and accurately estimate the fluctuations of the future stock market. Therefore, they analyze in meticulous details all factors that might affect the movement of the stock market."

"Normally, some research reports on future market trends published by hedge funds have prospective impact," said Zhang.

Arbitrage style supports blue chips

"The profitability model of the Chinese stock market is relatively single-threaded," said CITIC Securities Research Institute researcher Sun Shengquan. "In summary, it is selling high, buying low and profiting from the difference in stock prices.

"In the eye of international hedge funds, the idea of holding and waiting for a price surge has risks. If the market experiences systemic risks, most stocks will drop drastically. Unless the shareholders know about this ahead of time and sell the stocks in advance--otherwise they can only sit there, waiting to die."

At the end of May, the Chinese stock market dropped substantially because of the sudden stamp duty increase. Many investors were trapped. This was an obvious example.

"The hedge funds will bring a completely different investment philosophy to the Chinese stock market," said Sun. "That is, to make profit by utilizing the price differential among different financial investment instruments to conduct arbitrage and make a profit. Compared with the single profitability model of holding and waiting, this model is more capable of avoiding market fluctuation risks."

The stock manipulation methods used by hedge funds are plentiful. For example, they believe stocks in the same sector with different performances provide huge arbitrage opportunities. Usually, they would purchase blue chips in a certain sector and concurrently short-sell poor-performing stocks in the same sector, at a specific ratio.

If the sector performs as well as expected, the price increase of blue chips will certainly exceed other stocks in the same sector. The benefits in buying blue chips will more than compensate for the loss in short selling the poor-performing stocks. If the forecast was wrong, the decrease in poor-performing stocks will certainly be bigger than the decrease in blue chips. In this case, the profit from short selling will more than compensate for the loss in the drop of blue chips. This is another risk-free arbitrage trick pursued by hedge funds.

"This operating mindset will have profound influence on the trend of the entire stock market in China," said Zhao Min, a fund manager at Huaan Fund Management Co. Ltd. "As more and more hedge funds enter the Chinese stock market, blue chips will be courted continuously while poor-performing stocks will be dumped. The future polarization of individual stocks will be unavoidable. By the same token, as seen in the development track of foreign mature markets, when institutional investors such as hedge funds become the main participants of the stock market, 20 percent of the blue chips will account for a big chunk of the stock index, and 80 percent of stocks that perform poorly will have little impact. The stock selection strategy of the hedge funds has very important effects on market polarization."

In line with international markets

Cross-border arbitrage transactions are another "catalyst" fuelling the entry of international hedge funds into China. At present, international markets have a few China stock index futures: the FTSE/Xinhua China 25 Index futures listed on the Hong Kong Stock Exchange, the CBOE China Index futures on the CBOE Futures Exchange and the SGX FTSE/Xinhua China A50 Index Futures on the Singapore Exchange.

Following the entry of international hedge funds in the A share market, the once severed trans-regional arbitrage "link" has been quietly repaired. Using the simplest method, if the price of the corresponding domestic stock index is higher than the overseas China stock index futures, the funds would sell the index products domestically and buy the overseas China stock index futures products to earn the price differential. The converse is also true.

Using the time differential to conduct arbitrage is also a survival tactic of international hedge funds. As the Chinese stock market and international financial markets become more and more integrated, the price differential of financial products in the same sector will automatically become consistent. If the futures price of copper drops during the London trading timeslot, the opening price of copper during the Shanghai timeslot the next day should be low. If the Dow Jones increases the day before, the opening price of the Hang Seng Index in Hong Kong the next day should be high correspondingly. International hedge funds are fully capable of conducting arbitrage, utilizing the time differentials in different regions of the world and the interrelated influence of different prices of the financial products.

For example, an international hedge fund may purchase an A-share stock in the nonferrous metals sector, heating up the global futures prices of nonferrous metals overnight. When the global copper and aluminum prices increase, the prices of nonferrous metal stocks in China will usually rise the next day. Then, the international hedge funds can reap huge profits from stock investments.

"When an international hedge fund enters China, it will first target some index funds and closed-end funds," said Sun. "Their stock composition is similar to the overseas China stock index futures products. As hedge funds usually use leveraged transactions, the size of the capital is multiplied. Once they discover a certain arbitrage opportunity across boundaries, they will engage heavily in buying and selling domestic indexed financial products to maximize profits, causing more fluctuations in the Chinese financial market."

Strict government controls

"A large portion of the hot money we are familiar with is capital from international hedge funds," a private equity fund manager divulged.

"From the standpoint of some governments, the damaging power of hedge funds toward international financial stability is severe," said Wu Pengfei, a researcher at Guotai Junan Securities Research Institute. "But, since their actions are concealed, the financial regulators of many countries are unable to track them and take preventive actions. We have to guard against international hedge funds entering China and making waves in the market."

As hedge funds get bigger and bigger globally, their impact on the economy is more profound. The task of regulating hedge funds is also getting more attention.

At present, there are close to 10,000 active hedge funds with assets totalling approximately $1.5 trillion. The United States and Britain, where the majority of these hedge funds are based, advocate risk control through dialogue and maintaining vigilance, particularly through the strictly regulated investment banks to "indirectly regulate" the hedge funds. On the other hand, Germany seeks more direct regulation of hedge funds.

(Xinhua Finance)