Hedge Fund Investing in Asia

Smart access to Asian markets

Originally published in the November 2007 issue

After the Asian crisis, there were wide spread claims that speculators were responsible for the collapse in Asian currencies. Today, the dust has settled, investors have regained their confidence in the region and the Asian hedge fund industry is booming. There are now more than 1,100 single hedge funds (out of which 65 new funds came to the market during H1 2007) and 147 funds of hedge funds, compared to only 160 single hedge funds in 2001 (Eurekahedge).

Assets under management by hedge funds jumped from USD 12 billion in 2000 to USD 167.7 billion at the end of H1 2007, a rise of 13% over the first six months of the year, or about USD 20 billion (Eurekahedge/ AsiaHedge). This translates to over 10% of global hedge fund assets. It is expected that the Asian hedge fund industry could be worth USD 250 billion by the end of the decade (AsiaHedge).

These figures do not, however, reveal major changes under the surface of the Asian hedge fund industry.

Due to poor market conditions in Japan, hedge funds focusing on Japan long/short strategies have shrunk by about 20% from USD 48 billion to USD 38.6 billion. This was offset by ex-Japan managers, especially China, which grew very strongly. Eurekahedge estimates that there are currently more than 90 hedge funds investing in the Greater China area, with roughly USD 12 billion in total assets, up from 14 funds and USD 184 million in 2001. Thus, there has been a rotation out of Japan and into other Asia-based investment strategies.

Unlike in previous years, capital has not been removed from the region completely but has stayed there and relocated, pointing to the increased stability of the Asia Pacific hedge fund industry. As many hedge fund managers started investing in Asia investment after earning their spurs in Europe and the US, the number of managers located outside Asia is still fairly high. As at Q1 2007, 63% of Asian hedge funds assets were managed from the UK or US, and only 24% were managed locally in Asia.

But this figure is expected to change rapidly in the coming years. According to the InvestHedge Billion Dollar Club ranking in October 2007 some 27% already had an office in Asia and several established hedge fund companies from the UK and the US are planning to set up a local office next year.

Two city-states are leading the growth of the Asian hedge fund industry. While Hong Kong has a longer history as a centre for hedge fund management and services, Singapore is gradually catching up. This is mainly due to easier registration and greater tax clarity. While setting up a hedge fund in Hong Kong takes a couple of months, the same procedure can be completed in Singapore within a few weeks. These two city-states have advantages and disadvantages as can be seen in table 1.

The place to be invested

The smaller scale of, and lower volumes traded in, the underlying Asian capital markets, have been a limit on the assets managed by hedge funds in and across the region (particularly in terms of stock lending and derivative trades). This situation has improved in recent years, but even today about 48% of Asian hedge funds have less than USD 50 million under management. That still compares favourably with more than 60% three years ago, and this proportion is stabilising. Only 9% of Asian funds have more than USD 500 million in assets, with fewer than half accepting new capital. A typical equity long/short manager in Japan for example has a capacity of perhaps USD 500 million, a manager focusing on Asia excluding Japan can manage up to USD 250 million (AsiaHedge). Furthermore, hedge funds that focus on a particular region or country seem to have reached their capacity, as finding alpha is becoming increasingly difficult.

As a result, they either start a new strategy or widen their focus to make it more global in order to be able to absorb additional capital. However, the situation seems to vary from one manager to another and also from one country to another. While some managers claim that they can only invest up to USD 500 million in a particular country, others can absorb more than double that amount.

Despite being a relatively young market, the capacity picture in Asia has begun to resemble that of the rest of the world: popular managers soft-close within 12 months, a good track record ensures a close within 24-36 months, and many managers who have been around for two to three years with a decent track record are already closed. Hence, new investors looking for Asian hedge fund exposure are left with younger managers that have only 6-18 months track record and capacities of between USD 25 million and USD 75 million. In consequence, selecting the right Asian hedge funds requires a long due diligence process. Funds of hedge funds that have started to operate in the Asian market many years ago now have a significant advantage, as they have secured capacity with quality managers with a longer track record and they have the infrastructure and experience to identify promising managers across a wide region.

Many industry experts attribute the surge in Asian hedge funds assets to the fact that global investors were generally underweight in Asia and hedge funds provided a way to participate in the Asia-Pacific growth story without the large downside risk of long-only investments. On the other hand, there are also investors who still shy away from Asian hedge funds as they combine two characteristics they are not familiar with: First, they do not have a good understanding of hedge funds and second, they are sceptical about the sustainability of Asian growth. But as has been shown above, the Asian economies are booming – not based on speculation, but based on real fundamentals. And unlike long-only strategies, hedge funds are able to provide much better downside protection.

Asian economies and markets are heterogeneous and many industries are highly fragmented. Company research coverage from investment banks is fairly low and concentrated on large caps. This results in tremendous market inefficiencies that offer alpha generation opportunities. Out of more than 19,000 listed companies in Asia, the vast majority are unknown. Accounting standards are also slightly different. Putting valuations on firms in Asia requires a great deal more insight than a simple analysis of the balance sheet and ownership structures can hide a lot of ills. There are also corporate localisms, for instance charitable giving is generally a euphemism for corporate bribes. Interpreting these numbers requires a lot of direct knowledge.

Most markets vary

As Fig.3 shows, Asia can be broadly categorised into three different market environments. While countries such as Australia and Japan belong to the most developed and efficient economies with liquid and stable markets, countries such as Thailand, Indonesia and the Philippines are still fairly inefficient, with small stock markets, few liquid stocks and frequent political and economic instability. In between those two categories lie countries such as South Korea, China, and India, which have reasonably deep and liquid markets and political situations that are fairly stable.

Besides inefficient information flow, Asian institutions have been slower than their counterparts in other markets to adopt low-cost trade execution alternatives. According to Greenwich Associates, Asian institutions execute nearly 85% of their total trading volume via single stock trades with a broker sales trader. But as a greater number of stocks are traded in local currencies and more debt is available in these currencies, the market environment for hedge fund managers has improved, lifting capacity restraints over the last 10 years. Today, Asia accounts for nearly 30% of the global stock market capitalisation. Additionally, more than one-third of the global volume in exchange-traded derivatives is generated in Asia (Futures Industry Association). While Korea has the highest volume index options market in the world, Japan has the largest government bond market. Hong Kong has the largest covered warrants market worldwide and India has the world’s most active single stock futures market (Bank for International Settlements, World Federation of Exchanges, Futures Industry Association).

Due to a still underdeveloped institutional asset management, retail participation in Asian markets is high. Asian investors generally have a strong risk appetite, often day trading in stock options, which leads to a “greed and fear” mentality. This can drive valuations to extremes, as we currently witness in China. The higher equity volatility (compared to more developed economies) leads to stronger deviations from fair value. Hedge funds can benefit from this situation by identifying mispriced securities and setting up mean reverting trades or index dispersion trades.

It is important to note that Asian markets have different characteristics when it comes to trading patterns, liquidity, availability and cost of stock borrowing (see below). This creates arbitrage and diversification opportunities for managers with the right knowledge and expertise. As Fig.4 shows, retail participation in Asia is high.

More than just long/short

The investment opportunities for hedge funds have grown over the past decade as shorting has become much easier. Fig.5 shows, while countries such as Hong Kong, Korea and Taiwan are small compared to Japan, they are already borrowing a remarkable amount of stock. Although shorting single stocks has become possible in many Asian countries, there are still a number of countries such as Malaysia, Indonesia, Thailand and the Philippines, where shorting is difficult or even impossible. Also, stock borrowing fees are often staggeringly high. In reality many managers hedge their long positions through index shorts, thereby reducing systematic equity risk significantly.

Despite the strong growth in Asian economies, equity indices (including Japan) have not performed that well over the long term. In contrast, equity long/short strategies have done much better as shown in Fig.6.

The P/E ratios of many Asian markets have caught up with developed markets in recent months. China, India, and Indonesia for example now have higher P/E ratios than the most developed markets and can no longer be considered cheap.

Consequently, the past strong headwind (from rising markets) is expected to slow or even reverse and stock picking will play a greater role going forward. This should allow hedge fund managers to better differentiate themselves from long only managers. They are better suited to navigate through a potentially choppy market. Equity long/short continues to account for the lion’s share of Asian hedge fund strategies making up 55% of the total hedge fund universe in Asia.

Despite the concentration in equity long/short, this number has been gradually coming down in the last few years from roughly 80% according to RMF estimates. While relative value, event driven and global macro strategies have begun to develop, the biggest increase can be found among multi-strategy managers, as they are able to invest flexibly wherever the liquidity is and can allocate to the most promising strategies. Fig.7 & Fig.8 gives an overview of strategies that can be found in Asia today.

Volatility dispersion is a popular relative value trade

Volatility dispersion trading aims to take advantage of relative value differences in implied volatilities between an index and a basket of component stocks. Normally, the implied as well as historical volatility is different from the index volatility due to the correlation between the stocks that make up the index. If the manager is long the volatility of each constituent and short the index volatility this can be viewed as a long correlation trade which is most profitable when markets sell off. Another approach is to trade index volatility between different markets.

A special situation approach could include searching for companies with changes in their dividend policy. In Japan, for example, there is increased pressure from shareholder activists to increase dividends or buy back shares. Recent developments such as Steel Partners, a US-based activist, trying to take control of Bull-Dog Sauce Co in August, failed however. M&A deals are not welcome in Japan. Japan’s financial regulator, the Securities and Exchange Surveillance Commission (SESC), believes that domestic companies have increased cross-shareholdings so as to protect themselves from takeovers. As a result, the SESC is going to implement the Financial Instruments and Exchange Law (FIEL), nick-named J-SOX (Japanese version of the Sarbanes-Oxley Act), in the next few months. It is expected that the new law will become effective starting on 1 April 2008 or later. This new law will require hedge funds with more than ten Japanese investors or whose total investment amounts to more than a third of the fund to file or register with the regulator. These funds will then be subject to scrutiny. As a result of such developments, the number of corporate actions has been disappointing in Japan.

Announced M&A volume in emerging Asia, however, surged 80%, reaching USD 315 billion in deal volume, and the number of announced deals increased by 15.3% to 5,950 transactions for the first three quarters of 2007, thereby creating a healthy environment for hedge funds.

Smart access to markets

In summary, Asia remains well positioned for future growth. While exports are still significant, domestic markets are developing steadily and offer the prospect of internally driven growth. Asia has grown faster than the rest of the world and it seems likely that it will continue to do so. The region has already decoupled from the US to some degree, but a complete decoupling seems unlikely. Financial markets, unlike economies, will remain more tightly linked. While the future looks bright, however, Asian markets are likely to remain volatile as they are less liquid and less transparent than their more developed counterparts in the US and Europe.

As a result, investors would be well served to invest in Asian hedge funds that have the skill to extract gains from the significant growth opportunities and the tools to manage the inherent risks of this evolving and dynamic market. It is important to note that while equity long/short managers still dominate, other strategies are gaining a foothold. Asia remains the place to be invested and Asian hedge funds offer a smart way to access these markets.

Della Casa, Rechsteiner and Lehmann are on the Man Investments Independent Research Team