Scoring with heavy bets on internet, tech and casino stocks, hedge funds investing in the Greater China region gained an average 20 per cent last year compared to a flat MSCI China index, their best showing in five years.
By contrast, Japan-focused equity funds gained an average 26 per cent last year, data from Eurekahedge showed, lagging a 29 per cent rise in the Nikkei 225 in dollar terms - a performance similar to low-cost exchange traded funds and insufficient to justify hedge funds' hefty fees.
The outperformance helped encourage Chinese capital to emerge as a growing force in an industry that is dominated by US and European institutions such as pension funds and endowments.
China funds will also likely build on net inflows last year as top performers such as Avant Capital Eagle Fund and LBN Advisers China fund lure investors. Eurekahedge estimates China funds raised a net $1.2 billion in 2013, which compares with net outflows of $323 million for Japan funds.
But a repeat performance by Chinese managers as a group this year will be difficult as valuations for so-called new economy sectors have become stretched, according to some industry experts.
"Some of the long-lasting winning sectors and stocks could see sudden breaks," Theodore Shou, chief investment officer of Skybound Capital in Hong Kong which invests in China-focused hedge funds.
Chinese IT companies as measured by the IBES MSCI index are trading at 25 times forward 12 months earnings, a hefty premium over the MSCI China Index that trades at just 8.9 times.
Investor favourite Kingsoft Corp Ltd, an entertainment software firm, trades at 30 times, 181 per cent higher than its 5 year median price to earnings ratio. Internet giant Tencent Holdings Ltd, which saw its market capitalisation top $100 billion last year, trades at nearly 35 times.
Shou added that fund managers will have to place a greater emphasis on stock selection, as opposed to sector selection, this year.
Shorting commodity stocks
Short positions in sectors such as commodities and in state-owned companies also helped China funds, portfolio managers and investors said.
"Resources are being allocated away from a lot of fixed-asset investments, commodities, real estate into what we call the new economy, namely a lot of alternative energy, internet, software, environmental related stuff," LBN Advisers chief executive Benjamin Chang said.
His firm, which earned a 40 per cent return in its $250 million long/short fund, profited from short positions in companies such as Yanzhou Coal Mining Co Ltd (-45 per cent) and Zhaojin Mining Industry Co Ltd (-63 per cent).
Winning picks included Tencent (+99 per cent), Kingsoft (+309 per cent) and waste-to-energy company China Everbright International Ltd (+165 per cent).
One of the top performers, Avant Capital Eagle Fund, gained a stunning 200 per cent-plus last year through bets on small and mid-cap stocks, its chief investment officer Raymond Jook said.
Among the biggest China hedge funds, winners included the $2 billion Dragon Billion China Fund which gained 11.2 per cent through the end of November, the fund's newsletter showed.
Others include the $120 million Springs China Opportunities Fund (+36 per cent), the $92 million Legends China Fund (+39.3 per cent) and the $70 million Dalton Greater China Fund (+31.9 per cent through Dec 27), according to data confirmed by their money managers.
Dalton's returns partly came from its exposure to Taiwanese chipmaker Himax Technologies Inc, which benefited from Google Inc taking a small stake in its display unit, said Tony Hsu, a portfolio manager at Dalton Investments.
The stock, which the hedge fund started betting on in 2011, rose 513 per cent last year.
Gaming companies were also big winners for Dalton as Macau raked in $45 billion in gambling revenue in 2013, nearly 20 per cent more than a year earlier. Galaxy Entertainment Group Ltd rose 129 per cent and Melco International Development Ltd, rallied 216 per cent last year.
Copyright @ Thomson Reuters 2014