SHANGHAI/HONG KONG, March 15 (Reuters) - China's

computer-driven "quant" hedge funds are beefing up risk

management and retooling their portfolios to conform to the

state's definitions of fair play, as regulators clamp down on

the $260 billion sector to revive retail investor confidence.

Hedge fund Leon Capital said it will monitor liquidity risks

more closely, JoinQuant has reduced its exposure to

small-capital stocks, Lingjun Investment has committed to a

"bullish stance" on Chinese equities and Siyuan Quant said it

would invest in hi-tech companies to "service national

strategy".

The crackdown on funds using statistical models and computer

algorithms to make trading decisions follows a February market

crash dubbed China's "quant quake", reminiscent of a

machine-driven 2007 Wall Street selloff that preceded the global

financial crisis.

China's stock market plunge to five-year lows showed how

statistical quant trading models can lead to market herding and

stampedes. Retail investors, who account for more than 70% of

trading, railed at programme traders and "flash boys" who flip

shares in nanoseconds for quick profits.

Funds are now girding for the reshaping of a sector that has

thrived by exploiting China's market inefficiencies and

volatility, as regulators prepare to publish further curbs,

according to people familiar with regulators' thinking.

Regulators are walking a tightrope between efficiency and

fairness, as China's increasingly deregulated market has already

lured global quant giants including Man Group, Two Sigma and

Winton.

Wu Qing, the new head of the China Securities Regulatory

Commission (CSRC), has zeroed in on quant funds, an industry

that had doubled in three years despite punishing losses in the

broader market.

"We must pay high attention to fairness... especially in a

market dominated by small investors," Wu told a press conference

on March 6, vowing to enhance regulation of quantitative

investment.

In his first month at the helm, the CSRC has restricted

short-selling, suspended Lingjun accounts for disrupting market

order and punished another quant fund for high-frequency

trading.

"Frequency, leverage, short-selling - these three words have

become sort of taboo" in public discussions for hedge funds,

said Alfred Zhu, marketing director of Cedar Capital, a

Shanghai-based quant fund manager.

'TRAINING AND ADMONISHMENT'

Following its punishment by the regulators, Lingjun said it

was "deeply sorry" for the negative impact of its trading,

committed itself to a long-term "optimistic view" on China

stocks and vowed to "improve trading models, rigorously control

trading progress and constraints and ensure a smooth and

balanced trading process".

Leon Capital will beef up monitoring of market signals such

as liquidity, volatility and stock index-futures spreads, said

the firm's general manager, Ji Yanhong. "If you sense market

dangers early, you don't panic."

Siyuan Quant founder Wang Xiong said China's quant quake was

caused by computer models guiding too much money into rising

small-cap stocks, so that "when the boat capsized, everyone was

found standing on the same side".

"We need to pay more attention to company fundamentals" in

constructing models, rather than just price and volume. We will

use advanced technology to invest in hi-tech companies to

service national strategy and the real economy."

China's 28 leading quant fund companies were summoned to

Shenzhen on Feb. 29 for compliance training by the exchange,

said two people with direct knowledge of the event.

All the big players went, "as compliance is a priority now,

given Lingjun had just been penalised," one of the sources said.

"It was a good opportunity to communicate directly with

regulators."

At the session, organised by the Shenzhen and Shanghai

exchanges, regulators urged participants to strengthen risk

control, warning against misbehaviour such as spoofing and "pump

and dump" tactics, the source said. "It was both training and

admonishment."

The CSRC and the exchanges, which enforce much of the

regulator's policies, did not reply to Reuters requests for

comment.

'TUSSLE' OVER PROGRAMME CODES

China's private quant fund industry sprang up in 2010, when

the country launched its first stock index futures, providing an

essential shorting tool for hedge funds seeking to profit from

price falls. Since then, the market has attracted Wall street

traders and data scientists in search of "alpha", or

outperformance.

Quant fund giant Yanfu Investments told investors at a

roadshow on Feb. 27 that it is not engaged in high-frequency

trading and does not "trade intensively near market open and

close".

"Regulators hope trades don't impact markets, and we're

moving toward this direction," said Vice President Huang Si

Mindi.

In addition, the watchdog has been asking quant funds to

hand in programme codes for closer scrutiny, said a person who

has been in touch with regulators.

"There has been a tussle over this," the person said. "Hedge

funds see codes as business secrets. Regulators argue it would

be safe in the hands of government."

The Beijing Fund Town Research Institute says quant

algorithms can be "partially" transparent. "Being totally

transparent is too costly and not realistic," it said in a white

paper.

Jack Schwager, head of research at FundSeeder Technologies,

said Chinese restrictions on short-selling of stocks - an

essential tool for hedge funds - do not help the market.

"There is nothing inherently wrong in short selling," said

the author of "Market Wizards". "Stocks go down because of

negative or deteriorating fundamentals... Critics of short

selling are basically scapegoating."