As investors poured more capital into these strategies, the performance of small stocks soared, perpetuating a self-reinforcing cycle. Despite this, the liquidity risk associated with such strategies has been mounting but largely overlooked.

In the meantime, foreign investors were retreating from China’s stock markets amid heightened geopolitical and economic uncertainties. These investors, predominantly institutional and long-only in nature, tend to favor large-cap, high-quality names. Consequently, their exit has bolstered the outperformance of China's quant strategies over traditional fundamental players.

However, the landscape took a drastic turn in 2024. The relentless decline in China's broader stock market prompted intervention from the "National Team" to avert a financial system crisis, focusing primarily on the large-cap segment. Consequently, quant strategies find themselves in a precarious position, compelled to cover shorts and liquidate long positions, resulting in losses on both fronts.

The recent “quant crisis” episode is likely to prompt investors to reassess the riskiness of quant strategies, potentially shifting their focus back to fundamental approaches. Chinese stocks have already reached attractive valuation levels, and signs indicate that the recent capital outflow, notablely observed since last August, has stabilized by late January (Please refer to the chart below for cumulative northbound net capital flow since 2020). In our view, fundamental strategies are wellpositioned to capitalize on this shift.

As for China quant strategy, it may just be a matter of time before investors move beyond the recent fiasco and re-engage. Of course, the strategy itself will need to evolve to adapt to changing market conditions.

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