Asian Fund Industry

Asian Fund Industry

Originally published in the June 2008 issue

Assets invested in hedge funds focusing on Asia declined by approximately 10% in the first quarter of 2008, representing only the latest chapter in the development of the Asian hedge fund industry. As is frequently true with regard to both investing in hedge funds and investing in Asia, the details become more interesting as they become more clearly understood. Assets invested in Asian hedge funds fell from over US$111 billion at the end of 2007 to just over US$100 billion, which, combined with the negative performance and ceteris paribus (all else being equal), is likely to have constituted a market development eliciting collective investor capital withdrawals. Yet investors actually allocated an additional US$1 billion to Asian hedge funds, only partially offsetting the negative performance impact in total hedge fund assets in Asia.

The growth and concentration of capital, as well as the combined and intertwined influences of both emerging and developed economics in such close geographic proximity, are only two of the factors which suggest the potential for substantial growth in the Asian hedge fund industry. As a testament to the divergences of economics between developed and emerging and their implications, it is relatively well known (but bears restatement for context) that since the very early days of hedge fund industry development (1990) through to the present, an investor in the Nikkei 225 would have lost over 5% annualised. It is also well known that an investor in Emerging Asia (results vary by specific index) generally would have at least doubled their investment in the last few years, in some cases, returning greater than 100% in a single calendar year. Clearly the divergences in performance and across the regions and time periods represent an opportunity for long and short investing, ceteris paribus.

Industry estimates of the Asian hedge fund industry are based on the strategic focus of each fund and not on the geographic exclusivity, firm location or legal domicile of the hedge fund structure. It is interesting to note that more than half of the funds which comprise the Asian hedge fund industry are themselves located in Asia, with the balance being located in the US and UK. Progressive structural characteristics have contributed to the development of the industry located in Hong Kong, Singapore and Australia over the past few years, with fewer funds currently located in China or Japan. A recent softening in attitudes towards hedge funds has also been seen from countries such as South Korea.

Indicative of the early stage of development of the Asian hedge fund industry, the industry is significantly less concentrated than the broader hedge fund industry, with slightly less than 13 of Asian hedge funds with assets of more than US$1 billion under management, while the overall industry has greater than 70% of assets in funds in excess of US$1 billion in size. On a broader scale, while the Asian region represents over 20% of global assets, the region represents nearly 21% of global bank assets (Milken Institute) but the Asian hedge fund industry represents only approximately 5% of the capital invested in hedge funds. Smaller still and with greater potential, the overall industry represents approximately 1% of global financial capital, while capital invested in Asian hedge funds represents only 0.25% of total Asian financial capital. Ceteris paribus, the scope of opportunities is significant on a global scale.

The Asian hedge fund industry is composed of nearly 23 equity hedge strategies, a stark contrast to the broader industry (13 equity hedge) in a period where equities lost over 20% across Asia. Viewed within this context, the broad relative overweight that the Asian hedge fund industry has toward equity hedge, at an aggregate level, accentuated losses for the industry. Similarly, the Asian hedge fund industry has approximately half of the exposure of the broader industry to macro strategies. Over a trailing 6 months period (ending Q1 08) during which both global and Asian equity markets fell precipitously, macro funds gained nearly 11%. Macro gains offset losses across the total industry through short US dollar, long commodity and long government fixed income, while remaining relatively neutral, in an aggregate sense, to broader credit and equity market weakness. The Asian hedge fund industry received a much smaller benefit of this trend in macro performance, further accentuating the performance volatility.

Prior to the weakness of Q1 08, investors in Emerging Asia over the last three years may have become complacent with gains ranging from steady to strong and with only few, isolated and temporary instances of weakness, none of which were protracted. With the recent volatility serving to recalibrate some of these assumptions, two qualities exhibit compelling characteristics from an investor’sperspective, which are likely to serve as a catalyst for the continued development for the Asian hedge fund industry, ceteris paribus. First, the ability to invest long and short provides the opportunity to reduce individual portfolio volatility and minimise correlation with other asset classes and markets. Secondly, the inverse relationship exhibited between macro strategies and volatile equity markets also presents a noteworthy portfolio dynamic. As the expected volatility pattern for Asian investors shifts from being one of primarily positive volatility to a more normally and evenly distributed pattern of positive and negative observations, Asian investors are likely to view the ability to invest long and short across diverse strategies as a compelling diversification tool.

Of all the opportunities for growth in Asian hedge fund investing, event driven strategies are the most dynamic. Corporate structure and culture for many years have inhibited and resisted, to varying degrees at different points in time, the influence of foreign acquirers. A handful of shareholder activists, both Asian and foreign, have initiated involvement in Asian markets, with mixed levels of accomplishment, at best. Reflective of the aforementioned structural and cultural characteristics, event-driven strategies investing in Asia represent less than 8.5% on the industry, significantly less than the total hedge fund industry level of 23% in event-driven. This under-representation of event driven opportunities has constituted a missed opportunity cost for the Asian hedge fund industry; globally since 1990, the HFRI Event Driven (Total) Index has returned (annualised) over 13.6% on a volatility of less than 6.5%, while over the same period the Nikkei 225 has lost (annualised) nearly 5.5% on a volatility of nearly 22%. Identifying the catalyst for a more progressive policy inclination toward acquisition activity has been a challenge for many global M&A specialists, and the prospects are not much clearer at present. However, it is plausible that contingent on this catalyst occurring, the cumulative latent opportunity set would comprise an extremely compelling environment. One could reasonably expect a rapid convergence to the industry level of event driven strategies, as well as expectations of performance realisation as efficiency and liquidity penetrated previously non-transparent capital structures.

All else equal, the combination of hedge fund industry structural convergence, secular growth, divergent economic influences and the prospects for more progressive socio-economic policies creates a dynamic landscape for continued evolution of the Asian hedge fund industry. Normalising across some of the variation between the overall hedge fund industry and the Asian hedge fund industry provides some insight into the performance characteristics and portfolio benefits that continued development of the Asian hedge fund industry is likely to provide to investors. That investors have continued, thus far, to allocate to Asian hedge fund strategies on weakness observed over recent months constitutes a constructive development by virtue of its opportunistic nature, of course, ceteris paribus.

About HFR

Chicago-based HFR Group, founded in 1993, is a global leader in the provision of hedge fund data, research, indexation and asset management. The HFR Group of companies includes Hedge Fund Research, Inc, and HFR Asset Management.