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Hedge Funds in Asia

Tuesday, December 19, 2006

Thailand and the Hedge Fund Connection

"An enterprise culture is one in which every individual understands that the world does not owe him or her a living."

Peter Morgan, b.1936, former director general, Institute of Directors (UK)

1998 Asian Crisis Re-dux? That is the sad memory evoked by yesterday's near 15% mini crash in Thailand's leading SET index after the monetary authorities heavy-handed efforts at administrative measures to stem the rise of the Baht. The local bond markets were also battered to the tune of 30 bps across the curve as sellers fled en masse.

Thailand's currency had reached 9.5 year highs versus the US Dollar and the Bank of Thailand's newly installed governor, Ms. Tarisa Watanagase, had had enough. In her anxiety and haste to stop the record US$950 million in weekly inflows on Thailand's capital account versus the US$300 million weekly pace experienced in November she panicked the financial markets. Lets not forget the fact too, that stemming the currency (temporarily) was a move to appease Thailand's powerful export industry lobby groups.

Back in 1998, many high profile global hedge funds (including Julian Robertson's Tiger) dominated information flows out of the region's central banks. Thailand's currency and forward markets succumbed to devaluation and a lot of well-placed hedge funds made a killing. It is not too surprising what a well-timed visit by an employee of the BoT to Jackson Hole could have had on a successful macro bet at that time.

The same cannot be said today in which the landscape of players has changed. The days of the multi-billion dollar global macro bully are past. In their place are many more, smaller single managers, of the pan-Asia long/short equity variety.

Net of fee returns for hedge funds investing in Asia have been solid so far in 2006. The average returns from a portfolio of hedge funds reported by a well-known Asian bank showed that Asia long/short equity strategy returned 12.59% through early December. This compares with 0.02% net of fee return for Japan long/short equity hedge fund managers and 13.33% for US long/short equity managers.

According to a recent NY university study, Asia ex. Japan's hedge fund industry reached US$102 billion in 2006 or about 8% of the total US$1.325 trillion hedge fund industry. This puts it at 48% of total estimated Asian hedge fund AUM (that include Japan and global managers too).

How does this compare to 2003? Well, then Asia ex. Japan estimated AUM were close to US$25 billion or 40% of total Asian assets. This was 3% of the estimated US$950 million total hedge fund industry.

While there are a few single managers that focus exclusively on Thailand, their approach is tilted towards taking an investor activist, private equity approach in addition to the ubiquitous long/short equity approach. Many of these players, if they learned anything from 1998 was to install liquidity gates and lock-ups. They should survive the current volatility as investors simply cannot pull out of their funds the next day. That said, managers are almost certainly long-biased in approach using futures on the index as their primary hedge. So one can expect potential bargain hunting in the current environment.

The bulk of capital involved in Thailand is likely to be pan-Asian long/short equity managers. This means that they will look at Thailand in addition to Korea, Malaysia, Singapore, Taiwan, HK and China as well as other geographies. As they also tend to be long-biased managers, they will in all likelihood be looking to add to positions rather than to liquidate wholesale and run.

While the motivations and practice of global macro and CTA/currency funds may be different (and a whole lot harder to identify and quantify) the chances are that it is the mutual funds and retail players that are likely to be the big short-term losers in the recent downturn as the Asian hedge fund industry continues to outgrow other regions like North America and Europe (albeit from a lower capital base). Mahalo.

Nomura Continues Global Hedge Fund Pitch

"Business, more than any other occupation, is a continual calculation, an instinctive exercise in foresight."

Henry R. Luce (1898-1967)

After over 20 years "playing defence" by Japanese financial institutions, Nomura just signalled to the world an aggressive offensive strategy to make waves in the US$1.375 trillion global hedge fund industry. Bloomberg reported that Japan's largest broker paid close to US$890 million for a 15% stake in Fortress, in a deal that values the hedge fund/private equity manager at approx. US$6 billion. Rich indeed.

Nomura's purchase follows on from its November 2006 purchase of Instinet, the electronic equity execution shop from Silver Lake Partners. The jewel of the Instinet deal was its roster of an estimated 700 hedge fund clients.

This made sense, as an increasing number of hedge funds have been turning to direct market access and other low-transaction cost pipes to execute buy/sell orders as low as 2 bps a share versus the 15-20 bps a share transaction costs associated with broker-fed orders who promote their research-led value-add model.

What is going on? In the former instance, Nomura will be able to further increase its penetration (one would think) into higher margin global hedge fund execution business. Ironically, this business rather than the Asia or Japan long/short equity managers has the highest value in the hedge fund industry. First, because order put-throughs are bigger and second, they tend to use more leverage and sophisticated derivative instruments. This should contribute to the Nomura bottom line from day one.

The Instinet transaction gave them critical market penetration on the commodity side of the industry. One that is growing at a fast rate at the moment. Despite what they say, it also gives them access to "flow", that is to say they will be able to "see" where the multi-currency hedge fund flows are going in the world and so better be able to respond in competitive pricing in its battle to get a share of high-margin credit derivatives, commodity trading and loan services.

Who knows, a next logical step might even be to set up a bone fide prime brokerage operation? Of course, that would require a greater balance sheet capital committment in addition to an assortment of other legal and re-rating considerations.

Finally, Nomura can now start to effectively broaden its range of hedge fund and private equity products to sell through its retail brokerage network as well as to domestic institutional investors.

Nomura has existing product distribution relationships with Blackrock (for fixed income products) as well as with Thomas Weisel in the area of private equity. Of course this presupposes that the portfolio managers and traders at Fortress who, coincidentally are looking for an even greater payoff with an upcoming IPO, will stay around to continue in the business. That is a big question-mark.

With a baby step now in place to grab some of the global hedge fund business one can expect potentially more strategic acquisitions in other growing areas such as credit derivatives, commodities, foreign exchange and risk arbitrage. Sounds very much like the Morgan Stanley model doesn't it?

Also, one would expect a return back to analyzing Japan with a view to breaking into the GS, MS cartel of business that has a stranglehold on many Japanese manager and strategy flows. Why? Because the comparatively smaller Asian hedge fund business is in high growth mode and will continue to attract global funds over the foreseeable future.

Indeed, a capital introduction service and incubator as part of a renewed emphasis on Asian hedge funds may only be a matter of time...

The only missing piece would then be a range of Nomura fund of hedge fund products. How fitting a comeback would that be! Mahalo.

Thursday, December 14, 2006

Brand Name Fund of Hedge Funds Seen Scrambling in Japan

"Your legacy should be that you made it better than it was when you got it."

Lee Iacocca, b. 1924, former chairman and CEO, Chrysler Corporation

The hedge fund of fund (HFoF) business in Japan is at a crossroads. Recent turbulance including the departure of the chief investment officer at the Ivy FoHF complex has again put the spotlight on the industry and the future buying/selling patterns of Japanese institutional investors.

The aforementioned firm had (according to a summer 2006 Bloomberg article) around US$2 billion in sales in Japan. This was after a steady stream of redemptions that many global "brand name" FoHFs experienced in 2005. At its peak the same firm probably had close to US$3.5 billion in Japanese client sales.

Other well known losers have been FRM and Grosvenor. The latter is believed to have suffered the steepest redemptions on the back of reportedly lack luster performance over an extended period. And there are almost certainly another half a dozen other names that have experienced substantial "asset bleed" in Japan.

So how has the FoHF business become so toxic? In the early 2000s, most local distribution partners were typically re-selling FoHF products to Japanese financial institutions. Those institutions were particularly anxious to goose up their portfolio returns and comprised what became known (negatively) as "hot-money" or "performance-chasers".

Aside from ongoing concerns and questions with regards to transparency it was an easy relationship in which the FoHF would split some portion of their fees with a local distribution partner (like a Japanese trust bank or broker) who in turn added a sales fee on top of everything else to the end investor in Japan. Think about that - fees on fees on fees on....

So how did many of these FoHF products actually perform? Many are secretive about their performance and do not often report to commercial data vendors. Somehow this is part of their marketing strategy maintain some kind of aura of exclusivity in the industry.

That said we have tried to understand what was going on. Using the HFR Fund of Funds Composite Index (Offshore): 2002 2.5%, 2003 11.08%, 2004 6.19%, 2005 7.73%. But if we add in likely distribution fees these numbers might have been reduced by another 2% each year to give 2002 0.5%, 2003 9.08%, 2004 4.19% and 2005 5.73%. Add to that recent up-ticks in the risk free rate and the opportunity cost of HFoF vs. other investments underwent a not so subtle change.

Interestingly, really big Japanese institutions report that they privately would pay only 70-75 bps in upfront management fees for HFoF product that was publically available at 1-1.5% per annum.

Also, when returns of HFoF was noticeably lagging some late-comers including a prominent west-coast name offered product to certain investors in Tokyo at a 80 bp fee all-in.

The result was that a trickle out of brand name HFoF manufacturers became a flood!

When Basel II regulation changes became a source of concern with its resulting impact on Japanese bank capital requirements in early 2005, doing business selling HFoF products ground to a halt. In fact product was dumped.

So balance sheet worries were compounded by an overall negative experience with these brand name FoHFs with regards to performance. Poor performance triggered redemptions among disgruntled pensions. Some of them turned to single managers and niche products (emerging markets), private equity, real estate and other structures like ABS/CDOs as well as going back to long-only investing opportunities.

In this period Japanese investors also started to question the whole FoHF fee model - fees on fees. "Why should I pay for my HFoF manager to fly business class around the world and stay in 5 star hotels, on top of everything else I pay him?" This was a common gripe among investors.

In other words, the investor started to flip back through their OMs to rationalize what exactly they were paying for. When performance is/was there this was overlooked. Not any more, and this too became an additional irritation.

All told, from 2005 between US$12-15 billion is likely to have been redeemed from the brand name FoHFs by Japanese institutional investors. And for some of them additional redemptions are likely to continue.

The HFoF model, their products, fees and how they are marketed need to evolve to the new reality. They must learn to Adapt or Die - especially those with significant exposure to Japanese institutional investors.

In fact, if I was an institutional investor in another region I would pay particular attention to the influence and weight of Japanese institutional money also invested in the FoHF product. Now might be a time to negotiate lower fees in return for "more sticky" assets. Mahalo.

Thursday, December 07, 2006

Hedge Funds: The Growing Visible and Invisible Force in Japanese Equities

"When money is at stake, never be the first to mention sums."

Sheikh Ahmed Yamani, b.1930, former Saudi Arabian oil minister

The impact of hedge funds on Japan's financial markets is well documented. What is less known and yet key for the supervisory authorities (BoJ, FSA etc.) and financial intermediaries (prime brokers, exchanges, administrators, custodians etc.) is where this growth in hedge fund activity will be tomorrow?

I think part of the answer lies in the U.S. and the development of the industry over there.

First some color. Again, we are restricting talk to Japan and mainly equities and equity-related derivatives. Consider a 2006 Columbia University study that looked at 2001, 2003 and 2005. The numbers of Japan hedge funds increased thus: 152, 178 then 406. Assets under management (and before leverage) over this period increased thus: $13 billion, $21 billion then $55 billion.

These numbers pale before the size of the TSE market capitalization, which is where I noticed that the author did not include the impact of so-called "Big Global Funds". Isn't one of the biggest hedge funds in Tokyo (after Sparx) Citadel? And isn't it the case that SAC and in the past GLG have been very active sources of Japanese equity brokerage commission on "The Street"? So why not include these and other heavy-hitters in any calculation of hedge funds on Japanese equities? How can anyone dare to claim they know the size of the universe of hedge funds in Japan and not include any estimate of these players?

Admittedly, in some cases it may be taking place where you have a global player (a la Och-Ziff) with a dedicated Asia Multi-Strategy fund product. But the fact remains, only a few of these players have numbers that you can trace - many do not. Also, it is not so clear exactly what proportion of total AUM a global player has decided to dedicate to Japanese equities or related strategies. They tend to be by their very nature very opportunistic in chasing alpha producing opportunities around the world.

Plus, what about the growth of regional managed account and managed account platforms that mimic the performance of hedge funds themselves? This is another aspect that is not "picked up" by so-called knowledgeable database vendors. What a hole in our understanding of the impact of hedge funds on Japan.!And that is before you even consider things like market depth in various equity cap sizes (believe it or not it changes), liquidity, implied volatility in certain strategies (like convertible arbitrage) as well as leverage employed, cost/availability of borrow etc.

Bottom line: we are currently grossly underestimating the impact of hedge funds on Japanese financial markets. I for one am not surprised that hedge funds might account for about 33% of the market capitalization of TSE equities in 2005/06. Goodness! It might even be higher.

Why? Take a look at the trading value of stocks (Tokyo, Osaka and Nagoya) by types of investors. For the month of Oct 2006, the category called "Foreigners" accounted for close to 42% of the value of all shares traded. In 2002/03 this number was around 31%. This category probably accounts for the bulk of hedge fund activity on the cash equity side, and it does not really even account for the derivatives where they are likely to be equally large players.

Interesting too, "Member Accounts" (stock exchange members who are mostly Japanese) was at 26%, "Insurance Companies" at 0.15%, "Banks" at 6%, "Investment Trusts" at under 2%,
"Corporate Business" at 1.35% and "Individuals" at 22% (data courtesy of exchanges).

What does this all mean? Well, it looks to me on the surface that Japanese institutional investors are not very active purchasers of their own stocks (perhaps as they have been burned so much in the past) and perhaps as their investments are skewed so blatantly towards fixed income and fixed income-like vehicles (like real estate).

This cursory analysis also suggests that the next time the market takes a nose-dive, it might be the stampede of "Foreigner" and "Individuals" who you will hear heading for the door. And that might not be so easy to collectively manage for the authorities as it did so vigorously through various administrative measures in the past.

On the bright side, there may be a developing argument for Japanese equities to become a greater part/portion of the domestic institutional investor appetite. After all, this is Japan Inc. we are talking about with many world class companies now focused on promoting shareholder value. And what about the elephant of public funds in the room? That is for another day. Mahalo.

Tuesday, December 05, 2006

Look Out Investor Activist Funds in Japan...the Supervisory Authorities May Soon Have You in Their Database

"One machine can do the work of fifty ordinary men. No machine can do the work of one extraordinary man."

Elbert (Green) Hubbard (1856-1915), American businessman, writer and painter

An earlier story today on Bloomberg News that the U.S. Securities Exchange Commission is planning to set up a database that tracks the insider trading activities of hedge funds is pretty interesting. Not only did the article stress that up to now the authority does not have an institutional memory to trace the activities of multiple fund activities, but that it must have been a factor in not recognizing potential abuses in the past. They call this a tracking system. I suspect that a similar tracking system will be considered by another financial center - if it is not already in place, and that is in Japan.

Why? Aside from the well-known activity of the CEO of one Japanese activist fund (Murakami of MAC Consulting fame) that eventually led to his arrest, it is not simply the activities of the well-known funds that must be a concern but many other "free-riders", or very often business colleagues in other funds who jump into the same trades...all around the same time. Such "gang-tackling" is likely to be picked up by the supervisory authorities and probably presupposes that there will be some sort of co-operation with exchanges and among the brokers. Yes, the same brokers that are in Japan or abroad and that may be themselves deeply involved in the trading activities of such hedge fund clients.

Like in the U.S. one can expect a greater emphasis and reliance on codes of ethics and compliance reporting presumably to move the legal liability to the brokers or others who knowingly/unknowlingly aid or assist such activity - not that this isn't already part and parcel of the Chinese Wall that is supposed to operate between the investment bank and equity departments of many banks and brokers in Kabutocho, New York and London.

Of note, illegal trading by hedge funds is a politically hot-button issue at the moment, in the U.S as well as in Japan. This is especially given the growing incidence in the press from the likes of well-known "shorts" but other interlopers who have targeted bigger and bigger corporate prey. The activities of Carl Ichan, Kerkorian, and Nelson Peltz are well known, but there are literally hundreds of others involved mostly engaged in legal activities.

The last time I saw any data, hedge funds accounted for between 35-45% of the market capitalization of activity on the NYSE. This compares to a figure of just over 30% for hedge fund activity of the market capitalization of the T.S.E. So, all signs point to even more activity by hedge funds in equity trading. This is something that Japanese authorities are well aware of. As the Bank of Japan recently remarked in a Dec 04 2006 report: "Hedge funds are big players in financial markets and their activities could have a destabilizing effect".

Like in the U.S. it seems logical to assume that the exchange survellience departments will have to "surrender" potentially suspicious reports on a regular basis to the FSA or other authorities to better track the buying and selling of their hedge fund clients/surrogates. Of course, there will be issues of whether it is the client putting through the trade or the prop desk of the brokers/bankers on their own behalf. There are tricky definitional issues on the horizon with associated costs.

If this happens, then isn't it logical to assume that better cross-border information sharing should and would be a next step? After all, a number of hedge funds in one jurisdiction operate as investor activists in others.

It is still too early to know if the S.E.C. is engaging in window-dressing or whether they will actually create a meaningful database, properly staffed that will keep abreast of potential insider situations related to big and not-so-big corporations.

Ironically, the cleaning up of corporate balance sheets in Japan and a focus on shareholder value is a part of the financial-social engineering that is being fostered by Japanese authorities in order to facilitate a sense of industrial and economic efficiency - something that Japan Inc. needed and has needed in order to regain and preserve its international competitiveness.

As ever, there is a fine line between encouraging the conditions for such change and at the same time not to choke off the activities of the market-place by imposing unduly transaction high costs on the marketplace participants.

Whatever the final direction, it certainly seems to this observer that Japan's supervisory authorities might do well to take the initiative and create their own tracking database very soon. There are many hedge funds lining up to take a crack at "promoting shareholder value" Japan Inc. as I write. Mahalo.