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HONG KONG (Reuters) - For investors in Asian hedge funds, it was China and not the region's hottest major market, Japan, that provided the best bang for the buck in 2013 - a result set to ensure greater capital inflows into steadily growing China-focused funds.
Scoring with heavy bets on Internet, tech and casino stocks, hedge funds investing in the Greater China region gained an average 20 percent last year compared to a flat MSCI China .MSCICN index, their best showing in five years.
By contrast, Japan-focused equity funds gained an average 26 percent last year, data from Eurekahedge showed, lagging a 29 percent rise in the Nikkei 225 index .N225 in dollar terms - a performance similar to low-cost exchange traded funds and insufficient to justify hedge funds' hefty fees.
The outperformance helped encourage Chinese capital to emerge as a growing force in an industry that is dominated by U.S. and European institutions such as pension funds and endowments.
China funds will also likely build on net inflows last year as top performers such as Avant Capital Eagle Fund and LBN Advisers China fund lure investors. Eurekahedge estimates China funds raised a net $1.2 billion in 2013, which compares with net outflows of $323 million for Japan funds.
But a repeat performance by Chinese managers as a group this year will be difficult as valuations for so-called new economy sectors have become stretched, some industry experts say.
"Some of the long-lasting winning sectors and stocks could see sudden breaks," Theodore Shou, chief investment officer of Skybound Capital in Hong Kong which invests in China-focused hedge funds.
Chinese IT companies as measured by the IBES MSCI index are trading at 25 times forward 12 months earnings, a hefty premium over the MSCI China Index that trades at just 8.9 times.
Investor favourite Kingsoft Corp Ltd (3888.HK), an entertainment software firm, trades at 30 times, 181 percent higher than its 5 year median price to earnings ratio. Internet giant Tencent Holdings Ltd (0700.HK), which saw its market capitalisation top $100 billion last year, trades at nearly 35 times.
Shou added that fund managers will have to place a greater emphasis on stock selection, as opposed to sector selection, this year.
Short positions in sectors such as commodities and in state-owned companies also helped China funds, portfolio managers and investors said.
"Resources are being allocated away from a lot of fixed-asset investments, commodities, real estate into what we call the new economy, namely a lot of alternative energy, Internet, software, environmental related stuff," said Benjamin Chang, chief executive officer at LBN Advisers Ltd.
His firm, which earned a 40 percent return in its $250 million long/short fund, profited from short positions in companies such as Yanzhou Coal Mining Co Ltd (1171.HK) (-45 percent) and Zhaojin Mining Industry Co Ltd (1818.HK) (-63 percent).
Winning picks included Tencent (+99 percent), Kingsoft (+309 percent) and waste-to-energy company China Everbright International Ltd (0257.HK) (+165 percent).
One of the top performers, Avant Capital Eagle Fund, gained a stunning 200 percent-plus last year through bets on small and mid-cap stocks, its chief investment officer Raymond Jook said.
Among the biggest China hedge funds, winners included the $2 billion Dragon Billion China Fund which gained 11.2 percent through the end of November, the fund's newsletter showed.
Others include the $120 million Springs China Opportunities Fund (+36 percent), the $92 million Legends China Fund (+39.3 percent) and the $70 million Dalton Greater China Fund (+31.9 percent through Dec 27), according to data confirmed by their money managers.
Dalton's returns partly came from its exposure to Taiwanese chipmaker Himax Technologies Inc (HIMX.O), which benefited from Google Inc (GOOG.O) taking a small stake in its display unit, said Tony Hsu, a portfolio manager at Dalton Investments.
The stock, which the hedge fund started betting on in 2011, rose 513 percent last year.
Gaming companies were also big winners for Dalton as Macau raked in $45 billion in gambling revenue in 2013, nearly 20 percent more than a year earlier. Galaxy Entertainment Group Ltd (0027.HK) rose 129 percent and Melco International Development Ltd (0200.HK), rallied 216 percent last year.
Editing by Edwina Gibbs