Ex-Wall Street bankers are betting science can exploit opportunities in China's often rumour-driven stock market, with some predicting the quant-driven fund industry to grow by as much as 10-fold to 100 billion yuan within a few short years.
Former Goldman Sachs banker Shen Yi is confident his newly-launched 20 million yuan ($3.17 million) quant fund, which trades purely on complex mathematical calculations pre-programmed in computers, can beat the market.
Models sum up history and predict the future, said Shen, who holds a doctorate degree in physics from Oklahoma State University. Markets change, but human nature doesn't.
Since 2010, when China rolled out index futures, margin trading and short selling, more than 30 quant funds, or those that use statistical models rather than fundamental analysis to make investment decisions, have been launched, many of them by former Wall Street bankers like Shen.
There are no official or industry data on the size of China's quant fund industry, but Shen, based on his knowledge of how his rivals are doing, estimates the assets under management to be around 10 billion yuan. He believes the industry could grow 10-fold to 100 billion yuan in just three years.
These fund managers are betting that the quantitative approach, which follows a set of mathematical techniques to evaluate risk, pricing and timing of trade, can get traction in China as mutual funds struggle to make profits in a stock market which has fallen nearly 30 percent over the past 2 years.
In a bull market, no one would listen to us. But now it's different, said Tang Weiye, who manages about 200 million yuan for quant-driven hedge fund Credence Oriental Partnership.
The fund has so far generated a return of more than 200 percent, helped largely by its short futures positions during the 2008 market slump, he said.
After all the ups and downs in recent years, investors are saying we want some modest but steady returns and don't want to suffer from market volatility, said the Stanford-educated and former IBM programmer.
But managing a quant fund in a tightly-regulated market, like China, is no easy task.
Chinese investors are only allowed to sell stocks on the second day of purchase, preventing funds from conducting intraday trading and limiting their trading manoeuvres.
Secondly, a stamp tax rate of 0.1 percent of transaction value is a significant hindrance for high-frequency trading, while the cost of stock borrowing for shorting purposes, according to Tang, is typically around 9 percent on an annualised basis, compared with less than 3 percent in the United States.
Another constraint is a shortage of hedging tools in China. Index futures and short selling were introduced just two years ago but with many restrictions still placed on how they can be used by institutions.
Running a quant fund in China is not easy, said Kin-Leung Chan, managing director of Hong Kong-based China focused hedge fund Rega Technologies, which uses quant techniques to filter out investment ideas.
While fund managers hope China will introduce more policies that would benefit quant funds, regulators have so far taken a cautious stand after quantitative hedge funds were criticised for contributing to the market sell-offs during the 2010 flash crash, when the Dow Jones index <.DJI> fell nearly 1,000 points before bouncing back in minutes.
It's understandable that regulators are cautious towards things that they're not familiar with, Shen said.
But the development of quant hedge funds would actually help regulators' efforts to curb excessive speculation and boost liquidity, he argued.
For example, when a certain stock is over-valued relative to its peers, certain quant models would generate and execute sell transactions to seize on the investment opportunity.
It's easy for investors to get emotional and prejudiced when trading, but computers don't, said Liu Zhen, former U.S.-based money manager at Brevan Howard and D.E. Shaw who now heads E Fund Management Co's quantitative investment department.
Exploiting those human weakness is how quant make money.
(The story has been corrected to change stamp tax rate to 0.1 percent, not 1 percent, in 12th paragraph)
(Additional reporting by Nishant Kumar in Hong Kong; Editing by Michael Perry)