Global Investors: Give Me Alpha (Plus a Premium) for Asia

"Competence, like truth, beauty and contact lenses, is in the eye of the beholder".

Laurence J. Peter (1919 - 1988)

Fact number one: the hedge fund industry has been bleeding AUM over the last 6-9 months and the downtrend is not yet done. For example, a recent Lipper Hedge Fund Asset Flows report for 1Q09 pointed to a loss of close  to US$115.7 billion -  the second worst quarterly outflow since 1994. A good portion of that was due to poor performance in addition to outflows from Asia due to risk-aversion among global investors. 

Fact number two: a key, and forgotten point, has been the makeup of investors fleeing the industry en masse. The bulk of the investor base which amounted to as much as US$400-500 billion, came from hedge fund of funds (HFoFs) and high new worth individuals (HNWI). This author estimates that as much as 75% of the capital that flooded Asian hedge funds from the early 2000s came from this fickle investor base. For example, in 2005/06 there were an estimated 75 HFoFs with an Asian focus. Many of them are now closed due to poor performance and heavy redemption losses and they will not be coming back.

Fact number three: Asia-specific manager performance shows a high correlation to beta indices that are liquidity and momentum driven. This is again, a proven fact. Once liquidity (i.e. exchange turnover/transaction volume) declines then the ability to generate alpha also tends to decline as over 70% of strategy assets tend to be driven by the directional moves of the region's equity markets.

Fact number four: non-equity related strategies are capacity constrained. If you accept the previous point then it becomes clear that you will not get large single manager funds with $4-5 billion in AUM. And, these are the AUM you need in order to be attractive to larger institutional investors. It also means that the vast number of currently "profitable" hedge funds are likely to make impressive monthly % performance gains on low AUM, which is always a red flag.

Fact number five: if, one is of the opinion that the global equity markets may yet see more volatility on the downside, then Asia presents further risk, and whereas in the past hot money investors sought approximately a 5-10% premium on returns for going oversea, that might actually rise now that the recent Volatility Shock environment has shown global investors how correlated the equity and credit markets  can be. 

As a result, all the hot air about new strategies and new managers setting up in Asia should be taken with a large dose of indigestion pills. Global institutional investors are not enamored with alpha from Asia but rather with the beta potential, especially as it relates to growth in small and mid-cap stocks. The region's bond markets are still too small and illiquid while other strategies will tend to have a strong correlation to the overall global credit market conditions. This is why, unless there is a regional push to finance locally established firms, Asian managers will remain the poster children for orphan beta generators for institutional investors and for HNWI the opportunities will only be tempting if the manager can generate 2-5% net of fees per month. Mahalo.

Institutional Investors May Offer Hedge Fund Lifeline, Someday

"If a house be divided among itself, that house cannot stand."

Mark (circa 50 - 100 AD)

New Testament Bible

Shakeouts are never positive if you are on the losing end. The steady drop off in liquidity among Asian equity markets indicated by falling turnover, market cap and the proportion of institutional investor participants spells continued BIG trouble for the hedge fund industry. The only hope may be for the region's institutional investors to take a lead out of the CalPERs playbook and "gang-tackle" the seeding business.

BoNY recently reported that Asian institutional holdings of global hedge funds are down 40% year-on-year through 2009. Most of the selling that took place was directed at hedge fund of funds. Similarly, AsiaHedge reported that out of the universe of funds that they identify, 129 funds closed down in calendar year 2008. This was roughly 25-30%. Moreover, the prospects for further closures and asset flight should continue especially with so many managers failing to produce positive absolute returns.

This is a serious issue for the hedge fund industry itself, service providers, services in general, tax revenues (which should now fall) as well as the standard of living of participants and their associated economies. Corporate boards are also no longer under the proverbial gun to deliver shareholder value now that the scrutiny of activist managers has waned.

What we should be asking is, whether the Volatility Shock that started in September 2008 was a cyclical event or an secular one. Too many ostrich in the sand "experts" couch their state of the industry analysis in terms of cyclical factors - "good for the industry...", "survival of the fittest"..."the industry will bounce back even stronger...". This is naive.

The battle for the regeneration of hedge fund industry in Asia has two sides to it. First is supply of alpha generating talent. This means a pipeline of new managers. Under the current environment of increasing overhead costs, bureaucracy and legal requirements for start-ups the barriers to entry were raised for 2009. It will take over $100 million for an ongoing concern to survive a couple of market cycles, as well as to attract any long-term desire for institutional assets.

If you thought that there was a shortage of quality talent prior to 2007-08 what about now? The global industry shrank from a reported $1.89 trillion in Jan 2008 to $1.25 trillion by Dec 2008.

The next issue is demand. Institutional investors such as pension funds, and life insurance companies continue to have rising liabilities for the foreseeable future. They all face the same dilemma of needing non-correlated alpha that can generate some multiple over LIBOR (400-600 basis points) in order to meet anticipated liability exposure. And many cannot and will not raise the exposure to stocks (too volatile) and bonds (low yields). This leaves liquid alternative investments including hedge funds.

But we have already seen that the supply of those mangers is shrinking anyway, which means that a previously tight SS-DD situation will get tighter as demand remains the same or even increases in the years ahead.

This is why the CalPERs seeding model called the Sprout Program makes so much sense. CalPERs already has the in-house skills to pick managers so why not take away that task from HFoFs, do it internally and eventually create hedge fund capacity with an enterprise value that might benefit employees at some later date.

In return for this, the emerging managers still initially under the CalPERs umbrella with CalPERs money to help them build a meaningful track record). As I see it, the goal is not to find the next George Soros, but rather to have a strategy and process that is transparent, disciplined and scalable producing steady, decent returns. And if it fails, presumably the business will be simply closed down with monies pulled.

Asia's institutional investors would be wise to consider such a model. They could collectively reduce search and transaction costs as well as to negotiate the strategy, fee and capacity agenda of many of the future hedge funds. It makes so much sense, that it is amazing why it has not been done before.

Unfortunately, it may yet be a few years before the regions investors realize what opportunity they might have to really embrace hedge fund strategies and talent. For the potential return will require some risk. Mahalo.

Long Short Equity Suffering Confidence Crisis

"Victorious warriors win first then go to war, while defeated warriors go to war first then seek to win."

Sun-Tsu (circa 400 BC) The Art of War, Strategic Assessments

A vicious cycle is afoot in Asia (and globally), and is threatening the very viability of an ongoing once vibrant, Asian hedge fund industry. The disappearance of market beta and the continuing theme of poor absolute performance carrying over from 2008 into 2009 will trigger more "silent fund shut-downs" which has apparently reached 2-3 managers per day so far this year as investors pull monies and retreat to cash or cash-like equivalents.

The previously most active sponsor of long/short managers in Asia were the fund of hedge funds based in the U.S. and Europe. They used to represent around 35-40% of all allocated monies to hedge funds in Asia. More stable and long term investments by so-called institutions like U.S., Canadian pensions and/or endowments represented a fairly small sliver of total monies allocated (probably around 10-15%).

Much of this never got it allocated as they were the most skeptical about the skill of the region's managers as well as big issues of scalability of their business models.

These investors initially preferred to get exposure to Asia in their portfolios through their allocations to NY and London-based multi-strategy managers like OZ, Ramius, Mariner, Highbridge in the early and mid 2000s. For local expertise in strategies like so-called activism they often went in via local specialists, although this broke down with a number of scandals in Japan in 2006 related to MAC Consulting.

According to data from HSBC Private Banking, YTD performance for the those managers with a Japan Long/Short Equity strategy has been down -1.60%, with the only saving grace a sparse number of multi-strategy Asia shops like Bennelong, Artradis and PMA (Sparx) which have managed to eke out positive returns for the most part.

This is ultimately the only way to foresee any modest revival in investor interest in the region: absolute performance, including capital preservation for the sophisticated investor. The alternative will be that the investor will opt for more cost-effective methods of buying exposure to the region's beta once a bottom has set in; and a bottom will eventually set in.

All manner of service providers are also suffering from the downturn in the hedge fund business and are laying off staff or downsizing accordingly. Things have gotten so bad that the much heralded annual hedge fund conference hosted by GS Tokyo in November may be cancelled. So the short term situation is bleak.

Another manifestation of the current regional malaise is that Singaporean authorities are doing what they can via tax policy to entice some of the Hong Kong business to relocate onto their shores.

It would be wiser to establish a region-wide initiative to encourage the development of a single, region-wide tax and bureaucracy for new or migrant fund firms from the west. They should also look to increase the number of derivative instruments useful to hedge outright equity positions over a number of exchanges; lower margin requirements and generally create an attractive environment for long term participation and investment by global hedge funds looking to escape the inevitable "heavy hand" of legal and taxation that is coming in the U.S. and in Europe.

Now is the golden opportunity for Asian authorities to take a united stand to promote an industry to enhance their capital market development for the coming global market rebound. Asian consumers are almost certainly going to play a key role in that rebound.

And as the regions banks suffer in unison with their western brethren it is important too for cash-rich institutional investors in Asia to team up with hedge funds in order to channel capital into profitable, high growth industrial ventures in their own backyard. They can learn from the experience and skill of hedge funds. Capital needs to be recycled closer to home.

If this is done, it very well may be a new era of growth investing via long/short hedge funds will take off in Asia spuring new strategies and profitable opportunities. The clock is ticking. Mahalo.

The Incredible Shrinking Asian Hedge Fund Industry

"Everything's got a moral, if only you can find it."

Lewis Carroll, 1865 from Alice in Wonderland

The incredible shrinking Asian hedge fund market saw combined assets drop to around 9% of estimated US$1.2 trillion in global industry assets as at the end of 2008. This is in stark contrast to about 15% of global hedge fund assets that Asia represented in late 2007 (when industry assets topped US$1.87 trillion).

The scary thing is that the Asian hedge fund industry may shrink to under $80 billion by 2010 as the number of hedge fund "corpses" continue to pile up; especially if many long/short equity managers do not learn how to profit from short positions! The possible losses would take the Asian hedge fund industry back to late 2004- early 2005 asset levels.

Latest data from HFR confirmed this longer term negative trend.

It started once international investors started to flee Japanese markets in 2006. Equity Long/Short strategy alpha proved fleeting and illusory, while the so-called activist theme broke down when a number of high profile managers were exposed in legal difficulties. Institutional investors started to sour on Japan, quickly followed by the rest of Asia as the "levered beta factories" collapsed in stunning correlation with the region's equity benchmarks.

Japan was important as it was the first to crack; it also offered the deepest equity market so once that went it was a matter of time for the rest of the region to tumble lock-in-step. Bad sentiment in one geography can easily lead to highly correlated liquidity issues across many geographies.

The hedge fund asset pullback picked up steam from mid-2007. This was due to a drop in Chinese and Indian equity markets that chased away a number of fund of momentum (hedge fund of fund) investors.

Meanwhile, a broader theme of de-leveraging, a reversal of the carry trade and a flight to quality led to a massive pullback in global portfolio investments in so-called "risky" assets in Asia. The bubble had burst and and money pulled back into the most liquid, and "safe" instruments - U.S. Treasuries.

Volumes on regional stock exchanges plummeted and continue to so so as retail investors have also been forced to delever, either directly or indirectly.

All told, this makes Asia a pretty barren trading environment these days for active long/short equity managers. Fundamentals are not shaping out too good as the U.S. and European consumer markets reduce demand for Asian exports while a number of local currencies remain undervalued, with the Chinese Yuan being the obvious miscreant.

Sadly, the short term outlook for the overall industry in Asia remains bleak. Hedge funds will continue to close at an alarming rate; capacity from quality managers will continue to shrink as liquidity remains tight across many asset classes; and, as long as the cost of doing business is remains prohibitive, multi-strategy single managers (the big boys) may stick to opportunistic night desk investing in Asia out of London and New York rather than in expensive Tokyo or Hong Kong outposts.

One man's pain can be another's opportunity. It is time for the region's financial and commodity exchanges as well as their respective monetary authorities to seize this moment to save the industry. Even after accounting for all its high profile "faults" the hedge fund industry plays a positive role in the efficient movement of capital through an economy. They can provide liquidity to markets across various time periods and they can also act to ensure that the management of public companies act in the interest of shareholders - by keeping a vibrant voice on board level policy. Enough of the old style waste and politic-ing.

Greater co-operation and coordination among Asian partners would be an important step to increasing the attractiveness of the region once the industry starts to grow again. This would mean a greater number of high quality derivative instruments to trade, to hedge and speculate in; lower transaction costs and the removal of unnecessary bureaucracy involved for start-up managers; tax breaks to encourage rather than discourage exchange-related activities and trading; and, greater coordination when regulation finally takes shape.

It makes sense to nurture the hedge fund industry as a valuable addition to the region's service industry employment; to retain talent and ultimately to secure a greater number of high value investment opportunities for local institutional investors. The alternative will be Asians relying on Londoners or New Yorkers to continue to manage their trillion dollar pension and insurance assets; an unsavory thought for Asian patriots and Asianophiles like me. Mahalo.

Japanese Investors "Ran for the Hills" September 2008

"The greatest mistake you can make in life is to be continually fearing that you will make one."

Elbert Hubbard (1856 - 1915)

September 2008 marked a watershed in Japanese investing in hedge funds. Single managers and hedge fund of funds alike report that virtually all categories of investors from insurers, to banks to regional banks and trading companies put in redemptions en masse.

Rather than vilifying all Japanese investors as representing "fast money" the fact is that they were doing what virtually any other institutional investor has been doing around the globe. This author contends that out of an estimated US$30 billion, as much as US$21 billion or roughly 70% came out of hedge fund of fund vehicles, and the bulk of that negatively impacted mainly U.S. based operations.

Who suffers? A large number of so called multi-billion dollar brand-name HFoFs clearly took the biggest hits. The list is likely to include many well-known multi-strategy shops like FRM, GAM, UBS, Ivy, Arden, Optimal, Weston and a few others such as EACM. For many of these managers, Japanese investors typically represented between 10%-25% of total AUM.

It is perhaps the mid-tier FoHF operations, previously with around US$1 billion in AUM that are likely to have suffered the most. For them, the short term impact of the current liquidity crunch has probably put back their AUM growth back 2-3 years. In order for their business model to survive they must now step up marketing in the U.S. market - already damaged by the Madoff fiasco - or else look to merge/roll-up with other middle-market FoHFs. It is the lack of critical mass that might force them into irrelevancy when institutional investors ever come back to investing with them!

The reason for the unanimous fear and departure from hedge fund strategies is well known. For many of these Japanese institutional investors (who operate like well-oiled, slow bureaucracies) senior management meetings all occur around the same time in Tokyo. Typically, they all face the same challenges and tend to move as a group in order to not stand out. This means that when the larger operations make a decision on investments all of the smaller operations will tend to follow.

The question remains, where have these funds gone? The double whammy of investment losses and potential US$ currency losses will no doubt frustrate senior managers back in Tokyo. But, the choices are very slim these days so it is almost sure that some of these funds will eventually be back - probably once the bottom in many markets is already "in". Unfortunately, the reputation of Japanese investors as "hot money investors" may not recover quickly a fact that might worry a number of single hedge fund managers going forward. Mahalo.

U.S. Treasuries: The Real Economic Pearl Harbor

"Misery is when you heard on the radio that the neighborhood you live in is a slum but you always thought it was home".

Langston Hughes, 1969 "Black Misery"

Falling interest rates globally will have a pervasive influence on asset allocation among fixed income, equities and alternative assets. The tipping point will be whether Asian investors continue to buy or sell U.S. Treasury securities. This, and not the more generalized climate of negative sentiment mentioned by Warren Buffett will be the "Economic Pearl Harbor" of 2009 and beyond.

And initial indications are not encouraging.It is a well known fact that Asian investors dominate holdings of U.S. Treasury securities.

According to U.S. Treasury data, foreign holdings of U.S. Treasuries increased 29% to roughly US$3.1 trillion from Jan to Nov 2008. This was also a rise of 32% Y-o-Y. It indicates that in a global flight to quality trade, U.S. Treasuries continued to be the asset of choice among global investors.

Combined Asian investor holdings of U.S. Treasuries comprised 46% or US$1.4 trillion. This was 6% down from the Nov 2007 level. Of particular note was the massive jump in Chinese holdings by 49% to US$682 billion, with the Taiwan and Tahiland also increasing their holdings by 16% and 25% respectively (albeit from a lower absolute numbers). This is in stark contrast to other Asian investors (Japan, Singapore, Korea and India) whose holdings actually declined.

What does this mean? It means that a special buying program by the Chinese is still intact (for now). It also means that non-Asian central banks and institutional investors have stepped up their holdings too (e.g. U.K. and Caribbean central banks).

It also means that those investors who appear to be tiring of U.S. Treasuries (Japan and Korea) are now probably ripe for alternatives to low-yielding Treasuries. Back in 2003 and 2004 this "opened the door" for massive structured product sales in Asia including sub-prime based CDOs and bonds. The problem now is that a combination of: poor fund of fund returns; the pressure of Basel II regulations; and Madoff-inspired fears of product transparency and liquidity means that many traditional buyers are going to be sitting "paralyzed" by a sense of risk aversion.

In theory "untainted" FoHF brand names should be the winners in the next hedge fund buying cycle. The problem is that many of these product providers have failed their investors with average HFoF performance returning minus 19% in calendar year 2008 and the marketing pitch of diversification also proving a sham.

So which strategies will be the winners in 2009? It certainly looks like Korea and Japan should be prime geographical targets for education programs to help end investors get firmer footholds into managed futures, global macro and certain long-only exposures that might be cost effective. There is little this author sees in terms of HFoF getting signficant market share unless they try to sell managed account HFoF products that might see some favorable traction over the medium term. Mahalo.

The Hedge Fund of the Last Resort

"She thought that maybe - just maybe - Western Civilization was in a decline because people did not take time to take tea at four o'clock."

E.L. Konigsburg 1996, "The View from Saturday"

December 25, 2008 and the Bank of Japan reportedly decided to take (even more) drastic measures to revive the ailing patient, the Japanese economy. With no monetary policy bullets left in terms of interest rates (with the lending rate at 0.1%), the BoJ has moved from buying JGBs and CP to taking on corporate debt. The backstop has moved from the banking sector, then indirectly to the broader economy in the credit markets to directly boosting the industrial base.

The BoJ is signalling in no uncertain terms that its economy is flatlining, and barring flying over Tokyo Bay and dropping yen on the country there is nothing to stop the inevitable hard landing. Stocks are poised for further downside pressure as expected earnings are revised down.

The BoJ must now be considered the biggest hedge fund in Asia playing across a number of diverse asset classes including currencies, stocks, interest rates and now corporate debt. The irony is that there are no other "natural buyers" other than other Sovereign Hedge Funds (central banks) with an appetite to invest in such close to distressed opportunities. This begs the question that Asian political leaders need to sit down the collective risks and opportunities together- or else- expect a growing threat of social and politicial unrest in the region; and not just from a few displaced farmers, but from unemployed white collar workers!

While central banks have correctly tackled the economic levers individually it is becoming very clear that a more co-ordinated political strategy is now the best option to avoid what looks like a growing risk of cascading national economic disasters leading to global depression. It is noones interest to see this happen.

Other Sovereign Hedge Funds (central banks) in the U.S., U.K., Europe and elsewhere (China) are likely working the phones in the next few weeks. The biggest Sovereign Hedge Funds need to sit down very soon. Mahalo.