Room for growth: hedge funds in the Asian milieu

Against a background of boom times, Weiping Chen from the Judge Business School, University of Cambridge, discusses the prospects for the Asian hedge fund market

Traditionally, Asians have held mixed feelings toward hedge funds. On one hand, speculative trading, especially the attacks initiated by large global macro hedge funds such as George Soros' Quantum Fund and Julian Robertson's Tiger Fund, was blamed by government officials across the region for Asia's worst financial crisis in 1997 and 1998, which swept away hundreds of billions of dollars of wealth.

Dr Mahathir Mohamad, the former Malaysian prime minister, is well known for his outspoken criticism of Soros's and other hedge fund managers' speculation.

Yet on the other hand, Asian investors started to understand that "there are different types of hedge funds, and a lot of them aren't half as risky as they are perceived," says David Zobel1, a managing director of Deutsche Asset Management in London. When the Asian investors are frustrated by low interest rates and bond yields, and volatile stock markets, they begin to add hedge funds to their portfolios.

In fact, both institutional and individual investors have witnessed a boom of hedge funds since the late 1990s, although the marketplace is still dwarfed by the dominance of US and European players. (Citing information compiled by the Financial Times, CFR finds that, in early 2005, there were around 1,000 hedge funds focused on European activities with $250.7bn assets under management. The majority of these fund managers are in the UK, holding a 74.44% market share in Europe.)

Alexander Mearns, chief operating officer and director of Eurekahedge, an alternative investment consulting firm based in Singapore, says: "In the last three-and-a-half years, we have seen Asian hedge funds grow beyond anyone's wildest imagination."

Jim Rogers, the co-founder of the Quantum Fund, says: "Everybody is setting up a hedge fund. I am told a new hedge fund is being set up in Asia every other day." 2

In 1995, only five hedge funds joined the industry in Asia. However, according to Eurekahedge, there were 162 Asian hedge funds in 1999 managing $13.8bn; in 2003, the number increased to 380 with $34.5bn under management; in 2004, there werere more than 500 hedge funds managing in excess of $59bn. More than 100 new funds were started in the first 11 months of 2004 alone, most of them setting up in Japan, Hong Kong, and Singapore.

The example of California Public Employees' Retirement System (CalPERS), the largest US pension fund with $207bn under management, may demonstrate the attraction of the Asian hedge fund market.

Recently, a CalPERS' representative visited Hong Kong-based Vision Investment Management and KBC Alpha Asset Management in Singapore. They also met with fund managers at Sparx Asset Management in Tokyo.

Asian hedge funds are usually small businesses. According to a Eurekahedge report in April 2003, 70% had less than $50m under management and one-third of funds managed less than $10m.

In Asia, even managers who are very credible to a new operation find it difficult to achieve scale quickly.

There are several reasons for the limited scale of Asian hedge funds. First, the Asian hedge fund industry is young: fewer than 100 funds have been running for more than three years. The supply of fund managers with a good track record and reputation from existing firms is limited.

Furthermore, experienced professionals from US, Europe, and Australia are not keen on moving to Asia. Therefore, good fund managers are scarce. Secondly, many allocators are unfamiliar with Asian capital markets, which vary widely from country to country. Allocators are also less comfortable with strategies in this region.

rationales

The investments pouring into Asian hedge fund market are not irrational. The main reasons for the Asian hedge funds boom include:

• High growth in the region

Compared with the West, Asian countries enjoy certain advantages: increasing populations, evolving markets and growing middle-class consumer sectors.

The ratio of private companies to public ones is much lower than in Western countries, indicating that Asian markets still have great potential. The US, meanwhile, is plagued by its record trade and budget deficits and the dollar depreciation. Europe is also troubled by slow economic growth and high unemployment.

"Over the past few years, east Asian economies have provided a strong impulse for world trade," said Jean-Philippe Cotis, chief economist at the OECD, who added that Asia's "steadying influence should not be overlooked" amid global uncertainties.3

Another indication of the high growth rate in Asia is the surprising equity market performance. The Thai stock market gained 17% in 2002 and another 117% in 2003. In Indonesia, shares rose 8% in 2002 and 63% in 2003. Malaysian shares jumped almost 23% in 2003.

• Inefficient financial markets

Compared with the sophisticated equity and debt markets in New York and London, Asia's capital markets are underdeveloped and less liquid, which has attracted more and more large institutional investors to explore mis-pricing opportunities.

• Undeveloped hedge funds industry

Currently, Asian hedge funds only hold about 6% of the $1trn assets controlled by hedge funds. At the same time, Asian equity markets make up slightly under 16% of total market capitalisation of all of the world's listed companies. There is an obvious potential for the undeveloped Asian hedge funds to grow.

performance

After an astonishing 30% gain in 2003, Asian hedge funds did not perform well in 2004. The average return in the past year was merely 5%, according to ABN Amro. "In a very strong market environment like we've had this year in much of Asia," says Zobel in 2004, "hedge funds tend to underperform, just as they outperform in a very difficult environment."

However, Eurekahedge points out that the performance was still far better than US/global hedge funds in 20044.

Money flowing into Asian hedge funds had risen from around $15bn in 1999 to a little more than $20bn in 2002, before leaping to more than $40bn in 2003 and $60bn in 2004, according to Eurekahedge.

But returns fell, as measured by the ABN Amro Asian Hedge Fund Index, which fell from about 27% in 2003 to a little more than 5% in 2004. The ABN Amro Japan Hedge Fund Index produced similar results, falling from producing nearly 20% in 2003 to a little more than 10% in 2004.

Nevertheless, Asian hedge funds (as represented by the ABN Amro Eurekahedge Index) outperformed global/US hedge funds (as represented by the CSFB/Tremont Hedge Fund Index), recording 23.1% against 13.2% for the CSFB/Tremont index.

To explore more mis-pricing opportunities, some hedge funds abandoned the traditional long/short strategies and moved to more risky assets. It is reported that, in the past, Asian hedge funds invested 70% of their portfolio in long/short equity funds. Today, only 50% of Asian hedge funds' money is in that strategy, with the rest in riskier areas.

The trend demonstrates that hedge fund managers are moving away from plain vanilla long/short to more sophisticated arbitrage and quantitative funds to explore all sorts of market inefficiencies.

For example, ABN Amro's Singapore Office has offered the market an art-based fund of hedge funds to wealthy individuals and corporate clients in Asia. Art-based funds buy various works of art, hoping that their portfolio will appreciate in the future.

According to Dow Jones, ABN Amro Singapore's new hedge fund of funds will try to invest in at least five established art funds. Besides changing strategy to further diversified its risk, ABN Amro Singapore can broaden his investor base.

According to the rules set by the Monetary Authority of Singapore, investors must place a minimum of S$20,000 ($12,000) into a fund of hedge funds. A single hedge fund however, requires a minimum investment of S$100,000.

Another example of diversification is hedge funds' allocation to Chinese capital markets. Traditionally, Japan has been the most favoured investment target for fund managers. However, China is becoming a new hot spot, even though its domestic equity market is still immature and lacks an effective short-selling mechanism.

Most of the hedge funds focusing on China hold securities of Chinese and China-exposed companies listed on the far more liquid Hong Kong and New York exchanges, and their predominant strategy is relative value.

Qinhan Capital Management, a firm which is based in Shanghai, has gone one step further by launching multi-strategy funds in the first quarter of 2005. Qinhan invests a quarter of its portfolio in every area of China's capital markets, from its A-shares, to government and corporate bonds, to convertible notes.

To facilitate its investment in China, Qinhan even teams up with an international investment bank that has a quota under China's Qualified Foreign Institutional Investor (QFII) programme - at a considerable fee.

Due to the lack of a short-selling mechanism, Qinhan's exposure to China investment is not hedged. Furthermore, it bears liquidity risk because it takes time to convert its Chinese local currency holding into dollars.

regulatory environment

The competition between Singapore and Hong Kong to be the second-most-important Asian financial centre after Japan is intense. Both cities have tried to adjust their legal systems to encourage the cultivation of hedge funds .5

Singapore

In June 2001, the Monetary Authority of Singapore issued new guidelines, allowing hedge funds to be sold to the public, subject to a minimum subscription of S$100,000, among other requirements.6

The major structure of the other requirements include adequate and prominent disclosure in the prospectus of the high risks of investing in hedge funds and the investment manager's qualification: having at least two executives with a minimum of five years' relevant experience.

These guidelines were proposed to provide more investment choice for those who understand higher risks associated with hedge funds.

Hong Kong

The regulator in Hong Kong, the Securities and Futures Commission appointed a board to consider authorising the selling of hedge funds to a mass audience onshore.

Although the SFC proposes to establish minimum investment criteria, it does not intend to control asset allocation or degree of leverage. There will be reporting requirements to adhere to. Since the Securities and Futures Commission issued its consultation paper in 2002, the proposal has been welcomed by hedge fund professionals, with comments mainly focused on the selection of generally acceptable accounting principles.

industry outlook

Although industry performance 2004 was unsatisfactory, professionals hold a rosy expectation of further development.

Tom Ashworth, a director at KE Absolute, a Hong Kong fund-services company, believes Asia's share of the hedge funds market will grow to more than 10% of the industry's assets under management by 2007 to around $200bn.

Eurekahedge's Alexander Mearns predicts that proportion will rise even more - to around 16% in five or six years. Joanne Murphy sees no sign of Asian hedge fund activity slowing: "The industry views the compound growth in the Asian alternative market over the past three years as substantial... the industry is still growing and we anticipate this will continue," she says.7

footnotes

1 http://yahoo.businessweek.com/magazine/content/04_51/b3913155_mz035.htm

2 ibid

3 http://www.iht.com/articles/2005/05/29/bloomberg/sxpesek.php

4 http://yahoo.businessweek.com/magazine/content/04_51/b3913155_mz035.htm

5 Information was mainly summarised from Ernst & Young (2002), Starting Up A Hedge Fund In Asia. Certain requirements have been updated to reflect recent developments.

6 The minimum investment threshold was later lifted.

7 Wong and Murphy. 2005. 'Quality in abundance'. www.hfmanager.com

references

Barra Rogers Casey (2001), An Introduction to Hedge Funds. The first in the BRC Hedge Fund Series.

Ernst & Young (2002), Starting Up A Hedge Fund In Asia.

Goetzmann, W. and S. Ross (2000), Hedge Funds: Theory and Performance. Working paper. Yale University and Massachusetts Institute of Technology

Harrison, M. (2000), Hedge Funds - their contribution to securities markets. CSU - Research & Policy, HKEx.

Ineichen, A. E. (2001), The search for alpha continues: do funds of hedge funds managers add value? UBS Warburg

Jaeger, L. (2001), Risk Management for Multi-Manager Portfolios of Alternative Investment Strategies. AIMA Newsletter.

Ridley, M. (2004), How to invest in hedge funds: an investment professional's guide. Kogan Page

Soueissy, M. and R. Sidani. (2003). The Risks Underlying Hedge Funds Strategies. Masters dissertation. HEC. Université de Lausanne.

Staff Report to the US SEC. 2003. Implications of the Growth of Hedge Funds.

Wong and Murphy (2005), 'Quality in abundance'. www.hfmanager.com

www.iht.com/articles/2005/05/29/bloomberg/sxpesek.php; www.washingtonpost.com/wp-srv/business/longterm/asiaecon/stories/malaysia090597.htm; www.yahoo.businessweek.com/magazine/content/04_51/b3913155_mz035.htm