The Asian hedge fund industry has changed dramatically in the last decade – from small players with limited means of hedging to a powerhouse offering a range of strategies
The Asian hedge fund industry has come a long way in a relatively short period of time. At the time of the 1997/1998 financial crisis in the region, there were, worldwide, just a handful of hedge funds with a sole Asian focus, managing less than $5bn of assets.
Today, despite the contraction that has taken place as a consequence of the 2008/2009 global credit crisis, more than 1,100 managers exist, controlling assets in excess of $130bn. That equates to approximately 8% of the world’s hedge fund assets.
Originally, with only very limited means of hedging economic risk other than via equity derivatives and index futures in the most developed markets such as Japan, Australia and Hong Kong, more than three-quarters of the funds were running long/short equity strategies.
Today, the total percentage involved in that area has fallen to a little over 40% as largescale capital market reforms have ensured that diversity truly kicks in, especially in the larger emerging markets.
Several strategies that did not exist even as recently as three or four years ago are now beginning to take up a significant share, especially macro, multi-strategy, foreign exchange and interest rate-related strategies.
Weathering the credit crisis
With the exception of funds focusing on equity-linked arbitrage strategies, most Asian managers have not, historically, geared their portfolios to anything like the same degree as seen in other, more developed regions.
With the underlying capital markets tending to be more volatile and prime brokers in the region not being prepared to lend their capital on an aggressive basis, balance sheet leverage of the funds that we have analysed over the past six years has seldom been in excess of 1.5 times. As a consequence, when key lenders started to withdraw capital in 2008, forcing many hedge funds to contract their funds’ balance sheets at the worst possible moment with markets plummeting on low volumes, the pressure was much less acute in Asia. Indeed, at the end of 2008, when sentiment and lending reached their nadirs, several managers were able to reduce gearing to the point of holding net cash, thus ensuring that they could meet the wave of redemptions that had been placed during the panic and global flight to cash.
Appealing underlying macro-economic scenario
Despite the savage inventory adjustments that took place at the end of 2008 and beginning of 2009, leading to a sharp contraction in Asia’s trade with the rest of the world, the domestic aspects of most Asian economies have shown remarkable resilience. Even the large, sluggish behemoth that is Japan is managing to surprise economists and its own central bank on the upside, albeit marginally.
Forecasts for the next fiscal year continue to suggest that the region’s prospects for growth are far better than those in the Western developed economies, where it is more a question of what levels of contraction need to be factored in. With asset allocators continuing to revise their Asian weightings upwards, it would seem fair to suggest that the local capital markets will remain liquid and volatile for the foreseeable future. Such a scenario should provide plentiful opportunities for the majority of the more sophisticated hedge funds operating in the region.
Japan (finally) produces compelling alpha
2009 has, so far, been a good year for Japanese long/short equity managers. Relative to the benchmark indices, it is looking even better. How has this happened given that the stock market has been a huge laggard to most of the rest of the world, with an economy best described as turgid?
There are several reasons but the main driver has been that, after several years of significant underperformance and general capitulation by disaffected foreigners, value and mid cap stocks are beginning to perform. Indeed, so far this year, the local small cap value and general value indices have outperformed the Topix by a factor of two.
Most Japan long/short funds have a net long exposure to mid caps because their long books tend to have some value and growth stocks in them, whereas their short books tend to be more skewed towards larger, more liquid stocks and index futures.
This mismatch was the main reason that many managers performed very poorly when smaller companies collapsed in 2006 and 2007 following the Livedoor share trading scandal. Many hedge fund managers in Japan used to manage long only, value driven portfolios so this reversal plays into their hands. At the same time, some industries are struggling to survive in the current environment (consumer finance, real estate brokerage and airlines spring to mind) and that is offering rich pickings on the short side.
Meanwhile, almost every category of investor that invests in Japanese hedge funds has withdrawn their capital, fuelled by abysmal returns or general apathy.
As at the beginning of September, the best performing Asian focused fund in 2009 and one of the best performers over the longer term is Arcus Zensen, managed by Peter Tasker and Mark Pearson.
This year, the fund’s net asset value has risen by around 40% and the compound annual return since inception in 2001 is almost 12%. Yet the fund’s size has shrunk from $350m+ in 2007 and currently stands at just $70m. Imagine how things are for those that have not performed as well! Of all the equity strategies pursued in Asia, this is by far the least crowded in a market which is probably the deepest in terms of underlying liquidity.
That is why I regard it as one of the most compelling opportunities for the rest of this year and 2010. Those that cannot see the way forward by allocating assets to long only managers in Japan might wish to consider allocating to long/short managers instead in the hope that the “double alpha” described above enhances returns markedly.
Edward Cartwright, head of business development, Castle Asia Alternative, LGT Capital Partners
