Wealthy Chinese investors are turning to “sunshine” private trusts, the prototypes of hedge funds in the communist nation, as the property market cools, stocks slump and bank-deposit rates fail to match inflation.

China’s private trust-fund assets tripled to 138.3 billion yuan ($22 billion) in the 18 months to Sept. 30, according to the most recent data from the China Trustee Association, while global hedge-fund assets have stalled at around $2 trillion. The sunshine funds are exempt from some rules placed on Chinese mutual funds, even as limitations such as a ban on short selling means they can’t operate as hedge funds in the same way managers in Hong Kong, London and New York can.

“It comes back to the lack of investment choices,” said Fraser Howie, a Singapore-based managing director of CLSA Asia- Pacific Markets who co-authored the book “Red Capitalism” on China’s financial system. “The challenge for China will be, can these funds really differentiate and deliver absolute performance independent of whether the stock market was rising or falling.”

The Rongzhi Hedge Fund Index that tracks 938 sunshine private funds almost doubled from the end of 2006 to December 2011, beating the CSI Stock Fund Index, which includes all Chinese open-ended stock mutual funds, by 47 percentage points. China’s mutual-fund industry shrunk about 35 percent from the end of 2007 to 2.1 trillion yuan in September as the Shanghai Composite Index tumbled almost 60 percent from its 2007 peak.

Beating Key Indexes

The Rongzhi gauge dropped 18 percent last year, outperforming the CSI Equity Fund Index by 7 percentage points. The Shanghai Composite retreated 22 percent.

Sunshine private funds are yuan-denominated pools set up by trust companies that raise money from wealthy Chinese clients of banks, with a minimum investment of 1 million yuan. Advisers, such as Beijing-based Springs Capital Ltd., are then hired to run investments.

The pools earned the “sunshine” moniker for introducing more transparent practices of regular information disclosure, and by holding assets in third-party banks, as opposed to earlier private funds, which were largely unregulated. Sunshine funds are indirectly supervised by the China Banking Regulatory Commission, which regulates the trust companies that set up and raise capital for the funds.

Buffett Lunch

Zhao Danyang, who in 2008 paid $2.1 million in a winning bid for Warren Buffett’s annual charity lunch auction, is credited as the grandfather of sunshine private funds. Zhao set up what is believed to be the first sunshine private fund in February 2004. It returned 259 percent through March 16, 2007, or 84 percent a year, according to a report by Ba Shusong, a researcher at the State Council’s Development Research Center.

Sunshine funds are less hampered by restrictions that handicap mutual funds, especially in a declining equity market. Private funds can hold 100 percent of their money in cash when other investments become unattractive, whereas equity mutual funds are required to invest at least 60 percent of assets in stocks, according to 2004 securities fund rules.

Private funds are permitted to invest as much as 30 percent of their net-asset value in a single stock. For mutual funds, the cap is 10 percent.

“Sunshine private funds have been able to outperform mutual funds due to less restrictions on their asset allocations,” said Zhang Haidong, a senior analyst at Shanghai- based consulting firm Z-Ben Advisors Ltd.

Short Selling

Still, sunshine funds can’t short individual stocks as there are no detailed guidelines for trust companies to do so, said Z-Ben’s Zhang. At the moment, only securities companies, the segregated accounts that mutual-fund houses run for investors, and individuals can short stocks, he added. In a short sale, an investor borrows shares and sells them, in anticipation that a decline in the price will allow the loan to be repaid at a profit.

China in December broadened the securities eligible for margin trading and short sales to include stocks in the Shanghai Stock Exchange 180 Index and four open-ended exchange-traded funds including the China 50 ETF.

A regulation in July allowed trust funds to trade stock index futures once the trust companies that set them up have approval from the bank regulator. The establishment of a centralized securities lending exchange and regulatory relaxations are underway that are set to enable sunshine funds to profit from short selling individual stocks in much the same way their international peers can.

First Approval

Shanghai-based Hwabao Trust Co. in December became the first trust company approved for stock-index futures trades, according to information posted on the website of the China Trustee Association. Its first fund was set up at the end of last year, according to a company statement.

Sunshine private funds that raise money in China can’t invest in international securities without a government approved quota. Such quotas are mostly reserved for banks, mutual-fund companies, insurers and securities firms.

Hedge funds — investment pools that can wager on or against any assets — lost 5 percent in 2011, according to Chicago-based data provider Hedge Fund Research Inc., as global stock markets slumped and the European debt crisis worsened. Investors pulled $127 million from hedge funds in the fourth quarter, leaving the industry with $2.01 trillion in assets, according to HFR.

Global Funds

Eighty-eight Greater China-focused hedge funds around the world, including those that trade foreign-currency shares of Chinese companies quoted in international exchanges such as Hong Kong and the U.S., lost 14 percent last year, according to data from Singapore-based Eurekahedge Pte.

Sunshine fund adviser Springs Capital was founded in 2007 by seven former colleagues at Harvest Fund Management Co., one of China’s oldest and largest asset managers, who said they believed Chinese mutual funds’ best days were behind them. They left the industry in a year when average new mutual funds raised 7 billion yuan each, compared with 1.3 billion yuan in 2011, according to data reported by Shenzhen’s Securities Times in December.

‘Crazy Market’

“The market was crazy, people were crazy,” said Jenny Tian, a Hong Kong-based fund manager at Springs Capital. “We thought it was too good to be true.”

They were right. The Shanghai Composite index peaked at 6,092.06 in October 2007; it closed at 2,291.90 today.

Shawn Liu, who once ran 9 billion yuan of assets in the largest stock mutual fund for Shanghai-based Guotai Asset Management Co., is among newer entrants. In the first half of 2011, he and colleague Gerard DeBenedetto left to set up An Zhong Investment Management, an adviser to sunshine funds.

Liu had been an analyst for Standard & Poor’s in New York and China, and managed fixed-income investments for China Merchants Fund Management Co., an ING Groep NV venture, before the four-year stint with Guotai.

Managers at the largely government-controlled mutual funds have to surrender their mobile phones during trading hours and sit in offices monitored by overhead cameras, he said.

Incentive schemes have also helped drive managers from mutual funds, where individuals are prohibited from owning stakes in management companies, Z-Ben’s Zhang said.

More Transparent

Sunshine funds are more transparent than their unregulated predecessor private funds, and have to make weekly net asset value announcements, said Zhang. They aren’t required to disclose some information, such as how they allocate assets, that mutual funds have to make public, he said.

Springs Capital’s Tian said freer asset-allocation rules have driven the outperformance of sunshine over mutual funds.

“It is very important because in the A-share market, you can’t really short,” she said, referring to yuan-denominated stocks listed in China. “It’s basically cash and stocks. If you have a flexible cash-level mandate, that will give you much of the flexibility to manage the volatility in the market.”

Stock holdings of 142 sunshine private funds tracked by CRC Trust declined 11.5 percentage points from the end of 2010 to a low of 57 percent of their assets in May, the Shenzhen-based company said in a December report on its website. About 41 percent of the funds in the CRC Trust hedge-fund index cut stock holdings below 50 percent.

Underperform

Not all sunshine funds have outperformed. In April 2011, Shandong International Trust Corp. liquidated its Deep Blue No. 1 fund after its value fell 39 from its November 2009 start, according to data posted on fund consultant Howbuy’s website.

Chinese millionaires, who are restricted from international investments, control $2.7 trillion of wealth, according to a report by CapGemini SA and Bank of America Corp. last year. They are willing to pay more in fees to buy sunshine funds for their higher returns amid low deposit yields and falling property markets, said CLSA’s Howie.

Sunshine funds charge hedge fund-like rates, including about 2 percent of assets as management fees and 20 percent of profit as performance fees. The frequency and amount of withdrawals allowed after initial lockups are typically stipulated in the sunshine funds’ contracts, Z-Ben’s Zhang said.

Chinese mutual funds only charge management fees, ranging from 0.5 percent of assets for fixed-income funds to 1.5 percent for equity funds, according to An Zhong’s Liu.

The country’s state-controlled bank deposit rates have trailed inflation for 23 months, while home prices in Chinese cities have declined after the government tightened credit and introduced purchase curbs to prevent a real-estate bubble.

China’s 4.1 trillion yuan trust industry, which also includes property trusts, private equity and bank products, offers a hint at the potential for the growth of sunshine funds, said Zhang. Sunshine private funds accounted for 3 percent of total assets under management among trust funds, according to information posted on the China Trustee Association website.

“People want to invest in sunshine trust funds because of the poor performance of the stock market,” he said. “Private funds have delivered market-beating results.”