How China’s risky structured mutual funds may trigger the next stocks sell-off

China markets face more headwinds as mounting losses for risky structured funds, which are highly leveraged plays tracking equity indices, could ignite another round of sell-off in small-to-mid-cap counters and state-owned enterprises (SOEs).

“It was like a casino,” said Peterson Jiang, a 24-year-old graduate student who saw the value of the structured fund he bought shrink 91 per cent in three months. “I saw my money evaporate before I fully understood the rules of the game.”

Structured funds are mutual fund products that became star performers as the China market rallied until the rout in mid-June. Their size ballooned to a record size when the stock market peaked in June, before going belly-up with the market.

“Their meltdown mirrors the country’s deleveraging process and helps people understand China’s stock leverage drama,” said Jia Rongli, a fund analyst with China Merchant Securities. “The biggest concern is the systemic risk their downfall poses to the markets as stocks of some of the SOEs and small to mid caps listed in Shenzhen could be crushed in the ensuing chain reaction.”

Aimed at investors who do not want to borrow money from brokers, banks or the grey market to buy stocks – as many punters on the mainland do – structured funds use leverage to magnify returns in a bull market. The flip side is, losses are similarly amplified when stocks are heading down.