Asian Hedge Funds

A young and dynamic space

Q&A WITH ADRIAN WORTH, MANAGER RESEARCH CONSULTANT, MERCER, HONG KONG
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1. Why are Asian hedge fund assets small relative to GDP and local savings rates?
Firstly, financial markets in Asia are less mature than their US or European equivalents. This results in a smaller range of securities and instruments that a hedge fund can access and utilize in the context of a hedge fund strategy. For example, access to borrow in the China A-share market is limited, cutting off a significant opportunity set/risk management tool for a large number of managers. While this type of exposure can be accessed elsewhere (i.e. H-shares, US-listed ADRs), the regulatory environment in the A-share market effectively limits the amount of AUM that China-focused L/S managers can optimally run in this space. Furthermore, credit markets in Asia are less developed than their US and European counterparts where CMBS, RMBS, ABS and corporate loans and bonds are all of significant breadth and depth. All in all, financial markets in Asia do not offer the same broad range of building blocks as peers in the US and Europe, restricting the range of hedge fund strategies that can be operated at meaningful size (more than $1bn).

The available pool of institutional quality hedge fund firms remains limited relative to the U.S. and Europe, though we are witnessing strong quality growth and improved governance. This partly reflects the maturity of the hedge fund industry throughout Asia as well as the longer history of hedge fund investing in the US where today’s managersare perhaps fourth or fifth generation and the skills and experience have been passed down. In Asia, the history is shorter while true success stories across the pool of first generation managers are limited. For allocators overseeing global portfolios, the prospect of increased diversification via access to an Asian hedge fund often comes with high hurdles and quality expectations. However, that quality is clearly increasing across front and back office teams, and this bodes well for future industry success.

Thirdly, and this is linked to the two points above, Asian investors are, on average, less familiar with hedge fund investing and the potential role they play within portfolios. The pool of experienced hedge fund investors in the region is growing but remains fairly small, limiting the number of sponsors that can effectively underwrite a hedge fund investment. This dearth of local cornerstone investors is part of the reason why the Asia hedge fund community has such a long tail of managers with AUM under US$50m.

Finally, we would note that Asia has typically been regarded as a growth story. Many investors have chosen to access this through traditional asset managers (i.e., public equity LO managers). However, we are increasingly seeing investors’ preference for Asian hedge funds who could also offer downside protection in what have been volatile Asian emerging markets.

2. Are most of their assets raised locally or globally?
For a manager of institutional quality, the geographic breakdown of their investor base on average continues to be heavily weighted to the US and Europe (70-80%). The opposite is often true when looking at smaller, less institutional managers as well as those where language is a barrier for US and European investors (for example, mainland China and Japan).

3. Do Asian allocators invest in hedge funds more locally or globally?
We think this is quite mixed as there is certainly a desire from Asian institutional investors to diversify away from local markets, and on average they probably have a preference for US/Europe exposure which would include hedge funds. However, Asia-focused funds of hedge funds continue to offer overseas investors exposure to a universe of managers they find hard to access for reasons ranging from time zone, culture, language and network. Similarly, there is a growing trend in the region for family offices and HNWIs to seed or incubate local hedge fund managers. Although this is growing from a low base, it may be a sign of things to come.

4. What trends do you see in Asian launch activity?
The last few years have seen a number of “well-pedigreed” managers starting up in Asia. They are typically senior analysts/partners from high quality first generation managers or investment banks that have ambitions to run their own firm and the capital to fund the setup costs. Further, there is strong active demand among global investors for high quality Asia-based managers as they perceive the opportunity set in Asia as particularly attractive. The majority of new launches remains concentrated in long/short equity while the total number looks set to come in below that of recent years.

5. Is it still possible to profitably run a manager with less assets in Asia?
As noted above, the tail of small managers is very long in Asia, suggesting that many managers are able to run lean operations at close to break-even despite a low AUM. The problem for these managers is getting to a scale where they can invest in the business in a meaningful way. So, while a manager’s firm may be profitable, a low AUM and headcount is unlikely to pass muster for the majority of investors. This is particularly so for any investor of institutional size where there is a reluctance to account for the majority of a fund’s AUM. It leads to a chicken and egg dilemma for the manager that we see all too often.

6. Would you viewHong Kong and Singapore as the primary centres of activity?
Yes, with Hong Kong more active than Singapore. Hong Kong is seen as the gateway to China which is the center of economic activity in the region. It remains an important financial hub with management staff of China’s largest businesses regularly in the city to meet local and international investors. Singapore enjoys greater ties with South East Asia and FX, fixed income and commodity trading; this has spurred the creation of several high profile macro funds but the lack of liquidity in the region’s equity markets (e.g. Thailand and Philippines) has limited growth in strategies such as equity long/short.

Meanwhile, Japan seems to be losing competitive ground as their higher corporate tax rates and stricter labor market rules make them considerably less competitive compared to HK and Singapore.

7. How much do you see in mainland China, Taiwan, Japan, other countries and Australasia?
See above for Japan where net net, the hedge fund industry is probably unchanged from 5 years ago. We are not aware of meaningful activity in Taiwan, while mainland China boasts a reasonable number of institutional quality hedge funds. For the latter, managers with a presence there typically also have an office in Hong Kong with senior personnel splitting their time equally between the two hubs. There certainly seems to be value in having resource on the ground in mainland China, particularly for those applying a deep fundamental approach to equity long/short.

In Australia, the hedge fund industry continues to expand, with evidence of all the usual routes to establish hedge fund capabilities. Examples include traditional long only managers moving away from capacity constrained sectors to establish new strategies in the hedge fund space, spin offs from well-regarded managers to establish new firms, and innovative new boutiques. Local interest seems to be on an upward trajectory too as valuations in unlisted property and infrastructure investments start to look stretched, not to mention equities and bonds.

8. Are hedge funds active in frontier markets such as Myanmar, Cambodia etc.?
We rarely see managers with exposure to these small frontier markets due to reasons such as market liquidity, investor familiarity and corporate governance. Even long-only funds are hardly invested in these markets; for example, there are only 4 listed stocks in Myanmar as at September ’17 while the logistics of investing in Vietnam have prevented long-only funds from being active until they’ve reached a minimum size.

In contrast, the Philippines and Indonesia continue to make progress as developing economies and investable markets, although exposure remains modest. A particular consideration is access to borrow on the short side as hedge fund managers can be reluctant to hold meaningful net long exposure in these markets.

9. Do any particular strategies have higher or lower average risk-adjusted performance in Asia, through the cycle?
We are mostly attracted by high quality managers in the equity long/short space where dispersion and volatility create an attractive opportunity set and the potential for above average risk-adjusted returns. That said we are engaged with managers across all strategies as we seek to identify those managers we regard as best-in-class.

10. Is it true that a higher proportion of portfolio managers are women in Asia, than elsewhere – and if so does this apply to hedge and traditional strategies?
We have observed increased participation over the years.