Asian hedge funds eschew custody arrangements to safeguard assets

Lack of safeguards

hanuman-custody

As emerging Asian hedge funds become more popular with investors outside the region, questions are being raised about the custody arrangements – or lack of them – which are causing some concern.

Emerging Asia hedge funds are one of the most popular strategies for investors although there are significant challenges in investing into funds based in the region. Both managers and investors are keen to have exposure to the region. However, both find it can be fraught with complications, not least of which is the issue of ­custody of assets.

Service providers also express caution when dealing with the region. They say the smaller assets under management (AUM) of many Asian (excluding Japan) funds sometimes means they do not use custodians to safeguard assets.

If prospective investors view funds without custodians as operationally deficient and red-flag them, practitioners say allocations to the region could continue lagging far behind fund performance. This would mean Asia punching well below its weight for some time to come.

The financial crisis and surge of interest in Asia has thrown a sharper spotlight on emerging markets hedge funds. This has also highlighted the ability of service providers active in ­developing markets.

“This is quite a pivotal moment for custody on a global level as the market starts moving eastwards,” notes Jitendra Somani, head of global custody, Asia-Pacific for HSBC ­Securities Services.

“Significant south-south flows and a substantial amount of inflows into emerging markets in Asia present unique opportunities and challenges. A key determinant of success for service providers will be the ability to provide solutions to clients in each of the Asian markets,” he says.

“With diverse market infrastructures and different local regulatory environments, players who have an on-the-ground presence with local language skills, local timezone support and local expertise will have an advantage,” Somani adds.

Adam Wallace, the Hong Kong-based senior product manager, hedge fund services, Asia Pacific, at JP Morgan Worldwide Securities Services, says investors regard quality of fund counterparties as an important indicator of “how serious and institutionalised that fund will become”.

“In today’s competitive financial markets, primary driving factors in a hedge fund’s ultimate success include the fund’s level of institutionalisation, the counterparties it uses as well as the risk management framework and controls it sets up,” according to Wallace. “Post-financial crisis this is now fundamentally important, even more so than just performance.”

There is little point investing in a fund where assets have doubled in value if those assets are not held safely and remotely from the balance sheet of a failing bank, for instance.

Top 10 priority

Taco Sieburgh Sjoerdsma, chief financial officer of Sturgeon Capital which manages the five-year-old Sturgeon Central Asia Fund, says investors want to see one of the top 10 custody and prime brokerage names on offering documents. If those names are not present, further due diligence ensues or potential investors walk away.

“Investors want confidence and if you cannot give that you are two steps behind. It does not mean you cannot attract capital but institutional people want that,” notes ­Sjoerdsma.

“In the first two years we raised $30 million, for example, and did not work with a custodian, rather just with local brokers acting as custodians. But to get to $100 million we needed a reputable global custodian,” he adds.

Wallace says multi-primes are common in Asia but often newly launched funds have no custodian. However, he notes there is “definitely interest” particularly from funds in the range of $100 million and upwards to use a custodian to hold unencumbered assets that are not held by prime brokers as ­collateral.

“Typically, hedge funds will engage with a prime broker first and foremost to provide them with custody services [but] a growing trend is these managers then look to another custodian to park part of their assets and cash,” says HSBC’s Somani.

“As well as simple diversification, what they are looking for is a custodian who can provide the value-add services that they need such as fund administration, securities pricing, foreign exchange capability, distribution and so on,” he continues.

Asian fund managers, say practitioners, have a different mindset when it comes to enlisting service providers.

Smaller scale

The scale of the fund industry in Asia could be one reason for the difference with the funds industry in the US and Europe. Funds with over $1 billion account for less than 1% of Asia’s hedge fund assets. The average launch size in 2010 of an Asian-based fund was between $20 million and $40 million.

This is less than one third of the AUM in the average hedge fund that approaches BNY Mellon in the region for custody. Andrew Gordon, head of alternative investment services at BNY Mellon in Asia, says many portfolios are too small to justify them taking on ­independent custodians.

“Smaller managers do not have the operational infrastructure to manage third-party custodians, much as they do not have the ability to manage multiple prime broker relationships,” he notes. “There is a level of complexity around utilising separate custodians – making sure the asset being sold is being delivered to the right broker on the right day and right time, and that the cash is in the right place and so on.”

He believes the idea of using a custodian is good for medium-sized and larger managers. “That is where we see primary demand for our services. We have been mandated on assets under management as low as $75 million but in that case there was a cornerstone investor demanding good governance which for them meant independent custody and fund administration,” he says.

Managers agree the ideal scenario is having an independent custodian alongside third-party administrators and strong prime brokers.

“Institutional investors do not necessarily like managers using prime brokers [for custody] but when a manager is small there are compromises they have to make,” ­continues Gordon.

“They need an operational infrastructure that has some more depth to it. Investors are looking for controls and back-ups and quality of counterparty exposure and risk management. You have to make sure everything is in the right place and works. That is what the institutional investors want, and are demanding,” he adds.

Apart from ticking more boxes in due diligence, another important reason for Asian managers to enlist custodians with global reach is to access networks that can help funds meet with relevant regulation in geographically remote, yet important, areas where investors are located. This is the force that is “driving the industry at this point in time”, according to Chris Adams, head of hedge fund solutions at BNP Paribas ­Securities Services.

Legislation

Another issue is the growing reach and scope of legislation affecting the hedge fund industry and its operations. BNY Mellon’s Gordon says his team needs to keep abreast of regulatory changes in Europe and the US as well as Asia that could affect hedge fund clients.

“There is a regular flow of settlement changes and tax changes and foreign investor rules going on in the region but not necessarily more than we are seeing in other parts of the world. We have to keep ahead of the curve in terms of what changes are being discussed in regulation,” he notes.

“The Asian hedge fund community looks to Europe and America because most of the investors come from those markets, so having an infrastructure compliant with alternative investment fund managers directive or what is happening in the US with Dodd-Frank for example, is important,” he adds.

“The most pressing developments are going to be around regulatory changes,” agrees HSBC’s Somani. “In Asia what regulators have done is define the regulations based on who the client segment is from an end-investor perspective. In certain areas some regulators in Asia are seeking more oversight and trying to refine and re-establish the roles of ­service providers.”

International view

From an international perspective, Somani says, legislation such as the US Foreign Account Tax Compliance Act (Fatca) will have a sweeping effect. “This will clearly affect the practices of managers, and service providers will need to be ready and have the platforms in place to meet the changes. Adaptability and flexibility are key considerations for managers looking at service ­providers.”

Sieburgh Sjoerdsma from Sturgeon believes managers need a global operator “willing to expand and grow with its customer base into newly developing markets because even if you are running a run-of-the-mill fund, somewhere along the line most will look to make a small allocation to a small market, maybe a Laotian stock or something over and above Thai or Chinese ­securities.”

While HSBC’s Somani says an “onshore presence in Asian markets and ability to put a large infrastructure to service clients is becoming an important differentiator, one cannot be a credible custody provider with representative sales offices ­anymore.”

BNY Mellon’s Gordon adds that global custodians can help managers face the major challenge of recognising there is not just one homogenous Asian market but many nations and jurisdictions to understand from a business, regulatory and cultural perspective.

“Asia is an amalgamation of diverse countries, regulations and market infrastructure; there is no pan-Asian market. This factor drives trends in custody models quite significantly,” notes HSBC’s Somani.

“Managing counterparty risk, increased transparency around specific services such as FX, having local expertise and an ability to provide clients with access to that local expertise, diversification of service providers and an increased proclivity from asset managers towards outsourcing middle office functions are some of the trends determining product and service solutions for the custody industry,” he adds.

BNY Mellon’s Gordon adds: “If you take a look at the variation of market practices, settlement practices, language, legal systems and regulatory structures in the region – before we even get into different cultures – there are many.”

He says Asia markets are at different stages of development. “Some markets require foreign investor regulation to invest in India or China, South Korea and Taiwan, for example. Managers have to go through a process which may not be in itself particularly difficult or onerous, but invariably it results in the need to fill out different papers.”

China, a market many managers are eyeing, is restricted for foreign traders who must have access to a qualified foreign institutional investor (QFII) licence to trade yuan-denominated A shares and other securities listed on the mainland. “The licences are not easy to come by, and the willingness of regulators to issue them is driven by big macro as well as micro issues. There are not a lot of quotas being issued at the moment.”

The application for the Chinese QFII programme quota requires the custodian to be named, notes Gordon. As most hedge funds access China’s A share market through prime brokers that have quotas, a hedge fund rarely chooses its own custodian for the onshore market.

However, he says there are numerous other ways to access Chinese securities, including ones that allow more flexibility in picking a custodian. A “significant market capitalisation” exists in Hong Kong-based trading in H-shares of Chinese companies listed on Hong Kong’s stock exchange, for example. These are settled through the central clearing and settlement system in Hong Kong.

The depositary receipt market, comprising various companies whose securities are settled on the Nasdaq, for example, is also available as are global depositary receipts (GDRs). These settle on one of the main domestic central securities depositories (CSDs) such as Cleastream. For example, BNY Mellon’s custody unit can cater for H shares and ­depositary receipts.

Whichever emerging Asian market managers are considering, Gordon counsels to expect a lack of clarity on various issues relating to custody of assets. This will change over time but meanwhile investors and managers need to find ways of ensuring both sides are confident of the protection of assets.

 

Asia revs up for second coming

In general returns from some strategies for allocators to Asia (excluding Japan) so far this year have been healthy.

The aggregate 0.3% from the region’s industry to May 31, according to Eurekahedge data, undershot the 1.5% from funds globally. This masks the fact emerging Asian event driven funds made 9.2%, distressed debt managers generated 4.3% and fixed income made 3.9%.

The expectation of solid returns could partly explain why 38% of allocators responding to a Deutsche Bank survey in January said they would build Asia excluding Japan holdings this year while half planned holding steady. After subtracting those planning to cut allocation to the region, Asia was the second most popular region after North America.

Recently some European allocators, including notably Reyl & Cie in Switzerland and France’s NewAlpha Asset Management, sealed joint ventures with local experts to boost activity in seeding Asian funds.

Adam Wallace, the Hong Kong-based senior product manager, hedge fund services, Asia Pacific at JP Morgan Worldwide Securities Services, says this small but growing financing activity should help more managers in Asia “get up to speed” on quality of infrastructure and service provider requirements they will require to attract more institutional money.

He sees the renewed interest by remote investors in seeding as a “second attempt to access Asia. Previously a lot of fund managers from the US and Europe tried to manage funds from London or New York, which didn’t work.”

He notes, however, other reasons exist for some European and US investors to be reluctant to allocate more heavily to Asia. A major, yet simple, deterrent is “the tyranny of geography”.

To help overcome this, Wallace says, some Asian managers have established offices, sometimes including actual trading or shareholder service operations, in the UK and US, so remote allocators could conduct due diligence more easily.

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe

You are currently unable to copy this content. Please contact info@risk.net to find out more.

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here