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Hedge funds choose their spot

The hedge fund industry has exploded; conservative estimates suggest there are almost 500 funds based in the region. Most have ridden the wave of Asia’s rising markets. Now those returns are getting harder to come by. But, as Helen Avery reports, increased opportunities to take short positions offer managers hope of generating new, enhanced returns.

Asian hedge funds: Comfortable with quant

Playing long/short in China

Credit? A niche strategy?

Good times for distressed debt

Riding volatility in Asia

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“WHEN WE WERE marketing our Asia hedge fund five years ago,” reminisces a Shanghai-based hedge fund manager, “one head of a large US fund of hedge funds observed: ‘Shanghai, eh? I bet you get great sushi there’.”

Although the US manager’s knowledge of regional geography and cuisine was questionable, the comment was not entirely inapposite. Six years ago, most foreign investors in hedge funds – indeed in many other asset classes – regarded Japan as the only Asian economy suitable for investment.

These days it is an entirely different story. Hedge funds are finding opportunities across the region in China, India, Korea, Australia and southeast Asia, and the strategies they are implementing provide better returns for investors than those targeting the US and Europe [see chart]. This has resulted in a sharp rise in the number of Asian hedge funds, both within the region and outside it. However, like the industry in the US and Europe before it, the developing Asian hedge fund market is not without teething problems. Managers are realizing that the days of making a quick buck out of Asia are over. Scale, diversification of strategy and solid infrastructure are essential in order to attract capital and to deploy it.

The number of hedge funds with pure Asian strategies increased from 229 in 2001 to more than 800 in August 2006, and assets under management over the same period increased from about $18 billion to $124 billion, according to conservative estimates by hedge fund research firm Eurekahedge. The growing recognition of Asia’s potential is evidenced by the gradual shift in the geographical base of such funds. The number of home-grown funds has increased as Asian fund managers and investment bankers have left financial institutions at home or abroad to start up funds locally. In addition, foreign entrants wishing to get on the Asia hedge fund bandwagon have realized the importance of having a presence on the ground.

In 2001, under one-third of Asian hedge fund assets were being run from within Asia. Today half of the assets are managed from head offices within the region. “US- and Europe-based managers used to make the argument that, by being that far away, they could ‘distil the noise’ and make clearer decisions. But I think managers now admit that Mayfair and Fifth Avenue are not the best places from which to invest in Asia,” says Steve Diggle, managing partner at Artradis Fund Management in Singapore.

A presence in Asia is crucial to finding good investment opportunities, thereby attracting end investors. Many US hedge funds wanting exposure to Asia often struggle to find information. “US investors don’t really have a concept of what is going on in China and with Chinese companies traded on US stock exchanges,” says Ezra Marbach of Seekingalpha.com. “As a result, US hedge funds are relying on consultants to advise them on Chinese investments. But it is not as effective as being on the ground.” Marbach’s firm set up a website that provides information and analysis on Chinese stocks, including transcriptions of earnings conference calls of Chinese companies.

If resources allow, being on the ground is indeed better. Ed Mullen worked with the principals of Glenwood Financial Group (now part of Man Investments) before setting up his hedge fund, Emperor Greater China Fund, in mainland China several years ago. He runs a Greater China long/short strategy. He says: “There is, of course, the issue of time differences. Yes, there are arguably some strategies in China you could trade from Tokyo, London and the US from a night desk, but you are more likely to have an insight by being here. We employ a team of local professionals. We watch the local news in Mandarin, read the local papers, and talk with people in the shop we buy the papers from. There is no substitute for primary research, and you glean more information by being here.

The shifting geographical base of Asian hedge funds
AuM estimates at year-end by key head office location ($mln)
Total number of Asian hedge funds by head office location
Source: Eurekahedge

“Plus, we’re here in China permanently and not on a whistle-stop tour where you’re up against a tight schedule and constantly thinking about the next meeting or your flight back home. We can pop in and see companies whenever it is convenient and necessary.” Tudor, Citadel, Cheyne, Och-Ziff, Perry, and Frontpoint have all set up offices in the region – not in all cases to manage separate Asian funds but sometimes to manage the Asian parts of larger portfolios. What’s the best base?

Given the size and number of markets in Asia, choosing a base can be the first hurdle to overcome for managers wishing to set up shop. “You can’t club Asia together and treat it as one homogenous market. Asia is huge, both in its size and diversity. Therefore, you have to localize, and pick your spot,” says Harjit Bhatia, chairman and CEO of the Asia Pacific region at global alternative investment firm Ritchie Capital, which has approximately $2.8 billion assets under management. “It’s not like Europe, where, for example, you could choose to operate from Paris, London or Brussels and still do pretty much the same business from any of those locations.”

Although Tokyo and Sydney are natural choices for funds looking respectively for Japanese and Australian investments, strategies in other areas of Asia tend to be split between Hong Kong and Singapore. According to the Monetary Authority of Singapore and Hong Kong’s Securities and Futures Commission, of the estimated 450 hedge funds based in Asia, about 150 are based in Hong Kong and more than 100 in Singapore. According to managers, the decision to base in one or the other of these jurisdictions is governed predominantly by lifestyle choice, regulatory environment, cost and level of emphasis on Chinese investments.

Singapore’s cleaner air (Indonesia’s forest fires aside) and more suburban atmosphere than Hong Kong is winning on some grounds with hedge fund managers, who often tend to be in mid-career with families in tow. The MAS, which has a regulatory-lite approach to hedge funds, is considered to be more supportive of start-up funds. In principle, hedge funds operating out of Singapore have to register with the MAS as authorized/recognized collective investment schemes. However, hedge funds offered to institutional investors are exempt from this requirement. In addition, hedge fund managers are required to be licensed and regulated by MAS unless they provide fund management to no more than 30 accredited investors. “It’s more of a form-filling exercise to be honest,” says one accountant. “You have to meet the MAS, introduce yourself and tell them what you are trying to achieve, fill out a form for a licence and then you’re off. In as little as four weeks you can be up and running.” Some in the market say the US SEC frowns upon this but the MAS’s opinion is that the prime brokers, administrators and investors are disciplined in their due diligence checks. “It’s very much a case of ‘If you don’t touch Singapore retail investors, then you’re alright with the MAS’,” says an industry expert in Singapore. That said, there is a sense among participants that the MAS, despite its laissez-faire attitude, is not about to risk its reputation by having fraud on its turf. “The MAS might not rule with an iron fist, but it does keep a close eye on hedge funds,” says one manager. Indeed, its track record for avoiding fraud so far has been nearly perfect. Singapore-based Aman Capital Management, a $240 million fund, was forced to liquidate assets last year after reportedly losing money on its derivatives trades. “Aman’s clients walked away with 80% of their money intact. It seemed more a case of mismanagement, exacerbated by the exit of a large pool of invested money,” says one Singapore-based manager.

In Hong Kong, the SFC has taken a slightly stricter approach to issuing licences, so it can be more costly and time-consuming to get started. “One route managers are taking is to get started in Singapore and then move over to Hong Kong when there is more time and resources available to expend on setting up,” says a Hong Kong-based lawyer, According to Carlyon Knight-Evans, partner at Ernst & Young’s Hong Kong hedge fund practice, the SFC estimates that it takes an average of 12 to 16 weeks to review and approve an application from a prospective start-up hedge fund manager. “It can take a lot longer, though,” he says. “We have known applications to take as long as 12 months if the manager doesn’t provide the right information at the outset and where the SFC raises concerns about the proposed set-up,” he says. One of the most frequent grumbles about obtaining a licence in Hong Kong is the requirement for two qualified responsible officers. At least two employees have to sit and pass a series of exams set by the Hong Kong Securities Institute. It is not easy. Pass rates have been very low. Those taking the asset management paper have complained that the paper does not focus on hedge funds but encompasses the entire asset management industry in Hong Kong. However, Sally Wong, executive director at the Hong Kong Investment Funds Association (HKIFA) believes the exam is beneficial to managers. “The syllabus teaches an overview of the regulatory environment here in Hong Kong, and what the expectations are,” she says. “For a fund house, from an operational risk perspective, it is important to know the market.” Indeed, while the slightly stricter approach is a cause for complaint, some managers argue that it can act as a deterrent to have-a-go entrants, and ultimately gives hedge funds based in Hong Kong greater credibility. The more established capital markets environment in Hong Kong also means that managers are nearer to prime brokers and hedge fund administrators than in Singapore – although service providers are increasingly looking at setting up there too.

Logistics

Ultimately, managers say that the choice will in general depend on the type of strategy being implemented. “Hong Kong is of course part of China, as well as a long-standing player in the world’s financial and banking system, and the flow of China’s capital through Hong Kong is mind-boggling,” says Peter Douglas, chairman of the Singapore chapter of the Alternative Investment Management Association and director of GFIA, Asia’s oldest hedge fund consulting firm. Douglas says Singapore has become a more natural base for India hedge fund managers. “There are five India hedge funds in Singapore partly as a result of logistics.” Singapore Airlines runs more than 10 flights to India every day. Singapore’s close diplomatic and cultural relationship with India no doubt plays some role. Ten percent of the country’s population is non-resident Indian, and last year Singapore signed a comprehensive agreement with India allowing for capital gains tax exemptions.

The lower cost of setting up a hedge fund in Singapore than in Hong Kong has also attracted regional managers to open a second Asia office there. “Japanese, Korean and Australian managers have started opening management and trading offices here,” says Douglas. “It is easier from a regulatory perspective, but also operating costs are much lower than in Hong Kong.” The higher cost of office space and staff combined with the licensing burden in Hong Kong would triple his current cost base, he says.

Competition for capital

Cost is becoming an increasingly discussed issue in the hedge fund community in Asia. The gradual maturing of the industry has in some cases brought costs down but breakeven points are rising as competition heats up and end investors become choosier.

The average size of a hedge fund launch has had to increase in Asia, and some smaller funds are having to shut down. “On the whole it is harder to raise capital now in Asia than four or five years back when the concept was novel to end investors and due diligence was less important,” says Jay Moghe, CEO of Opes Prime Asset Management in Singapore. The days of launching with less than $5 million are over. Indeed in Singapore, smaller managers of such a size have reportedly been dropped by hedge fund administrator HSBC. Prime brokers are also pressuring funds to be larger. Moe Ibrahim, fund manager of the $240 million Asian Debt Fund in Singapore, says: “Funds need to be at least $7 million for prime brokers to service them now. And with no prime broker, you cannot go short.” The average fund in Singapore, according to Eurekahedge, has about $85 million in assets, compared with $20 million in 2001. In Hong Kong the figure has gone from $41 million to $120 million. Moghe believes the optimal average launch size to be about $20 million today, depending on the location. “If you’re looking for a get-rich-quick scheme, this is not the space for you,” says Jerry Wang, CEO and CIO of Vision Investment Management, the first and one of the leading funds of Asian hedge funds in the region, with $1.7 billion in assets under management.

As launch size has increased, so has the breakeven point. In Singapore, Moghe says you can get away with a $5 million launch if you use relatively economical service providers, pick a no-frills legal structure (about $30,000 to $50,000 he estimates) and do not have your office in a prime building. However, breakeven is said by one manager operating under those circumstances to be about $20 million. In Hong Kong, the minimum launch and breakeven points are double those in Singapore. And the conservatively estimated “magic number” for funds to reach before asset inflows start picking up pace is about $50 million in Singapore compared with $100 million in Hong Kong, say managers.

Pressure to increase size is a direct result of the growing number of Asian hedge funds. Service providers can now demand larger funds and stop operating at a loss, while investors have greater choice, and so can demand better infrastructure. “Institutional investors are less prepared to take the operational risk associated with start-ups,” says Ibrahim. “We have an internal lawyer, HR, operations guys, analysts and traders, and you cannot do that if you are running a $1 million fund.” There is also the simple fact, as in the US and Europe, that institutional investors are often limited to investing in larger funds where they will not be the dominant investor.

Growth of seed capital

Although it can be argued that raising money pre-launch is not an issue for managers with a long track record, money for infrastructure and a solid reputation, the growing difficulty of raising capital from a smaller base is spurring the development of a seed capital and hedge fund incubation market across the region. Moghe’s Opes Prime and a Japanese partner will offer capital to managers in the pre-launch phase. Moghe says: “Performance in the early stages of a fund is always better, as the manager is more driven. We’ll help those wanting to get started by allocating seed capital and even setting up a managed account with their $1 million, matching that and then letting them run for a year or two to gain experience and up their assets through returns.” Moghe says he receives one or two enquiries a week from potential managers. Vision Investment Management is launching a fund that will seed early-stage Asia hedge funds (Vision Angel Fund). Although some start-ups have become more prepared to give up equity to obtain seed capital, Vision’s Wang says the Angel Fund will participate only in the revenue and will provide a relatively hands-off approach to enable start-up managers to flourish. “We’ll share our experience of the regulatory environment, meet with management and introduce key investors, but this is not a hand-holding exercise,” he says. “The hedge fund industry is an entrepreneurial business, so we don’t want to run a turn-key product that would neglect that spirit.” From its own experience in investing with Asian hedge funds, Vision has found that annualized returns fall about 25% to 30% from the first year of a fund’s life to the third year. Ernst & Young’s Knight-Evans says: “Don’t write off start-ups. There are opportunities with them but, given potential capacity constraints in the industry, if you wait two years to invest you’ll have missed out. Just remember to do appropriate due diligence and look for some sort of prior track record, relevant experience and stability of staff.”

Capital-raising performance

Attracting capital and maintaining it is, like elsewhere in the world, largely dependent on performance. Asian hedge fund strategies have shown a positive performance and, on average, have done better than US and European strategies. However, there’s has been a relatively hard story to sell to investors. According to Asia Hedge, about 116 funds have shut down since 2000, yet the median annual return of these liquidated funds is about 3%. The demand for higher performance from Asian hedge funds stems predominantly from the fact that it is an industry dominated by European and US investors. These are looking for exposure to Asia as they realize there is greater opportunity for outperformance there. However, it is perhaps harder to justify an Asia exposure to hedge funds than to the region’s stock markets, which have shot up over the past few years (see chart). In part the good performance of the region’s stock markets is responsible for the proliferation of directional long/short equity funds that have dominated the Asian hedge fund industry. In December 2002, about 81% of Asia hedge fund strategies were long/short equities, and nearly all were long biased, if not almost long only. One reasoning was that if markets were going up, why short stocks?

Secondly, managers that had started in the region tended to come from a long-only background. Unlike in Europe and the US, many of the first hedge fund managers came from fund management houses, where they had been running long-only strategies. AIMA’s Douglas says: “The Asian hedge fund industry initially grew slowly as investors were not comfortable allocating capital to managers thousands of miles away. Start-ups were driven by money managers used to the idea of growing incrementally and with smaller salaries than big-bank traders. Traders were not about to leave their prop desks to make less money!” Douglas says new funds are now established more by investment banking refugees, who see a clear business opportunity.

The focus on long-biased investments by managers enabled long/short equity managers at least to compete with the stock markets for investors. In 2005, long/short equity Asian hedge funds returned 17%. “It has been a rising tide that has lifted a lot of boats,” says Eugene Kim, CIO of Asian credit hedge fund Tribridge. Where long/short managers in Asia have suffered, however, is through the intense competition.

The rising tide of Asia's stock markets ebbed in May and June
MSCI All Country Far East Ex Japan Price Index,from Jan 2003 to 16 August 2006
Japanese equity markets had a tough 2005
MSCI Japan Price Index from 3 Jan 2005 to 16 August 2006
Source: MSCI Barra

“There are just so many long/short managers, why would you invest with a start-up unless it were exceptional?” posits John Knox, director with $340 million fund of hedge funds KGR Capital. The plight of the long/short manager in Asia has been exacerbated by the pull-back of markets in Japan in 2005, and in the whole of Asia in May and June this year. It has underlined the high correlation of these managers to the stock markets, and is likely to cause a shake-out, say industry participants. Already, inflows to long/short directional strategies have slowed down. One manager in Singapore says he has witnessed a pull-back of inflows from private banks into its long/short fund over 2006. Indeed, investors tend to be less forgiving of dips in performance among Asian hedge funds than in their US and European funds. Managers report instances where investors have pulled out after one month of a drawdown, despite a prior 20 months of positive performance. “The significant investors in Asia are foreign and they run for the door in times of slight trouble,” says Artradis’s Diggle. “It’s logical. If you are sitting in Sweden and investing in Korea of course you’ll tend to panic quicker.” Is shorting possible?

The growing awareness of the importance of trying to keep up with stock markets but avoiding negative performance is encouraging market neutral long/short funds to start up. “We’ve seen market neutral become a sexier strategy since May,” says Christophe Lee, chairman of AIMA’s Hong Kong chapter and CEO of SHK Fund Management. “Investors were unknowingly or knowingly long beta, and now they want less net exposure. The easy money has been made and now managers have to make money the hard way.”

Just how hard it is to short in Asia, and therefore successfully run a market neutral fund, is often debated. Not all markets across Asia are open to shorting, largely as a result of the controversy surrounding the role of hedge funds during the Asian economic crisis of 1997-98. An IMF study later concluded, though, that hedge funds were certainly not the prime movers in the development of the crisis. But given the less open environment for shorting, liquidity is regarded as a problem. Indeed capacity constraints tend to be tighter across all strategies in Asia compared with the US and Europe because the financial markets are not as deep. A typical equity long/short manager in Japan would have a capacity of $700 million and in Asia ex-Japan about $300 million, maintain market participants. But managers of hedge funds and funds of hedge funds say that this will change as markets open up. Shorting, they claim, is not as hard as it once was, and is fairly simple to do if you put in the research. SHK runs a quantitative market neutral fund, which Lee says would just not have been possible to run five years ago. “Access to shorts has become easier,” he says. “There are now about eight to 10 prime brokers in Asia that work hard to get access to shorts, and borrowing costs have come down. Early last year, for example, it would have cost about 400bp on average to borrow South Korean stock. Now that is about 200bp.” Diggle agrees. “People say it’s hard to hedge in Asia but that isn’t entirely true,” he says. “Since spring 2003, lots of western money has come into the equity markets and so the pool of borrowing has increased, and therefore prices have come down. We pay about 50bp on a lot of the borrow.” Diggle believes the main reason managers don’t want to short is that they just choose not to. “Psychologically, people have a hard time hating markets,” he says. “It’s not the Asian thing to do either. Most managers in Asia are fundamental investors. They meet company managers, spend the weekend with them and want to share the dream that the stock will go up. It is hard to find good shorters here.”

Diversification of strategies

In addition to the number of market neutral strategies appearing, other approaches have started to crop up as managers realize investors’ need for diversification, and that growing competition requires differentiation. As of the end of June this year, long/short equity strategies accounted for 60% of Asian hedge fund assets under management compared with 81% in December 2002. “The bulk of securities offered in Asia are still equities, and when investors come looking for higher returns, it is still equities that can give you that. If arb strategies are returning 5% to 8% foreign investors won’t be interested as they can get that back home,” says Ronnie Wu, CIO of fund of hedge funds, Penjing Asset Management in Hong Kong. “That said, we are seeing a liberation of strategies and variations of long/short funds. There are activist funds starting to pop up – even outside of Japan. Quantitative strategies are becoming more popular. There are some credit funds. And some dedicated Asian macro funds have been setting up.” Single-country hedge funds such as those dedicated to Thailand and Indonesia have enjoyed tremendous percentage growth in assets under management, but not all investors are comfortable being exposed to one market. “Some of these markets are very volatile and can blow up overnight,” says one manager. “In 1996, Malaysia was the most liquid market in Asia and now it is a backwater. It sounds like a great idea, but sentiment changes very quickly in these markets. And western investors are so fickle you have to be nomadic.”

There are also opportunities for hedge funds to establish themselves as competition in private equity. Ritchie Capital’s Bhatia is in charge of building up a private equity and structured-solutions-providing business and eventually a hedge fund business in the region. Formerly regional head of GE’s private equity, distressed assets and corporate financial services businesses in Asia, based in Hong Kong, Bhatia knows the private equity space in Asia like the back of his hand. “There are many Asian company owners that need sensible capital and financial solutions in the restructuring space,” he says. “I can’t see why a smart hedge fund could not do as well as a private equity firm or buy-out fund. There is a definite space for people who can move fast, and provide flexible capital. The long-term returns would be high if a hedge fund can convince its end-investors to be patient.” China and India, in particular, offer good opportunities for such funds. To operate them successfully, says Bhatia, also requires strong local knowledge and a local presence. “I used to stay away from China earlier during 1997-2000, but there have been some positive changes, both in the regulatory environment as well as kind of deals emanating in the market,” he says. “Entrepreneurs there are much more welcoming of smart foreign investment. Returns on deals also have started to look quite attractive but you can’t take a one-year view, and if you do not understand the space, there is a likelihood you will get toasted.”

Annie Fung is managing director and co-head of Citic Capital Asset Management, the hedge fund arm of Citic Capital, the alternative investment house of China’s largest financial conglomerate. She agrees with Bhatia that China offers good opportunities. “There are some bad companies, but there are a lot of good companies too, and China is an economy comfortable with high sustained growth in the next decade. Managers should be able to find companies that double initial investments in three years.” The challenge, she agrees, lies in having a local presence. “And you can’t just be in Shanghai or Beijing. You can’t just be there for show. There are more than 50 mega cities in China and you have to travel around to conduct due diligence of portfolio companies. And that, of course, represents a challenge in itself. How can you standardize an investment process and instil a consistent investment approach if you have lots of offices?”

Fung also points out that investors should be aware of potential destabilizing effects of foreign hot money in China. “There’s probably more volatility than is healthy,” she says. Indeed, the nervousness of foreign investors such as the private banks and foreign funds of hedge funds is hindering the development of the Asian hedge fund industry to some extent, say managers. For Asia’s hedge fund market to mature, the number of stable domestic investors and large institutional investors of single hedge funds needs to increase. Attracting domestic money has not been easy. Japanese and Australian pension funds have been active users of hedge funds but other Asian institutional investors have been less forthcoming, and certainly not enough to convince their peers, says Stewart Aldcroft, regional director, Asia, for Noble Investments. “If the likes of influential institutional investors such as the Hong Kong Monetary Authority, the MAS or Temasek in Singapore publicly admitted to investing in hedge funds, it would make such a difference.” Aldcroft also laments the lack of impact felt by Hong Kong’s approval of sales of hedge funds to retail investors. Investors require a minimum of $50,000 to invest in single hedge funds and $10,000 in funds of hedge funds by qualified fund managers, which tend to be the big mutual fund houses. “It is a great idea but in more than three years only 13 funds have sought approval, and now more than half of these are closed. No one seems to have got this worked out,” says Aldcroft.

The HKIFA’s Wong is more upbeat. “Hong Kong has been ahead of the curve worldwide in enabling retail access to investors,” she says. “And it will ultimately raise the profile of hedge funds, which could encourage institutions.” But she says the success will hinge on the distributors. Eighty percent of sales are made through banks, and debunking the myths surrounding hedge funds to banking customers is not an easy process. The interest from high net-worth individuals in the region is less clear. Most wealthy Asian investors put their money with Swiss private banks, and it is difficult to know how much of that wealth is flowing back into Asia through hedge funds. One Asia manager suspects that the region’s wealthy are more interested in property when it comes to domestic investments, and another manager suggests they are more likely to put the money back into their own companies. “So much depends on liquidity flows from foreign investors in Asia, but they are nervous. They do not understand that Asia, and China in particular, is not a bubble. Until they do, the key to the maturity of the hedge fund market in Asia will lies with how much domestic and therefore more stable money is in the game,” he says.

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