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Do Hedge Funds Deliver What They Promise?

_{MARCUS STORR, HEAD OF ALTERNATIVE INVESTMENTS, FERI TRUST GMBH}

The year 2022 is one of the most turbulent years in the last decade, not only from an economic point of view but also from a political one. In this environment, there are several trends in the hedge fund industry that we have observed.

Competition for talents

The boom in technology development has enabled hedge funds to develop new computer-based quantitative strategies as well as strengthen their operation and execution capability. However, it has resulted in strong competition for talent between hedge funds and technology companies. The two industries are involved in a high-stake war for talent, hiring skilled mathematicians, physicists and computer scientists from each other. According to Revelio Labs, there has been a notable uptick in industry crossover recently, after hedge funds fell behind Big Tech between 2012 and 2014. The hedge fund titans such as Two Sigma, Citadel and Bridgewater possess special competitive advantage thanks to their size, and most probably their ability to pay.

Growth and distribution of hedge fund assets under management

FERI estimates that at the end of the second quarter of 2022 the hedge fund industry managed around $4 trillion in assets, with 66% of the assets under management belonging to hedge funds in Americas, 20% belonging to hedge funds in Europe, the Middle East and Africa, and 12% belonging to hedge funds in the Asia Pacific region.

Total assets under management have been increasing every year since the Great Financial Crisis in 2008, suggesting strong demand for hedge funds globally. However, the demand for UCITS-compliant hedge funds, which are popular amongst European investors, dropped sharply in the first quarter of 2022 with a decline of 4.5%. For most German institutional investors, hedge funds remain a sector only to be touched with caution. Based on the results of a 2022 survey by BAI, the main German lobbying body for the alternative investment industry, only 16% of the surveyed investors held investments in offshore hedge funds, with 17% invested in ‘liquid alternatives’ i.e. hedge-fund-like strategies in a UCITS format, whereas most of the investors loved real estate (77%) and private equity (75%).

The distribution of hedge fund assets is strikingly disproportionate, with a small number of funds managing most of the assets. The largest 15% of hedge funds (each with more than $500 million in assets) manage 90% of the total assets figure.

Hedge funds in elevated volatility environment

When global hedge fund returns are placed next to global equity returns, it is obvious that in the last decade hedge funds have been able to capture gains in up-markets and reduce losses in down-market. In 2022, with both equity and bond markets suffering from heavy losses, well managed hedge fund performance has been flat or even positive. Within the hedge fund industry, performance varies among different strategies in a wide range. Fundamental equity long/short, for example, has had a difficult year this year down 10%, which is still much less than the loss incurred in equity markets, thanks to the significant alpha contribution of the short book. In contrast, systematic macro and CTA funds have been flying since the beginning of 2022 and delivered on average returns of 14%, with many trend following strategies achieving high double-digit performance. All in all, it is safe to say that a market environment with elevated volatility, frequent dislocations and high dispersion like the one in 2022 provides an excellent environment for the hedge fund industry.

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Investing Into Offshore Hedge Funds Under German Regulation

_{MARTINA NITSCHKE, HEAD OF INVESTMENT DEPARTMENT AT VERWALTUNGSGESELLSCHAFT FÜR VERSORGUNGSWERKE MBH, BERLIN}

Martina Nitschke is Head of Investment Department at VGV – Verwaltungsgesellschaft für Versorgungswerke mbH, Berlin, which represents the interests of different professional pension funds in Eastern Germany and is responsible for the management of €16 billion in assets. She started with VGV mbH in 2003 and took over responsibility for the general capital allocation, and allocation to alternative investments, in 2018. The current alternative investment portfolio of VGV includes timber, infrastructure, private equity and offshore hedge funds. In her interview with Uwe Lill, Managing Director of GFD – Gesellschaft für Finanzkommunikation mbH, she discussed different aspects of offshore hedge fund allocation and how it could be done within the framework of the German Insurance Supervision Act (VAG). 

The current regulation allows pension funds and insurance companies in Germany to invest a maximum of 1% of their assets into a single hedge fund and 5% in fund of funds. Moreover, there are strict requirements regarding transparency, manager selection and the due diligence process, as well as risk management. The conservative, partly negative stance of investors in Germany towards hedge funds due to regulatory restrictions is not rational, according to Mrs. Nitschke. The so-called VAG-quota and hedge fund investment are fully compatible. Within the scope of VAG, a diversified investment in offshore hedge funds can be implemented efficiently. However, investors would need the help of legal and tax advisory, as well as a dedicated team to conduct due diligence on target funds, including economic, operational assessment and anti-money laundering scrutiny.

In her 20 years at VGV, Mrs. Nitschke has attempted to integrate hedge funds into her portfolio multiple times, both offshore and UCITS, but didn’t find noteworthy success. She and her investment team decided to give it another try, this time with the help of a professional hedge fund advisor. The attempt proved to be fruitful. Since inception in the middle in early 2021, the hedge fund allocation has delivered positive performance and has helped to stabilize the performance of the entire portfolio. Although the hedge fund allocation is not significant in a total portfolio context, the performance contribution is significant. According to Mrs. Nitschke the general alternative investment quota is expected to be further increased, including the hedge fund allocation.

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Fundamental Investing and Corporate Events in Europe

Opportunistic, selective and uncorrelated alpha

^{KAVEH SHEIBANI, CO-FOUNDER, LEXCOR CAPITAL LLP, LONDON}

Lexcor founders, Kaveh Sheibani and Nicholas Gourdain, aim to compound at 10% per year and protect their own capital and that of their external investors. They have surpassed this target and are up double digits in the first eight months of 2022.

The strategy does not easily fit into a standard bucket because it combines long/short equity with hard catalyst event-driven investing, synthesizing the two partners’ more than four decades of experience. 

Their personal approach is based on tried and tested common sense principles and builds on their multicultural and multilingual backgrounds. Sheibani left Iran in 1978 and has lived and worked in the US, France and UK, while Gourdain is half French, half Greek and educated in France. Sheibani speaks Italian, French, English and Farsi while Gourdain speaks Greek, French, German and English. 

The partners have formed a strong bond and Sheibani was at one stage invested with the long/short equity fund Montrica, where Gourdain worked. Gourdain was latterly head of research for Europe at TPG Axon after it acquired Montrica.

Sheibani co-founded and was co-CIO of the event driven fund Pendragon, which spun out of Salomon Brothers, which had been acquired by Citigroup at the time. At Salomon Brothers he believes they were one of the only prop trading team that worked on a co-portfolio management model running one book. 

This approach continues. The pair co-founded Lexcor in 2017, with a co-portfolio management structure where the duo get on well, intensely debate ideas and agree on all positions. This process guards against prejudices and behavioural biases such as confirmation bias. Lexcor is supported by three analysts, a marketing person, and Marble Bar for its infrastructure.

Fundamental criteria combined with catalysts

The long book, focused on 12-15 positions typically sized between 4-10%, has been the largest engine of returns. It blends event and catalyst filters with fundamental stock-picking criteria. Lexcor like sustainable cashflows, growth, quality and strong balance sheets. They seek companies that have a sustainable competitive edge through concentrated markets and high barriers to entry that create pricing power; they also give a high importance to management integrity. Share price targets under bull and bear scenarios are determined with a 4–5-year view and updated at least quarterly. Sometimes the bear case is above the current share price.

Catalysts sought could be fundamental or external. A recent example was a spin-off that highlighted a “sum of the parts” valuation anomaly. After a food ingredients firm, disposed of a commoditized corn starch business, its higher growth nutrition ingredients business was left at a much cheaper implied multiple than the peer group and was also seen as a takeover target. 

A more diversified and tactical short book

The short book is smaller, more diversified and has smaller positions. It is spread across 20-25 positions, typically between 0.5 and 2%. If a short position grows to c. 5% it will typically be reduced or cut. The shorts are not hedges for longs but are intended to make absolute returns and have done so.

Shorts have the inverse characteristics of longs: no pricing power, stretched balance sheets, deteriorating margins, aggressive accounting and sometimes even fraud. Price targets for shorts can sometimes be zero. Portfolio turnover is higher in the short book, with more tactical trading and attention paid to technical considerations such as short interest, which funds are short, and the risk of “meme stocks”. Corporate events that could complicate shorts, such as rights issues, special dividends and spin-offs, are also monitored.

Net long with tail risk hedges

Lexcor do not take a directional view on the market and maintain a net long equity exposure of 55-70% based on a bottom-up approach, though this is typically reduced to about 40-60% by tail risk hedges in the form of puts on European equities (or sometimes CDS-s). The puts and CDS-s generated a 10% gross return in March 2020, and the tail risk book has contributed positively since inception – though in more normal markets it is expected to be an expense.

The tail risk hedges are also designed to help the managers stay calm, sensible and objective since stress can upset perception of risk and lead to bad decisions. No meaningful leverage is used.

Cherry-picking event driven opportunities 

The opportunistic book is true to its name: sized between 0 and 30% of gross exposure, depending on the opportunity set. It has been uncorrelated to the long/short equity book and can sometimes even be counter cyclical when risk off periods throw up more dislocated situations.

This opportunistic sleeve can invest in merger arbitrage, holding company discounts and share class spreads, and is very selective. Monitoring every spread would be a full-time job which Sheibani has done before. Now Lexcor keeps a radar screen to cherry-pick opportunistic situations and in 2022 the book is having its best ever year, from just three positions: two equities and one corporate bond.

All four books have generated positive performance since inception, with longs making most, opportunistic second, shorts third and tail risk fourth.

German property and corporate governance

One multi-year theme around German real estate involved five different companies, with some winning and losing positions and several reshuffles in response to events.

The fundamental thesis included asset values below replacement cost, demand exceeding supply, limited cyclicality and potential for rent increases. The last of these was threatened by plans for a Berlin rent freeze, which led Lexcor to exit one position at a profit in 2019. They later returned to the space with two holdings at deep discounts to NAV that they expected to be acquired. Lexcor also accurately anticipated that within two years the constitutional court of Germany would overturn the rent freeze that was implemented in Berlin. But one position was wrong footed by a corporate action that neglected the interests of minority shareholders. The loss was relatively small since the holding had been downsized due to corporate governance concerns, and with hindsight Lexcor wish they had fully exited.

Incidentally, remedying the corporate governance weaknesses would have been too ambitious. Lexcor is very seldom overtly activist but does engage more discreetly in an active dialogue, sharing what it believes are constructive suggestions behind the scenes. One exception was when Lexcor had an 11% position in a firm that received an opportunistically low takeover bid during Covid, and Lexcor led the negotiations that secured a higher offer. In any case Lexcor prefers to work behind the scenes and avoid investments in companies where it is necessary for it to lead a public activist campaign given the disproportionate amount of time and commitment such a process can require relative to other investments in the portfolio.

Returning to real estate, when an anticipated takeover materialized with virtually no premium to net asset value, Lexcor decided to invest in the acquirer, but also developed concerns about its capital allocation policy since raising capital through a discounted rights issue when its shares traded at a discount to net asset value, seemed perverse when assets could have been sold at a premium. 

The biggest risk for this sector turned out to be geopolitical and macro: after Russia’s invasion of Ukraine, and rate rises, the whole German real estate sector pulled back.

Holding company discounts and restructuring

A successful 2022 trade involved one of the largest and most complicated global holding company structures, with three listings in three countries in three currencies, each of which was valued at over USD 100bn. 

A South African company, Naspers, traded at a deep discount to its stake in a Chinese technology firm, Tencent, partly because it had become a very large part of the South African index, which forced selling by institutions subject to weighting caps. To shrink itself and reduce the discount, the SA firm initially set up a second holding company Prosus listed in the Netherlands and then further downsized by offering Naspers shareholders the chance to exchange into shares in the new holding company.

The terms of the tender and conversion offer were potentially lucrative for arbitrageurs able to source the right sort of stock borrow, as that would enable them to set up an attractive arbitrage provided the exchange would close successfully, which was highly likely.

Lexcor was able to take advantage of this arbitrage opportunity. Less than a year later and a second opportunity arose as the discount of the holding company had gone to the widest levels it had ever been post the Russian invasion of Ukraine. The widening of this spread and the risk of Naspers and Prosus having too much concentrated risk in Tencent spurred their management team into action. In June 2022, Prosus announced its plans to sell down its investment in Tencent and use the proceeds to buy back shares in Prosus. Following the announcement, the discount of Prosus to its net asset value rapidly contracted from over 50% and traded between a discount of 30% and 40%.

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Commodity Investing in a Shifting World Order  

Opportunities for a dynamic and tactical approach

^{MARWAN YOUNES, PRESIDENT AND CIO, MASSAR CAPITAL MANAGEMENT}

Marwan Younes founded Stamford, Connecticut based Massar Capital Management in 2015, having previously worked for Jamison Capital Management and Graham Capital Management. Massar runs over $1 billion in discretionary macro strategies. 

Younes sees economic shifts, policy shifts and slowing growth creating a more volatile and sometimes unpredictable climate for directional and relative value investing in commodities, but a rich opportunity set for nimble traders who can think outside the box and be open minded about new ways of modelling markets.

Deglobalisation

Decades of globalization, declining trade barriers and tariffs and increasingly integrated supply chains, has at least paused if not reversed. Trade intensity, as measured by export and import shares of GDP, has been falling in nearly every major economic region, and even in the most open economies flat intermediate inputs reveal supply chain fragmentation. 

The rise of electric vehicles – forecast to reach 17% of car sales by 2030 – is one example of a consumer trend which could contribute to deglobalization, as it reduces demand for oil and also auto-parts, since EVs use much less parts that ICE vehicles. 

Deglobalisation is also driven by political extremism, which is partly caused by stagnating middle class incomes and increased inequality since the 1970s. The constituency in favour of free trade has collapsed everywhere except for a few very open economies. Nearly every major economic region is seeing more political polarization, which has reached a 50 year high, as measured by indices such as V-DEM varieties of democracy. This leads to more trade barriers, protectionism and isolationism.

Slowing China 

Meanwhile, economic growth in China, the largest locomotive of global growth, is expected to slow to less than half of its pre-Covid level. China has massive debt to GDP including private debt after malinvestment; and demographic challenges from low fertility rates and a population projected to shrink.

Geopolitics

A growing number of wars and conflicts are another challenge. The number of countries contributing troops to conflicts has risen from around five per year from post-World War II to the early 1990s to between 70 and 80 per year over the past decade, including internal, inter-state and internationalized conflicts. Clearly, countries with high political risk eg Russia, Iran, Libya, Algeria, are significant for global exports of many commodities such as oil and gas. 

All of this is set to make commodity prices structurally more volatile than pre-Covid, raising the baseline of volatility and creating two-way volatility risks as well as dislocating relative value relationships within commodities. 

Geopolitical risk is not always necessarily bullish – the US/China trade war in 2018 imposing tariffs on soybeans resulted in a price dump. 

Unprecedented relative value dislocations

Russia’s invasion of Ukraine severely disrupted normal relative value in global wheat markets. The calendar spread between July and December Chicago wheat jumped close to three dollars, having never previously exceeded 15 cents, as those with physical exposure to Russian wheat needed to hedge. Meanwhile the normal quality premiums reversed. High quality, high protein Matif wheat, used for bread and human consumption, went to a 50 cent discount versus low quality, low protein Chicago wheat, which is used for animal feedstock. This happened despite the fact that Matif wheat can be delivered into the Chicago future.

Non-linear modelling

Commodity traders need to rethink their models. Traditional linear modelling is standard, but does not work in extreme scenarios or at fringe price areas, when non-linear phenomena come into play. When prices change the rules change.

For instance, regulatory price caps in Spain and Portugal resulted in a negative spark spread of electricity versus its cost of production using natural gas prices in June 2022. 

There are also data challenges. Bloomberg shows a peak nickel price of USD 55,000 when using end-of-day price data, although large volumes traded at USD 100,000 on March 8th 2022 intraday during the morning hours amidst a massive short squeeze. The London Metals Exchange ended up cancelling a large amount of trades above USD 50,000 from that morning, but it is important to have the data available from these extreme events. 

Investors also need to model mean reversion outside a linear framework. For equities, higher prices generate positive feedback loops of raising capital and growth. For commodities, higher prices incentivize supply, substitution and destroy demand. After the 1970s oil price shocks, the US introduced fuel efficiency rules and average miles per gallon for new cars rose from below 15 to above 23 by the early 1990s. Gasoline consumption also took 10 years to return to its previous peak after the implementation of the new fuel efficiency standards. 

Static, linear supply/demand projections overlook three components of price shocks: permanent, risk premia related and frictional or transitional.

Taking Russian oil as an example, the permanent impact is that some barrels are now absent. The risk premia impact is that costs of freight need to reprice to allow for more expensive and less easily available insurance. The frictional impact is around rewriting contracts and reconfiguring supply chains. Western European oil refineries had been optimized to maximise yield from Russian oil and will yield less when using inputs of US or Saudi oil. It takes 6 to 12 months to reconfigure refineries to different types of oil, during which time less diesel is produced.

Commodity investors should expect more frequent shocks with a much wider range of uncertainty. They should probably run lower volatility to keep dry powder for taking advantage of opportunities. Liquidity has dropped dramatically and when it disappears there should be enough time to work out what the new roadmap is. A nimble, dynamic discretionary approach is needed because these new patterns and relationships cannot be modelled systematically across a range of markets, and market responses may even seem counter-intuitive. 

Imbalances often do not unfold as expected. The IMO ban on high sulphur fuel for example, which came into force in 2020, was widely expected to cause a spike in diesel prices, but they actually sold off. There are always multiple variables to juggle, including demand, regulations, substitution, and technology. 

There are very optimistic forecasts for metals used in electric vehicles, but it is very rare for commodities to go up fivefold in response to demand and much more likely that they see a small short term spike.

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Macro Investing in Asian Markets

Using local experts for Asian macro investing 

^{JIMMY LIM, CEO & CIO AT MODULAR ASSET MANAGEMENT (SINGAPORE) PTE LTD, SINGAPORE}

Jimmy Lim has spent 20 years trading Asian markets, at banks and on the buy side, in Singapore, Hong Kong, Tokyo and Geneva. Lim has been trading the Asian Macro strategy since his time at BlueCrest (2011-2015) and continued to do so at Millennium Management LLC (2017-2019). In January 2020, he spun out of Millennium to form Modular Asset Management and launch the Modular Asian Macro Fund, which was Asia’s largest macro launch in 2020 and led to Lim being featured in The Hedge Fund Journal’s Tomorrow’s Titans report that year. The Asian Macro strategy currently has $1.1bn in assets under management, and since 2011, has gross annualized returns of around 7% with volatility of 3% and maximum drawdown of -2.4% (outperforming most major asset classes during that same period). As at end-September 2022, the Modular Asian Macro Fund is up approximately +11.3% YTD (net). Furthermore, the strategy has generated a higher Sharpe ratio and a lower drawdown compared to most hedge fund strategy indices, with a slightly negative historical correlation to conventional asset classes and other hedge fund strategies. 

Modular trades mainly liquid currencies, fixed income, derivatives and options, with a small exposure to equities. Around 90-95% of the risk is in Asia, including Japan, New Zealand, China, Taiwan, Korea, Thailand, Malaysia, Singapore, Indonesia and the Philippines. If a trade has a high beta to US markets this can be hedged out. 

The 18-investment staff are grouped into product and country modules. Product modules such as FX and rates aim to deliver stable, consistent P&L through shorter term trades of 2-3 days. Country modules can cover all asset classes but are constrained to the market(s) in which the respective portfolio manager has a distinct domain expertise. Country modules include China, India, Taiwan, ASEAN and ANZ. One objective of the country modules is to trade like a local dealer in the harder to access countries such as China, India, Indonesia and Korea. Country portfolio managers are typically locals who speak the language, have a strong local network, and understand the local market and country. Lim oversees the overall strategy to make sure risk is well diversified and he fills in some gaps where there are no specialist portfolio managers for certain countries. 

Investment Process

Modular’s portfolio managers and researchers identify themes and build hypotheses and then leverage Modular’s strong local networks in Asia to visit countries to prove (or disprove) these hypotheses before identifying the best product – FX, rates, credit or equity – and then structuring the trade in the most beneficial way possible. Lim discussed certain themes he believes demonstrate current trading opportunities in the Asian macro space.

Climate change and the rice crisis

Climate change is an important theme in Asia, which led Modular to various currency trades. China’s extreme heatwave and drought in its central plains, India’s monsoon deficit in its rice planting states, combined with the worst ever floods in Pakistan, has sown the next rice crisis. This crisis will play out with a time lag of about 4-6 months, as buffer stocks across the region deplete and need replenishment.

As the world’s third largest rice exporter, Thailand is benefiting from higher rice exports, while the world’s second largest rice importer, the Philippines, will face a larger rice import bill. Recent visits to these countries have strengthened Modular’s thesis and Modular’s channel checks have identified other factors in favour of these trades. As Thailand enjoyed a bumper harvest, rice stocks are high, leaving the Thai government and rice merchants in a strong position to raise both export volumes and prices. Concurrently, Thailand is also seeing a recovery in tourism that reached 1.3 million in August – a very strong number considering there is no China traffic these days. This bodes well for the traditional tourism peak in November and December – which will be a source of foreign exchange for the country. Conversely, the Philippines is facing a greater need for USD – to import capital equipment and steel – as the new Marcos administration jumpstarts its mega infrastructure program. 

Modular structured the Thai Baht leg of the trade using forwards, as well as option spreads to exploit the very expensive downside skew. In contrast Philippine Peso options were richly priced, so Modular used a mix of spot and forward instead.

Korean yield curve anomaly

Another trade idea is founded upon an anomaly detected in the Korean interest rate swap curve. It is deeply inverted almost at GFC levels, with a spread reaching a recent low of -44 basis points between its two- and ten-year tenors, while most other Asian curves are flat. Historically, these inversion episodes are usually explained by Korea’s beta to the US curve and issuance of structured products by local asset managers.

This time however, three special factors lead Modular to expect the curve to steepen. First, Korea has a huge floating rate mortgage market, and the Korean government has introduced a mortgage conversion program with a 40-basis point incentive to switch from floating to fixed rate mortgages. This program will result in issuance of mortgage-backed securities worth 45-50 trillion Korean Won starting early next year. Second, the government is preparing to extend a loan conversion program (once again floating to fixed rate) to a broad base of SMEs hurt by the pandemic. This could result in another 20-30 trillion Korean Won of issuance. Third is the energy company subsidies. High LNG prices create a 30 trillion Korean Won deficit at the state electricity company, which could increase as the energy company builds winter reserves for the cold Korean winter. This subsidy will generate more KRW issuance. Taking these three factors together, there will be 100 trillion Korean Won of extra bond issuance, possibly resulting in 60% of the total KRW issuance for 2023. 

Modular has constructed a steepener trade, which earns positive carry. Trade expression for the steepener includes the less liquid interest rate swap curve, and the more liquid bond curve.

Broader Asian themes

The above trades are examples of Modular country specific and special opportunity ideas, but Modular has some longer term themes it is tracking.

One such theme is that fiscal challenges will increase as Asian countries copy the fiscal spending seen in the UK and Europe. In fact, Modular sees a growing risk of wage price spirals across the region, as the initial tendency by politicians is to raise salaries or give handouts to cope with inflation. Singapore has introduced a Progressive Wage Program to push lower skilled wages higher. Malaysia unveiled an election budget for 2023 on 7 October 2022, with cash handouts and tax cuts for the lower to middle income groups that it can ill afford. Indonesia faces elections in 2024 and is also likely to be generous. It is easy for politicians to promise pay rises, even if this poses a challenge for central banks.

Another big theme is the evolution of the EV story, which Modular continues to track across Asia. Electrical vehicles are creating competition between countries vying to be an EV hub. Indonesia uses its nickel resources advantage to lure EV battery plants and stainless-steel refineries. Thailand is leveraging its large auto manufacturing base, and Malaysia is leveraging its tech hub in Penang to produce controller chips for EVs. All of this can result in significant movements of FDI, resulting in large capital flows and hedging flows.

A third theme is the continuing fragmentation of semiconductor supply chains in Asia as the US Chips Act forces Samsung and TSMC to shift more leading-edge production to the US. In response, China is pushing ahead with the world’s largest import substitution drive – to flesh out its own semiconductor supply chains. Similar to the EV story, all of this can result in significant movement of investment, resulting in large capital flows and hedging flows.

Fourth, geopolitical uncertainty is inducing Taiwan, Japan and China to raise military spending. As China tries to catch up, the US will counter China’s influence in North Asia and also Southeast Asia. Not only will the military spending increase borrowing requirements for these countries, these periods of tensions also present volatility and good trading opportunities.

Finally, Asia’s response to climate change is yet another important theme. Historically, Singapore has issued government debt purely to create a benchmark for pricing corporate debt, as the government runs a fiscal surplus and does not need bond financing. For the first time, Singapore will be issuing special purpose bonds to reduce its vulnerability to climate shocks and to meet its green goals. This includes the coastal protection programs against rising sea levels and a 4,000km undersea cable to import green energy from Australia to meet Singapore’s goal of 30% green energy by 2030. Taiwan is yet another example, betting big on an offshore windfarm program to deliver 20.5GW by 2035 (from zero in 2017) to reduce emissions by half by 2050. Over time, this could significantly increase government borrowing and hedging flows in the longer end of the rates curve.

In conclusion Lim is very positive about the opportunities available for continued growth for the Asian Macro strategy. Modular is well placed to monitor and take advantage of the themes identified above and others.

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How to Generate Uncorrelated Returns in the Chinese Stock Market 

Adapting to slower and more cyclical economic growth

^{RONALD CHEUNG, PARTNER, OPTIMAS CAPITAL LIMITED, HONG KONG}

Optimas was founded in 2016 by Thomas Wong, who has senior sell-side and buy-side experience at firms such as Credit Suisse, Bank of America Merrill Lynch, UBS and Sculptor (formerly Och-Ziff). Optimas started with an anchor investment from a Hong Kong pension fund. The firm maintains a presence in Hong Kong and Singapore, has a research office in Taipei, and an investment team of 16 people, but there is one investment book ultimately managed by one portfolio manager. The firm has 38 employees in total. 

Investment objective is capital preservation and compounding at 10% p.a., with low volatility and low market correlation, which has been achieved. There have been no losing full calendar years.

China’s slowing growth 

Optimas observes how China’s economic growth has slowed from hyper growth to the average for emerging markets so that countries such as India and Indonesia are now growing faster. The Chinese government has ambitions for faster structural growth but in reality the slowdown can be explained by the three factors of production: labour, capital and productivity: and all three have been slowing.

Population growth has slowed even after the one child policy was ended, because it is expensive to raise children. And the ageing population is reducing the size of the labour force: in 20 years China will be one of the oldest nations with one of the largest populations aged over 60. Meanwhile capital’s contribution to growth is constrained by China’s leverage: China has had very high rates of capital investment and credit to GDP, and the high investment ratio has capped the marginal return of new projects. 

It is a normal pattern for the labour and capital drivers of growth to drop as economies mature, but usually productivity improvements make up the difference. That is not happening in China where applied R&D spending is low, stripping out product development. R&D matters most for innovation, which is also being hampered by geopolitical factors such as the Huawei-related 5G technology embargo, and the more recent ban on Nvidia exporting AI chips to China. This is challenging because China has historically been better at honing and refining imported technology than inventing it. 

Zero Covid policy and the property crisis 

Taken together these factors mean that growth is moving from structural to cyclical, and recently there have been cyclical headwinds.

The zero Covid policy has been constraining cyclical growth, with over 50 cities locked down at various times. This has intermittently disrupted at least 15-20% of the economy and exports. Vaccination rates remain relatively low for older people, which adds risk to reopening. 

The property market is now a headwind for growth. Property had been a reliable and well performing investment for many years and is the largest asset for most people in China, but the drivers of house purchases have been slowing. The number of marriages has dropped from 13.5 million in 2013 to 8.1 million in 2020. Urbanisation moves from farmland to city have also been slowing, from 29.5 million per year in 2011 down to 12.1 million per year in 2021. Property sales have dropped 40-50% in a month, which threatens growth.

Nonetheless China does boast leadership in some segments such as solar panels boosted by low costs of capital and subsidies; an ecosystem of e-commerce and mobile payments encouraged by the government; and areas such as AI face recognition or robotic medical treatment where more liberal rules on personal data let companies gather more data points and enable deep learning. These niches tend to feature prominently in many China strategies but not for Optimas.

Bottom-up large cap stock-picking 

The shift from structural to cyclical growth in China makes it no longer an easy buy and hold, or ‘buy the dip’ market where quality companies are multi-baggers. A basket of quality companies multiplied seven-fold since 2010 but has recently halved in value. In the past decade, during which nominal GDP growth averaged 9% per annum, MSCI China/SHCOMP merely returned 0%/3% CAGR vs. 10% by US equities as measured by SPX. But picking the right themes/sectors/stocks with the right timing has proven to be profitable, as exemplified by the spectacular alpha from commodities in the early 2000’s, financials in the late 2000’s, and consumer/TMT stocks in the past decade.

Optimas does deep bottom-up fundamental analysis of companies, balance sheets and management teams, looking for strong earnings growth and good risk management. The team of 16 analysts includes many country specialists focused on Japan, India and Korea, as well as sector specialists. They follow 400-500 mainly large cap companies very closely and do 250 field trips per year. In addition to the companies listed in their respective exchanges, the investment universe includes multinationals where Asia is a dominant share price driver, which can also feed into pairs trades. The largest exposures are in Greater China & north Asia, but the book is increasingly diversifying into India and ASEAN. 

Macro factors such as geopolitics, rate hikes and Covid, are considered but the aim is to hedge country, sector and style in order to isolate stock-specific risk. Net exposure does not normally exceed 10% in either direction. An example was when Covid started in early 2020, Optimas decided to cut gross exposure, informed by their analysis of the pandemic, and helped by their experience of SARS in Hong Kong, but they did not make any strong directional bet. 

Some sectors, such as internet and e-commerce, have faced regulatory headwinds as well as slowing growth as government regulation has become stricter. In China, Optimas take the view that private enterprise carries more political risk and SOEs have less political risk.

The book is diversified into 200-250 positions and a high conviction one can reach 3-4%, though probably not immediately; they are more likely to scale into stocks as more data points increase confidence in the investment thesis. Optimas aims to allocate incremental dollars to the best upside and downside ideas, adjusted for risk. 

Gross exposure varies with the stability of the market climate. Managing risk and drawdowns through active trading is always a key part of the process. 

A unique feature of the fund’s strategy is applying Asian expertise to invest in global stocks. Many global stocks, such as the European luxury, Global Semiconductor, or Japanese consumer, sectors, move with Asian driven factors. These companies tend to have better governance and better investor alignment, and more importantly less regulatory-driven volatility. By having a team of experienced analysts on the ground, Optimas is able to gain an information/timing edge.