simply be the adviser for the assets held by a trust or a securities company, which would sell and market the fund in its own name.

As part of the new regulations, funds are allowed to independently issue their own products, as long as they register them with the Asset Management Association of China, a self-regulatory industry organization supervised by the securities regulator.

This comes with pros and cons. On the one hand, it allows private funds to build their brand by dealing directly with investors to raise money. But by separating themselves from a trust company, they are required to consider a range of new administrative and operational issues, such as managing their own brokerage account and conducting their own trading.

“This kind of evolution is necessary, and it is good for the market in the long-term. It is going to leaven out the managers who have the ability to become fully fledged asset managers, versus those shops that are going to just retain their advisory role,” said Brian Ingram, chief investment officer at Ping An Russell Investment Management, a Shanghai-based asset manager that allocates assets for management by Chinese fund managers.

There are costs associated with severing ties with a third party. Issuing your own products means you have to set up your own trading desk—at a cost of up to 6 million yuan, said Wang Ming, a partner at Yaozhi Asset Management Co. LLP.“But if you set your eyes on the future, that’s something you should do if you want to grow bigger,” said Mr. Wang, whose fund set up China’s first self-issued bond-based hedge fund this year.

—Wynne Wang contributed to this article.