Asia MoneyBeat

More foreign hedge funds are devoting resources to China, attracted by strong returns, the potential for growth and signs that the country will continue to develop its financial markets.

China-focused hedge funds managed $12.9 billion in assets as of the end of September, exceeding levels before the global financial crisis, according to Eurekahedge, which tracks the industry. In the nine months ended Sept. 30, average returns from China-focused hedge funds eclipsed those in neighboring countries, with the exception of Japan.

“A lot of [China-focused] offshore funds are looking towards global equity markets as a way to play out China-focused investment themes,” said Michelle Lim, vice president at Deutsche Bank AG’s Hedge Fund Capital Group, which helps Asian hedge funds raise money. Some hedge funds are also exploring ways to invest within China, and foreign investors expect further opportunities as the government slowly allows a broader range of financial instruments in its push to further develop the domestic market.

Last month, China announced a basic plan for a newly established free-trade zone in Shanghai, where it plans to conduct trials that would give foreign companies greater freedom in the country’s tightly regulated financial markets.

Regulators are expected to promote the development of a futures market for oil and allow securities and futures companies in the zone to engage in over-the-counter trading in commodities and financial derivatives in the domestic market. Separately, Hongkou, a district north of Shanghai’s glitzy financial hub, is planning to offer tax and rent incentives to attract hedge funds.

For now, foreign hedge funds aiming to invest in China’s domestically traded assets are taking baby steps. Global Advisors, a hedge fund specializing in commodities and based in Jersey in the Channel Islands, for example, aims to raise 150 million yuan ($25 million) from local investors initially.

“The futures commodities market in China isn’t big enough to trade large volumes, so that will limit for now the potential size of our fund and the number of clients that can invest” in it, said Jean-Marie Mognetti, a principal at Global Advisors. The firm doesn’t expect to make a windfall from the start. “We see our Chinese development as an investment for the long term as China is a very important market,” Mr. Mognetti said.

Foreign hedge funds can’t operate investment vehicles on the mainland but have been able to raise money locally by cooperating with fund-management companies. Last year, Winton Capital Management, the largest managed-futures firm in Europe, teamed up with Chinese asset manager Fortune SG Fund Management to tap China’s futures market.

Global AdvIsors is awaiting approval for a commodity-based mainland fund that will be managed by one of China’s largest mutual-fund managers, Mr. Mognetti said, while Global Advisors will act as the adviser. He declined to name the local manager. A Shanghai-based director has already been hired, and the firm expects to launch the operation next year.

“Foreign hedge funds in China aren’t engaged in trading or activities that we might associate with hedge funds in the U.S. or the U.K.,” said Adam J. Steinberg, director of the China chapter of the Hedge Fund Association, a U.S. industry group.

Managed-futures funds elsewhere invest in exchange-traded commodities, currencies, interest rates and equity-indexes contracts. But China’s futures market, which was only established in the early 1990s, mainly comprises commodities contracts. Hedge funds usually trade a variety of derivatives, ranging from single-stock futures to listed options, that aren’t yet available in China.

Short selling, which is popular among hedge funds, isn’t common in China because the cost of borrowing stocks is too high. Short sellers sell borrowed shares in the hope of buying them back later at a lower price.

Faced with limited investment options in China, most hedge fund managers are investing in Chinese assets traded outside the mainland. Of the 170 China-focused hedge funds tracked by Eurekahedge, roughly 110 invest in Chinese stocks trading on international markets, including in Hong Kong and the U.S.

U.S. hedge fund Dalton Investments LLC, which opened its Shanghai office in 2010, has a $60 million Greater China fund focused on investing in family-owned holding companies traded in Hong Kong. It makes few exceptions for investing in mainland listed firms.

Similarly, Paul Waide, co-founder of Shanghai-based Amalfi Capital, said his technology-focused hedge fund mainly invests in Chinese stocks listed in Hong Kong and the U.S.

“If fundamentals drove prices on the [mainland] A-share market then we would consider investing,” Mr. Waide said, adding that about 40% of mainland-listed companies are controlled by the state.