Cash-rich institutions bought into companies whose shares were undervalued and bid up their prices constantly, wooing other market players to chase the rally, leaving eventually small-time investors carrying an empty bag.

The saga culminated in 2000 when Caijing magazine exposed the funds' unethical price-rigging, giving investors a rude wake-up call that they would fall prey to fund managers who were astute in manipulating prices.

Based on a document prepared by a Shanghai Stock Exchange employee, the financial magazine painted a grim picture of how fund managers rigged stock prices through 'churning' - the process in which fund managers engage in excessive trading to cause a diversion in the supply-demand balance.

The article triggered chaos in the securities industry as most retail investors were already convinced the stock market was little more than a casino. The consequence was a market slump that lasted until 2006.

Today, the mainland has overtaken Japan as the world's second-largest equity market in terms of market capitalisation; unchanged nonetheless, is the rampant insider trading where in-the-know funds and their managers make their millions at the expense of the small investors. So much so that the China Securities Regulatory Commission said in a recent statement that more alleged illegal deals will be put under judicial scrutiny this year.

In May last year, Tang Jian, a fund manager at China International Fund Management, was sacked for alleged inside trading. Mr Tang opened 'rat accounts' - bogus brokerage accounts owned by him or people affiliated with him - to reap illicit gains taking advantage of the multimillion-yuan fund he managed.

Fund managers are the champion wage earners who normally receive millions of yuan in annual incomes. In a somewhat perverse way, professional money managers are heroes to stock investors for bringing in handsome returns, even if they believe 'rat accounts' are growing in the rapidly expanding market.

The mainland has 59 fund management companies operating a variety of equity investment products. As of December 31 last year, the mainland's 363 mutual funds held shares worth 3.27 trillion yuan, accounting for 35 per cent of the total tradable market capitalisation, according to the China Securities Journal.

'The (2000) scandal sounded off an alarm at the fund management firms,' said Zhao Xuejun, the chief executive of Harvest Fund Management. 'The fund companies were forced to rectify their old mindsets and tactics,' he added, referring to the shift in investment focus based on valuations rather than the supply-demand balance.

In reality, there are thousands of underground funds that regulators would not be able to police, according to market observers, and there is no shortage of evidential cases of funds colluding with listed firms to publish false information and rig stock prices.

Take Liu Fang, an individual investor who was catapulted in to the national limelight after his investment tactics were unveiled late last year. Mr Liu bought more than three million shares of Shandong Jintai Group, a perennial loss-maker, at less than four yuan each. The shares jumped almost seven-fold later as it completed an overhaul programme.

On the mainland, loss-makers can change into a profit-making star after an asset restructuring. However, news of any corporate revamps was often disclosed to certain big investors before the official announcement allowing them to build up positions on the 'undervalued' stocks.

Beijing has been striving to set a healthy tone for the country's arcane stock market, depending to a large extent on mutual funds to buy stocks on valuations rather than rumours.

In 1998, the country's first mutual fund came into existence after the CSRC decided to steer the investment community to converge more with international practices. At that time, millions of mainland retail investors thought they had the Warren Buffett-style wizardry to make a killing in the stock market and irrationally bid share prices up and down.

To the amazement of the securities watchdog, the investors viewed mutual funds, all closed-end, as another type of equity to speculate on.

In the aftermath of the fund scandal, some managers decided to get back on the right track, and began adopting western-style expertise to buy shares on valuations.

Mr Zhao said: 'The fund managers have to adhere to the principle of buying on valuations though it was once a brand-new concept to the market. Basically, funds should base their operations on analysis and studies of company fundamentals.'

Since the establishment of the Shanghai Stock Exchange in 1990, mainland investors have been accustomed to buying shares on technical factors or on rumours; that is, all eyes were on the balance between the supply and demand.

Over the years, the regulator has wasted no time in pushing ahead with the plan to develop the fund industry. Funds were encouraged to buy large-sized blue-chips who would generate sizable returns through good corporate performances.

In 2001, Shanghai-based Huaan Fund Management became the first to start operating the mainland's first open-ended fund, which sells new shares continuously.

The company signed an agreement with Fleming Investment Management, the first such venture between a local firm and a foreign fund manager. Under the deal, Fleming provided expertise in fund operation, promotion and client services.

Huaan's tie-up with Fleming was just a baby step in the regulator's efforts to bring in overseas expertise. In October 2002, Guotai Jun'an Securities formed a Sino-foreign joint venture fund management firm with Allianz Group of Germany, spearheading the move to tap the potential equity market along with an overseas partner.

'The most substantial expansion in the industry has been in the Sino-foreign joint venture segment, which doubled in number from 14 companies in 2003 to 28 companies by July 2007,' JP Morgan said in a research report. 'The foreign-invested firms have rapidly expanded their market share from 14 per cent in 2003 to capture 41 per cent of the market.'

Foreign partners are allowed to hold up to 49 per cent in a joint venture fund management company.

'By allowing joint venture fund companies, the whole industry's corporate governance and technologies were enhanced in leaps and bounds,' Mr Zhao said.

Regulators took another important step to spur the growth of the domestic fund industry in 2003 when Beijing allowed select foreign institutions to invest in yuan-denominated A shares through the qualified foreign institutional investor scheme.

UBS Warburg became the first firm among foreign institutions to take part. The bank pumped its money into the mainland's infrastructure, telecommunications, transport and resource companies seeking to profit from the nation's buoyant economic growth. Previously, mainland market players had preferred to buy small-capitalised stocks because those companies' prices were easy to manipulate, creating opportunities for investors to trade on premium.

Since 2006, savvy investors have resorted to professional fund managers to chase safe returns, convinced they had the ability to single out that special stock. The country's more than 300 mutual funds generated 100 per cent returns for investors in 2006 amid a 121 per cent jump in the benchmark Shanghai Composite Index. The buying spree fuelled the fund sector's growth last year.

According to the China Securities Journal, the net assets of mutual funds jumped 282 per cent from a year ago amid heavy buying. The top three fund managers - China Asset Management, Bosera Asset Management and Harvest - each operated funds worth more than 200 billion yuan.

While the 59 fund management firms have become more disciplined operators, analysts said the market would not fully realise its potential until the underground funds are properly regulated.