Liu Yijun runs the most successful, oldest and biggest hedge fund that almost no one has ever heard of: Prime Capital Management.

From offices high in a gold-coloured Shanghai tower, the highly secretive manager controls more than $3bn. He invests exclusively in Chinese companies selected by a disciplined team of researchers who are among the best paid in the country.

In a decade of stockpicking with almost no ability to hedge any of its bets in China?s rudimentary markets, Prime has still managed to deliver average annual returns of almost 26 per cent, with just one losing year, according to documents from the fund.

Prime represents everything that is most desirable and frustrating for the growing group of western investors desperate to put money into China?s nascent hedge fund industry.

?Managers we see in China have really good numbers but are too opaque. No one quite knows how they do it,? says one investor.

The returns are exciting and yet little is known about the history of the firm. The manager is not very forthcoming with prospective investors, according to some who have spoken with him. ?He has his own theory about running a fund. The organisation is not like what most US investors would want to see,? says one of his acquaintances.

Foreign investors are also held back by rising demands for assurances on risk management, compliance and back-office processes ? concerns intensified since the fraud perpetuated by US fund manager?Bernard Madoff. Yet Prime, like most other Chinese funds, does not have the institutional controls that give western investors comfort.

As a group, greater China hedge funds saw some of the best returns in the world last year ? averaging gains of more than 19 per cent, according to Eurekahedge, the research firm.

That was in a year when the Shanghai stock market lost almost 7 per cent of its value, having dropped by more than 65 per cent since its peak in 2008.

With this kind of performance, it is little wonder that international pension and sovereign wealth funds are interested in finding Chinese managers to back.

The?Canadian Pension Plan Investment Board, one of the world?s largest pension schemes, hired a specialist consultant to perform a thorough review of onshore managers last year. It found just one onshore fund to invest in, according to a person familiar with the move. The Canadian board declined to comment.

In China, the hedge fund world is comparable to that of the wildcat pioneering days of its counterparts in the US in the late 20th century. Regulatory changes, though, are bringing the industry out of the shadows and giving it a solid legal foundation.

Some of the growing number of managers establishing businesses are the brightest investors in China. Others, however, may have made their fantastic returns through more dubious means.

Someone such as Mr Liu may turn out to be China?s own?Julian Robertson, whose Tiger Management was one of the earliest hedge funds. Prime has already spawned several other funds that have become successful and sought-after, reminiscent of Mr Robertson?s ?Tiger Cubs?, as the managers who left his fund to set up successful firms were known.

The mention of Mr Liu?s name provokes unease and sometimes awe among financiers who deal with Chinese hedge funds. Many decline to discuss Prime. Those who will describe a fund whose origins and source of success remain slightly mysterious.

When he began his fund in 2003, Mr Liu had been a futures trader inside the Yongjin Group, according to people who know him. Yongjin is a large private equity and investment group, whose founder and chairman Wei Dong committed suicide in 2008. Caixin, the Chinese business magazine, claimed that at the time he was under investigation by the Communist party for reasons that have never become clear.

Prime still uses the name Yongjin in Chinese and the same ship-silhouette logo, although the two companies are not connected.

No one has accused Prime directly of dubious trading or wrongdoing. A banker in China who knows the fund says it is very well run, although not in the way a US investor might want. A Prime broker in Hong Kong says it has one of the best risk controls and management systems of any in China. Prime itself declined to be interviewed by the FT but an employee said that it had never been involved in any insider trading.

However, one investor who considered putting money into Prime?s Hong Kong-registered fund, a $2bn vehicle opened by the group in 2010, says he ultimately decided the investment was too uncertain. ?We just couldn?t get comfortable with the set-up and how they made their money,? the investor says.

Not long ago Chinese equities were riddled with stories of insider trading, pump-and-dump tactics and cornering stocks.

?The issue in the past is that things called themselves hedge funds but they were really punters and insider traders, so there was scandal after scandal,? says Shen Yi, a former trader at Goldman Sachs who now runs his own onshore fund, Shenyi Shanghai Investment. ?Regulators were sceptical with good reason.?

For example, Ningbo, a city near Shanghai, is famed in hedge fund circles for its?zhangting gansidui?or ?limit-up kamikaze? investors. These managers would get a small group of friends to buy into a stock, then talk up its prospects to a wider group of friends.

The second group, who were in fact being duped, would rush to buy the stock and the manager would reap his profits by offloading his holdings when the stock hit its ?limit up? ? the maximum it could rise in a single day.

There are hedge fund managers operating in China today, even some large well-known ones, who have taken this approach many times, brokers and investors say.

The markets retain many murky aspects in spite of regulators? efforts to clean them up. The China Securities Regulatory Commission launched a crackdown on insider trading last year that has reached to the top of many of the country?s biggest funds. Ma Le, manager of Bosera Funds, and Yang Yi, deputy manager of Merchants Fund, are among those under investigation, according to state media. Ten people have already been detained, with more likely.

Despite the risks, there are big advantages to putting money into funds able to invest in China?s markets directly. There are more than 2,500 listed companies for managers to choose from when investing onshore, while those who try to play China offshore have only 160 or so listed in Hong Kong or the US.

?There is a very high dispersion between the returns on different Chinese equities, so there are real opportunities for stockpickers,? says Max Gottschalk, chief executive of Gottex Penjing, a Hong Kong-based fund of hedge funds. ?Domestic funds certainly have an edge, those that have invested on the ground in local analysts who can do proper due diligence and site visits.?

There are only a handful of such funds around. Industry experts believe that about half the assets in Chinese hedge funds, or roughly $15bn, are held by just 20 funds. It may be even fewer than that. Eurekahedge estimates the assets in onshore funds at just $3.1bn.

Adrian Harrison, a director in HSBC Prime Finance in Hong Kong, says the industry remains small and concentrated. ?When you get down to the 20th-biggest fund, you?re talking about only Rmb1bn in assets under management. The 10th biggest would be about Rmb3bn in assets,? he says.

This concentrated market makes knowing with whom exactly investors are placing their money ? their history, background and their connections ? even more important than perhaps any other market.

Some funds set up with the backing of a respected western institution have quickly won a client roster of the biggest endowments and pension funds in the world. Their initial backer acted as a form of quality assurance.

Hillhouse, which is more like a private equity fund that backs internet and technology companies, took this approach with initial support from Yale University?s endowment. Keywise, an equity long-short trader headquartered in Hong Kong but focused on China, similarly won a big following because it was backed by Harvard?s endowment, according to people who know the firm.

There are other ways to become comfortable with local managers. Brian Ingram, who conducts due diligence on funds in China, is taking an anthropological approach ? systematically building a detailed picture of fund managers and their networks.

A tall, softly spoken American, he works in Shanghai for an investment joint venture between Russell Investments of the US and Ping An Asset Management, part of the Shenzhen-based financial services group.

?In China, it may be that certain participants have greater influence on what goes on in the market,? he says. ?We want to understand who managers are, who they worked with in the past, who else do they know about, who else trades in the market and what is their experience. We also want to know who they trade with and why, where did their seed capital come from? All of these things could affect their adoption of certain strategies and their motivation for trading.?

The aim is to weed out those managers who are simply repeating, perhaps unthinkingly, the same strategies adopted by their previous employers. It is also to avoid managers whose trading might be skewed by the influence of a particular broker or backer.

There are also more mundane barriers to investment. David Walter, head of hedge fund research in Asia at Paamco, a global hedge fund investor, says the tax treatment of investments onshore ? and much of the regulation around fund structures and what managers can do ? remains too uncertain.

China?s government does want to deepen and broaden its financial markets and the institutions that act there. But it wants to encourage its own institutions and avoid the colonisation of its markets by an army of foreign players, in the words of one manager.

The ultimate aim may be clear but as with everything in China, the timing of rule changes to give clarity to the industry and investors remains uncertain. ?When you talk to the bulls they say this will be sorted out in six months,? says Mr Walter. ?When you talk to the bears they say you?ll still be waiting in five years.?


Chinese hedge funds Q&A

What is a Chinese hedge fund?

Until recently Chinese hedge funds in the conventional sense existed only outside the country, largely in Hong Kong. Their strategies were based on the Chinese economy but they invested in overseas-listed Chinese companies and global commodity markets. There was no formal way for funds to register themselves in China. They lacked the most basic tools, such as an ability to short shares. So-called onshore hedge funds were more buccaneering, going long-only and somehow making money off their wits or inside information. Policy constraints are now easing and a real hedge fund industry in China could be set to take off.

Who are the big players?

There are two groups vying for the Chinese market. First, there are the Hong Kong-registered firms that resemble hedge funds in more developed markets, such as Keywise and Prime. Second, there are funds that have grown up purely within China such as Zixi and Chongyang. These were mostly registered as ?sunshine funds? on platforms provided by trust companies, an arrangement that regulators believed made them more transparent. With shorting not possible, they followed long-only strategies but often still managed to make double-digit returns, some profiting from insider information and market manipulation.

Why the excitement?

Regulators have decided that hedge funds have an important role to play in deepening and stabilising financial markets. They are creating tools for investors and companies to hedge. In 2010 they launched a future based on the 300-biggest listed stocks in the mainland. They have also begun a trial programme that lets investors short a limited pool of individual shares. People in the hedge fund industry expect that stock options and a wider array of index futures could be launched as soon as this year. The government enacted an investment law in June that allows hedge funds to register as such for the first time and to raise money directly from investors.

What are the hurdles?

The government remains fearful that hedge funds could cause market turbulence. So while giving them more tools, it has also used controls to restrain them. To short individual shares, companies generally need to borrow them from a central clearing institution, which costs a prohibitive 8 per cent or so. Moreover, the number of stocks eligible for shorting changes significantly each day.

Another big hurdle is investors. It is easy to find investment products in China promising returns of 15-20 per cent, and many assume that these are risk-free investments. Hedge funds say they face an uphill battle in persuading investors that, first, it is important to take positions to manage risk and, second, that 10 per cent a year is a healthy return.