* CSRC cracking down on insider trading at mutual funds
* Mutual fund managers resigning in droves
* Three prosecutions completed, 30-plus investigations underway
* Investigation follows similar campaign in bond market in 2013
By Lu Jianxin and Pete Sweeney
SHANGHAI, July 1 A crackdown by Chinese regulators on insider trading in the country's $1.2 trillion mutual fund industry has sparked an exodus of fund managers from the industry.
The investigation is part of efforts to rebuild investor confidence in the country's lagging stock markets.
More than 100 asset managers have quit their jobs so far this year, almost twice as many as in the same period last year, according to Chinese data provider iFund. Industry sources reckoned a good many of the departures were due to fears of being caught up in the investigation.
A focus of the investigation is so-called "rat trading".
This involves fund employees using illegally obtained inside order information to front-run client orders, that is building positions in advance of a buy or sell instruction in order to take a risk-free profit when the transaction is executed.
Regulators are also investigating tip-offs by fund employees to relatives or friends on what stocks the fund plans to buy or sell, allowing them to take positions in advance.
The China Securities Regulatory Commission (CSRC) said in May that it was investigating more than 30 such cases, having concluded investigations into employees at Everbright Pramerica, China International Fund Management Co and Harvest Fund and Ping An Asset Management.
Three former managers at these fund firms, including one who worked for more of the firms, have been found guilty of "rat trading" and have been handed over to the police, the CSRC said. The penalties have not been announced, though imprisonment is a rarity in such cases.
One of the guilty who had worked for Ping An had left the company, a spokesperson for Ping An told Reuters in an email.
"The company is closely following and supporting the unfolding of the 'rat hunt' campaign," the spokesperson said. Ping An said employees are banned from directly or indirectly trading stocks.
The other companies did not comment when contacted by Reuters.
Fund managers said the problem was rampant but declined to give details, saying they were not allowed to discuss it with the media.
One fund manager said he expected the results of the probe to be released over time, and could involve some big names.
"The results will be announced gradually, possibly surprising the market since they are related to some industry stars," the fund manager said, requesting anonymity to avoid falling foul of the market regulators.
China has the world's 10th biggest mutual fund industry, with official Chinese data showing it is home to 91 mutual fund companies, with 680 funds managing 7.25 trillion yuan ($1.2 trillion) worth of assets as of the end of May, 2014.
The industry also boasts one of China's highest average annual salaries of over 1 million yuan ($160,300) per year, though fund managers have struggled to justify their earnings given the poor performance of equities in recent years.
CLEANING OUT THE RATS
More than $1.4 trillion - equivalent to 16 percent of China's gross domestic product in 2013 - has been wiped off the value of the Shanghai and Shenzhen exchanges since the Shanghai composite index peaked at 6,124 points in October 2007.
The index has declined over 60 percent from that peak, a performance completely at odds with China's rapid economic growth over that time, and contrasting with rallies seen in other Asian stock markets.
One reason domestic investors avoid the stock market in general is the widespread suspicion that the exchanges are platforms for insiders to fleece ordinary investors.
"Recent investigations showed that inside trading is still a prominent problem in the asset management industry," CSRC spokesman Deng Ge said at a recent press conference.
The mutual fund investigation follows a similar one last year into the trading practices in China's bond market.
It also follows the CSRC's prosecution of fund managers at Everbright Securities in the aftermath of the stock market "flash crash" in September, during which Everbright employees hedged against the impact of their own trading error at the expense of retail investors.
"From bonds to funds, regulators want to squeeze out irregularities in the capital markets to pave the way for further expansion," said Wang Ming, head of marketing at Shanghai Yaozhi Asset Management Co.
"The clean-up of the fund industry also aims to expand the cohort of institutional investors in the stock market; China's bond market is already dominated by institutions," he said.
Institutional investors, mainly mutual funds and brokerages, hold just 10.87 percent of listed Chinese stocks, CSRC data shows, whereas they hold the majority of shares in most developed markets.
If investor confidence in China's stock markets is restored , the prize would be substantial.
Investors have scorned Chinese equities, preferring housing and high-yield bonds instead, leaving China with one of the world's worst performing stock markets since markets elsewhere began recovering from the global financial crisis.
The speculative investment in housing and high-yielding but obscure wealth management products has produced economic distortions, and Beijing wants the stock market to be a viable alternative for both companies and investors.
Besides the regulatory clean-up, the CSRC is also liberalising the funds market and has just issued new guidelines that loosen derivative trading regulations, aiming to encourage innovation and promising to let in more foreign firms.
At the same time, the latest version of China's fund law, promulgated in June 2013, permits fund managers to trade stocks on their own accounts for the first time under tight conditions.
($1=6.21 yuan) (Editing by Nachum Kaplan and Simon Cameron-Moore)