China arrest puts heat on private funds

The arrest of the founder and general manager of Zexi Investment, a Shanghai-based private securities firm, has attracted unwanted attention to China's fast-growing private fund industry.

Xu Xiang’s detainment on Sunday (November 1) on charges of insider trading and stock price manipulation marks the fall from grace of another star manager. Some suggest China Securities Regulatory Commission (CSRC) is expanding its focus to private asset managers from the mutual fund segment, which has already seen many insider trading cases.

The arrest also sounds a warning to foreign institutions about the importance of due diligence when engaging mainland private fund houses, China's equivalent of alternative asset managers. Zexi is a name familiar to many overseas investors.

Xu's arrest was reported by state media Xinhua News and CCTV (China Central Television) at 11pm Shanghai time on Sunday, with the news channels citing confirmation from the Ministry of Public Security.

Police have taken control of Zexi’s offices in Beijing and Shanghai, examining documents and interviewing employees, while the firm’s website has been inaccessible and senior managers unreachable, report local media.

“The news was widely spread among private fund managers in Shanghai on Sunday night,” said a Shanghai-based private funds analyst, who asked to remain anonymous. “It is the first case among private securities managers. I think the regulator is shifting its focus to the private segment from the mutual fund industry.”  

The private fund industry has only been standardised for two years, he noted, and there is not yet a formal registration system in place, as both the Asset Management Association of China (Amac) and the CSRC do not have sufficient resources to regulate the segment.

The analyst hinted that authorities may have held off arresting Xu until the stock markets had stabilised after the summer's volatility, so as not to create further turmoil at the time. However, he added, the Zexi case could be the start of a longer-term focus on this area of the market.

Another Shanghai-based consultant said: “It seems that this is a solitary case at this moment; hopefully it should not have too wide-ranging an impact on the private fund space generally.”

Yet many will view a greater focus on the private fund industry as a likely outcome, following the exodus of managers from mutual fund firms to the private asset segment in the first quarter of this year. 

Xu Xiang, 37, himself has sought to remain low-profile, but some say the firm’s “too good to be true” track record have put the spotlight on him and raised questions among his competitors.

Zexi’s flagship product, Zexi No 3, has generated a total of 3,944% in returns since its inception in July 2010, and 382% this year as of end-October. The firm had four products ranked in the top 10 performers in the private fund segment this year as of September, according to third-party distributor Geshang Licai. China has 8,981 private securities fund firms, managing a total of Rmb1.67 trillion as of September, according to Amac.

The anonymous private fund analyst said: “If not because of price manipulation or insider information, it is hard to believe how [Zexi] could avoid the market correction every time and keep outperforming the broad market.”

Many market participants are well aware of the problem of insider trading or manipulation, he noted. Most private fund firms rely on one or two key portfolio managers, he added, so it is difficult for them to build up strong compliance rules and systems.

China’s private funds industry has been a dynamic and high-growth industry in the past two years, but corporate governance and compliance can be poor among such players, as fund managers and consultants have warned. 

Shanghai-based consultancy Z-Ben Advisors said in a note: “Zexi’s difficulties reinforce our belief that risk management in China remains extremely challenging and that due diligence on a manager can never be consider a finished job.”

Z-Ben said Zexi had not received mandates from offshore investors. But some overseas investors may have exposure to the firm through fund-of-fund or multi-manager products offered by Chinese brokers, which are inexperienced in managing such products but usually have financial ties to private managers in question, noted the consultancy.

Set up in 2009, Zexi had a total of Rmb15 billion ($2.4 billion) in assets under management at end-2014, making it one of the top 10 private fund managers in China, according to Geshang Licai. The fund house manages six products in a trust structure and has 11 employees.

Xu’s arrest is the first insider trading investigation of a private securities manager since the industry became regulated under the new Fund Law implemented in June 2013. The Amac has blacklisted five fund executives and four companies and punished 12 companies since it established a blacklist system in December last year. However, the firms in question are managers specialising in direct investment in non-listed equities or venture capital. 

In February, the CSRC punished five mutual fund companies for lack of compliance and risk controls and stressed the regulator will adopt a zero-tolerance approach to illegal activity. There was no further move or punishment of mutual fund firms until September 18, when it flagged another round of punishments. 

The regulator said it planned to punish 17 cases of stock manipulation, 18 of illegal selling and 12 of insider trading. This covers individual and company securities-trading accounts on the mainland and overseas.

Insider dealing – or ‘rat trading’, as it is dubbed – has been endemic in China’s mutual fund industry for many years. The CSRC has intensified its efforts to crackdown on these practices since 2010. The most recent well-known case is that of Ma Le, a former portfolio manager at Shenzhen-based Bosera Funds, who was arrested in 2013.

AsianInvestor could not reach Zexi for comment by press time.