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Hedge Funds in Asia

Thursday, November 30, 2006

Rise of the Mega-Fund

"Better service for the customer is for the good of the public, and this is the true purpose of enterprise."

Konosuke Matsushita, founder of Matsushita Electric

At a recent hedge fund conference in New York City sponsored by Absolute Return (November 2006) one of the list of illustrious speakers was Stephen Robert. Mr. Robert is the Chairman of Renaissance Technologies, a hedge fund specializing in quantitative strategies. It is headed by Professor James Simons and has amassed what some would argue to be the best performance numbers in the industry.

The flagship Medallion Fund (which is closed) started out in 1988 and sports an impressive average annual net of fee performance of 34%. There is a hefty 5% management fee and 44% performance fee. Renaissance decided to return outside money to investors and to leave the bulk of investors as insiders/employees. The reason: the fund had become outsized and unwieldly. Incidentally, Medallion has been up 80% so far in 2006.

What happened? Well, back in August 2006 the firm launched the Renaissance Institutional Equity Fund (RIEF). The goal was to target institutional investors so the minimum investment was set at a steep US$20 million. Simons claimed that the focus would continue to follow similar quantitative models used in Medallion except that there would be a twist - lower volatility and lower fees (as well as lower performance). It would focus on liquid US equities and target returns of 600 bps over the S&P 500. It would have exposure of 175% on longs and 75% on shorts, making it a long-biased fund. It would also offer an attractive goal of generating return with two thirds of the volatility of the S&P 500.

The goal has been to create the world first mega-fund managing US$100 billion. It appears to be on the way there. Big institutional investors cannot get enough of it. So much so that the firm is about to restrict inflows to US$2 billion per month heading into 2007, and may consider lowering that amount even more if necessary.

The fee schedule for institutional investors is also interesting and in many ways groundbreaking. There are 4 separate offerings: a) a fixed management fee of 2% p.a. and no performance fee b) a 0.5% management fee and a performance fee of 10% over the S&P 500 benchmark c) a 0.8% management fee and a performance fee of 25% over the S&P 500 benchmark, and d) a 0.5% management fee and a 35% performance fee over the S&P 500 benchmark.

Renaissance is going after the soft underbelly of an institutional investor's assets: that which is dedicated to U.S. equities and which has traditionally been dominated by the "traditionals" or mutual fund market-place. And considering how they, as a group, often fail to even beat their respective benchmarks this is a relatively easy decision for the investment committee of an endowment or pension fund - better returns at lower risk or simply better risk-adjusted returns. This cooincides with data which recently suggested net monthly outflows from US mutual funds.

Mr. Robert suggested at the conference that when one looks to invest in a quant-shop the question an investor should ask are forward-looking:"What factors in the model have changed? What new factors are likely to determine performance going forward?". The best managers will have rational arguments and theories and will not be wed to a single one. Sound advice.

The firm which boasts 50 PhDs, has approximatley 9 dedicated to their RIEF product - making sure that the smooth and automated model continues to generate its targeted risk/return profile. The combo fund (part mutual fund, part hedge fund) is here to stay and with Renaissance Tech AUM now around US$16 billion who is to say they won't be able to raise an additional US$84 billion in the future!

Remember, this type of product and its popularity has inevitable implications for product providers looking to tap Asia's very deep-pocketed institutional investors. More mega-fund wannabes are certainly on the way. Mahalo.

Tuesday, November 28, 2006

Global Hedge Fund Industry Themes

"Making money doesn't oblige people to forfeit their honor or their conscience."

Baron Guy De Rothschild, banking magnate

Here are a list of investment industry themes that have taken firm root in 2006 and should continue to impact 2007.

1/ Quantitative specialists taking hold with pension investors (e.g. State Street, GSAM, BGI, Bridgewater Associates, AQR etc.)

2/ Liability management anchoring and diversification entering into more and more strategic asset allocation debates on investment committees around the world

3/ Institutional investors continue to prefer "best of breed" products and product providers.

4/ Private clients still showing a proclivity to "chase" performance in both the long-only or hedge fund worlds. This will impact fund raising.

5/ Explosive growth in ETFs (cheap passive investment vehicles) is not a fad.

6/ Aggregate performance of hedge funds still heading lower with returns on average coming in around the cash + 400-600 basis points range.

While not all doom and gloom for hedge fund industry it is interesting to note what the expected real returns and allocations are for one of the biggest and aggressive users of alternative investments. What follows is the strategic asset allocation recently made by a prominent Ivy League U.S. endowment:

  • Real Estate 6% (exp. real return), 21% allocation
  • Private Equity 12% (e.rr), 14% allocation
  • Hedge Funds 6% (e.rr), 27% allocation
  • Fixed Income 2% (e.rr), 10% allocation
  • International Equity 7% (e.rr), 13% allocation
  • US Equity 6% (e.rr), 15% allocation
Of note, the real return expectation and strategic allocation to "hedge funds" has come down substantially for this institutional investor over the last couple of years (they were as high as 40% in hedge funds not too long ago).

In its place, real estate, private equity, international equity and to a lesser extent fixed income look poised for higher allocations. Incidentially, another endowment sent a big contingent of its investment team to live in China for a big portion of the summer.

Another startling fact is the almost equal allocation to be made to international equities and U.S. domestic equities. Wow! Perhaps the recent downward action in the US Dollar is part of this unfolding equation...

Think about it for a minute. If only a fraction of the world's institutional investors re-arranged their allocations along similar lines what would happen to the prices and volatility of some of these asset classes? Of course, this is not a realistic thought as hedge funds do not comprise such a large portion of many investor assets...but it could nonethless suggest that titantic changes may be coming that should benefit hedge funds at least over the near term. More another time on the investment allocations and expectations of Japanese institutional investors.
Mahalo.

Thursday, November 23, 2006

What To Expect from an SEC Audit

"If you want a place in the sun, you've got to put up with a few blisters."

Abigail Van Buren, b.1918, writer and journalist

Hedge fund managers that trade Asia's markets should be aware that an SEC audit may be coming your way and very soon. Talk in the markets suggests that they have already started this process targeting funds that are Asia and Japan-focused.

So what are the main surprises that you as a single hedge fund manager should be aware of? In no particular order here are a few tips to be aware of:

1) Third Party Marketing Contracts. Officers of the SEC will almost certainly be interested to see the written contracts to understand how this potential conflict of interest is formalized and who benefits from it?

2) Trades. The SEC will almost certainly be interested to see the actual trading tickets over a period of time to follow the trail of what the manager is doing, and in his/her process to assess internal processes and operational procedures on trade reconciliation.

3) The Handling of Cross-Trades. So-called end-of-month "window dressing" by which outstanding positions might be closed out only to be opened the following day (and month) are a particular area of interest. Too many times such activity may be conducted to benefit the manager (perhaps in terms of P&L calculations) and/or its prime broker which sees more commission generated flow. So, the SEC will probably ask questions to see if the activity is justified and whether the end-investor is paying unduly for this kind of activity - which might be a wash over the long term - but might nonetheless benefit constituencies other than the investors.

4) Trading Commissions. The SEC has developed pretty good baseline models as to how much a manager should be paying in trading flows to its brokers by strategy and geography. Do not be surprised if your fund is compared to this baseline with questions geared to how and why you paid so much in brokerage commissions? Have answers and in particular have a clear idea how this arrangement currently impacts your investors.

5) Treatment of Hot Issues. The SEC is also interested in the internal workings of IPOs as they relate to the hedge fund firm and its various funds. In the case of Japan this can be a significant P&L contributor as it was in 2004/05 for many funds. Why the interest? Again, it boils down to "fair treatment" of investors. They want to see and test how a manager distributes potentially favorable IPOs among various funds according to some criteria like the size of the fund/AUM. Clearly, the SEC might frown on a manager that had a class of funds for himself and family that took up an unusually large allocation from an IPO. Watch out!

6) Documentation and More Documentation. The SEC will want to see all paperwork to and from prime brokers and administrators to the investment advisors. Before they arrive at your office for the one to two week audit make sure you have all copies made and ready for inspection. It will save time and a lot of stress.

7) Compliance Documentation. It is always a good idea to have these all copied and prepared in advance, if possible in electronic form so that the SEC officers can take it away. Find out in advance of the visit what they will want to see and have it available for them.

8) No Excuses. Whatever happens in your life, do not expect the SEC to postpone their visit to accommodate the changes. If and when they say they will come and conduct the audit they will come. This is not like an U.S. jury duty summons - it is a lot more definite just like death and taxes.

As ever, we suggest that you get proper legal advice and as the old boy scout motto goes: "Be Prepared." Mahalo and Happy Thanksgiving to all.

Wednesday, November 22, 2006

Big Japan Hedge Fund Assets Slipping

"It is not the crook in modern business that we fear, but the honest man who doesn't know what he is doing."

Owen D. Young

Interesting happenings among Asia-dedicated hedge funds. For the June through early November 2006 period, 10 of the biggest hedge funds with a Japan Long/Short Equity focus saw combined AUM fall from US$7.5 Bln to US$6.9 Bln, a decline of -8%. On a YTD (year to date) basis the combined performance was down -7.84% when one excludes the notable standout performance of Penta.

Over the same period, the top 7 hedge funds with an Asia Long/Short Equity focus saw AUM hold steady at US$7.7 Bln. On a YTD basis, the average performance of similarly focused Asia funds was up 8.49%.
Mahalo.

Friday, November 17, 2006

The Great Annual GS Hedge Fund Symposium

"A conference is a gathering of important people who singly can do nothing, but together can decide that nothing can be done."

Fred Allen (John F . Sullivan) (1894-1956)

Each year in mid-November, a 2 day event absorbs the attention of over a thousand hedge fund allocators from around the world. It is the Annual GS Tokyo Hedge Fund Symposium - 2006 will mark the 7th.

Urban legend has it that in the early 2000s, the conference which was put on by the HK conference provider, Terrappin, ran into a dispute with the then sole-sponsor, GS Prime Brokerage. GS, which had been paying somewhere in the region of US$3 million to sponsor the event wanted to reduce that amount but Terrappin balked. Those were the dark days of investing in Japan which proved tough-sledding for many managers.

The result was stunning. GS pulled out of the originally scheduled December timeslot at the Four Seasons hotel and planned their own event a couple of weeks earlier - just enough time to still attract many of the original conference attendees and to see them jump on their flights and go back home. The turn of events almost devastated Terrappin's Hedge Funds World-branded conference. Luckily, the Nikkei rebounded strongly in 2003 resulting in more than enough attendees to go around that benefited both GS and Terrappin.

GS prime brokerage has thrived in Asia, and today, their Symposium is their single most important branding exercise in the region. New and established Japan, Asia and Global managers (typically numbering 40-50) are showcased to screened guests in a "speed-dating" type of environment. Only serious investors are encouraged to attend which was why there was believed to have been an unwritten rule not to focus on certain local investors (regional banks) with a "hot money" reputation. Moreover, teams of junior managers were discouraged so that only senior decision-makers could be flaunted in front of GS PB HF clients.

Imagine the scale of this network and the goodwill that GS has managed to generate when it comes to generating trading commissions by nurturing managers and leading investors to the HF water-well!

Not even a local Japanese bank or broker can compete to bring more managers and investors to Japanese financial markets!

What about the results? Well, this author took a look at the 2003 GS Symposium brochure and manager profiles and discovered the following interesting attendee facts and figures: there were 61 funds "promoted" by 40 investment management firms back then. The areas of expertise covered Japan Long/Short Equity (8 managers); Asia Established Managers (4); Convertible Arbitrage (4); Asia Long/Short Equity (5); Asia Multi-Strategy (5); Global Multi-Strategy (5); Global Long/Short Equity (5); and, Japanese Equity Market Neutral (3).

The moderators of the various panels were predominantly fund of hedge fund managers (European and US), one US family office, an U.S. university endowment, a GS fund of fund manager, and representatives from a Japanese lifer, Japan's largest agricultural co-op bank, and a Japanese non-lifer.

Finally but not least, of the list of managers this author found that out of 40 managers approx. 10 of them have since endured fund or firm closings, departing senior PM employees or outright sale to other entities. Repeat: 10 out of 40 of those managers that presented at the 2003 Symposium underwent substantial business-related change that might be construed as potentially negative.

That is not to say managers at the Tokyo Symposium are any more/less risky than the experience of hedge funds anywhere else in the world. It does underscores one potential risk factor which might might be termed as "fashion roadkill". Mahalo.

Tuesday, November 14, 2006

Emerging Hedge Fund Manager: Beware Of The Capital Raising Twilight Zone...

"The only place where success comes before work is in the dictionary."

Vidal Sassoon, b.1928, hair stylist

Not too long ago I was asked to make comments on the pitch book presentation for a U.S. based Long/Short Equity manager. Before I got to "the numbers" (the bottom line) in the book, I figured from the investment focus that the strategy would have a risk/return profile pretty close to that of the NASDAQ - lots of vol., feast or famine on returns and heavily driven by liquidity flows. I was pretty close to being correct.

One issue with this fund, not related to the performance, was the following: After three and a half years in existence it still hadn't broken the US$100 million AUM (assets under management) barrier. What was the reason behind this fund being trapped in an "AUM Twilight Zone"? I figured that the experience and lessons could very well be transferred to Asian hedge fund single managers. An April 2006 university study claimed that 64% of all Japan hedge funds are managers with AUM under US$ 100 million.

The "AUM Twilight Zone" is a tweener existence - AUM are small enough for the fund to be classified emerging. That means that it is not really big enough to be picked up by the vast majority of institutional investors who like to allocate in US$ 1 million to US$5 million slugs then follow-on with US$5 million to US$ 10 million slugs once a comfort level has been reached. On the other hand, the track record of 3-4 years is long enough that the fund should have already hit the US$250 million barrier.

So why the disconnect?

First, one must get real. Only a handful of special case managers start out with over a billion dollars on day one. The vast majority do not have GS-padded resumes, gilded reputations made on trading desks and the luxury of knowing that there is a whole team of people all moving into a new, locked and fully loaded operation. The fund launches and is closed.

The vast majority of single managers are boutique players- probably good traders or portfolio managers but less so business-builders or entrepreneurs. For many of these hedge fund players that is their dilemma - to build a team, overcome second seating and key man risk issues, and understanding where resources need to go in the race to build AUM. Investors expect this kind of planning and execution. And for the vast majority of managers their previous employer probably handled the majority of these issues including trade reconciliation and other back-office issues.

While the media prefers to portray the glamor side of capital raising the reality follows this type of pathway: friends and family (initial US$10-15 million); a couple of cocktail parties in Geneva and London and a White Knight investor drops (US$ 25 million) and you are off to the capital raising races. The firm might also hire one/more TPMs to divvy up investor segments for a 20% trail arrangement. At the same time the COO finds that he/she is spending spending an awful lot of time at broker cap intro conferences, making appointments and preparing marketing materials, populating commercial databases, revamping the firm's pitch book, paying to meet "serious" investors and thinking about SEC compliance issues in discussion with onshore and offshore attorneys etc.

In the meantime, the manager has to contend with the vissisitudes of beating market performance. And you can bet that in the start up phase, there has been a market upleg and downleg. The latter might hit performance and put the manager in the investor's penalty box, with investors effectively going "cold", meetings drying up and once warm lead allocators saying that they are "on hold for now." The manager has fallen victim to fashion roadkill, and is stuck in a Capital Raising Twilight Zone.

Tips to escape the Capital Raising Twilight Zone

The manager should re-think his business development strategy and consider:

1/ Outsource marketing or business development as the existing set-up clearly has not worked, and if it is already outsourced fire the 3PM (third party marketer) and find someone who delivers!

2/ Focus on the existing "pitch". Find a similar risk/return fund with a prominent name that is in the fund's peer group and find ways to explain how your fund is better - albeit just a little under-developed. Think about how the risk/return profile measures up against long-only benchmarks and show that it is better and not simply beta.

3/ Focus on product rollout - maybe a Long-only or 130/30 fund structure would get traction with institutional investors

4/ Avoid the splatter-gun approach to marketing and target specific investors better, meaning if FoHFs are "hot money" allocators think about other investor groups

5/ Get the message of the fund/manager out there in the media (conference panels and newspaper mentions) in his/her the area of expertise (no cheesy advertising though!)

6/ Approach Japanese and Middle Eastern investors as they are currently flush with cash and may be quicker to pull the trigger in return for capacity gurantees with an up and coming manager. True story. Back in the day, George Hall was seeded by a Japanese trading company in return for 40%-50% of the equity of his firm (I don't know the exact amount) 5-6 years later Mr. Hall bought out his Japanese investor an estimated US$300 million on the way to building a US$ 8 billion hedge fund firm that became known as Clinton Group. It could happen to you.

7/ Consider merging either by selling a stake in the firm to a regional bank (strategic investor) or a larger multi-strategy shop that may be looking to diversify their product offerings

8/ If performance is the issue - find additional PM talent and give up equity to do so. This deals with the substance and not form of the fund and is vital to avoiding the Twilight Zone

9/ Start speaking to seeders or incubators, if you must!

10/ And managers, do not swing for the fences (use excessive exposure and/or leverage) if performance looks sickly one year, it really won't help and shrewd investors will see through it pretty quickly.

Remember, success takes a lot of hard work. Mahalo.

Friday, November 10, 2006

Asia Multi-Strategy: A Misunderstood Secret?

"Making money is art and working is art and good business is the best art of all."

Andy Warhol (1926-1987), artist

A commentary in a recent drive-by media piece entitled "Japan HF Conference Highlights a Paucity of Strategies" caught my eye. With a majority of investors focusing on Japan Long/Short Equity and other Asian Long/Short Equity strategies I wondered what the reality must be?

First, a little recap with some historical context. It is true that Long/Short Equity has dominated captial managed by hedge funds in Japan and Asia. According to many analysts Long/Short Equity strategies make up over 50% of all AUM (assets under management) in Asia. Why? There is an historical context. Back in the mid 80s macro and managed futures were all the rage in the region, there were many investors and the beginnings of a few large hedge funds poking their noses into the equity markets.

The bias towards directional stratgies took on added interest with the explosion of the Nikkei and large cap growth under the guise of "a new paradigm" in the 1990s. Large U.S. trading shops like Salomon Bros. and Morgan Stanley started to ramp up their derivative trading operations and made huge big profits.

Big global hedge funds jumped onto the bandwagon not only playing directional strategies like Long/Short Equity in Tokyo but extending to these new and burgeoning relative value strategies including warrants, basket trading, ADR/GDR trading, volatility and stat arbitrage, convertible and stub trading. In short, the whole array that is being practiced today by dedicated Asia multi-strategy shops inside and outside the region. Urban legend has it that one player (same name as a famous U.S. military academy) garnered over 50% of its global trading profits one year out of Japan.

But with the 1998 Asian Crisis and the emergence of the Japan Premium the case for Japanese banks and brokers suddenly changed for the worse. It opened the door for international investment banks to get into profitable prime brokerage with hedge funds looking at the region. GS and MS established a multi-currency execution capability stranglehold that they continue to hold today.

The subsequent lengthy malaise in the region's equity markets together with disinflation, "hollowing-out" and the plummeting of Japanese interest rates sucked the wind out of many of these global actors: Citadel, Soros, Caxton, Tudor, Highbridge, SAC, Renaissance Tech, OZ, HBK and DKR. They reduced their estimated collective opportunistic exposures to the region and in some cases pulled back operations altogether to focus on other geographies and strategies as stock borrow became difficult for many to maintain balanced/hedges or positions. Many hedge funds focusing on Japan started to re-think their investment strategies as well (Penta, Joho etc).

Fast forward to May 2003. This marked the low point in the Nikkei 225 index and the perception that an economic turnaround of significant global proportions was underway in Japan. Suddenly the risk premium associated with investing in Japan was removed. The Japanese goverment refused to effectively "nationalize" local banks burdened by bad debt. The big global hedge funds (Multi-Strategy, Long/Short Equity, Equity Market Neutral, Event Driven) started to pile in and look not only at operational resources for Japan but for the whole Asia-BRIC investment theme. Reconstruction of Japan's economy and the weeding out of "zombie companies" became a profitable theme for many hedge funds.

Not surprisingly, the 2001-2003 window is the time when the vast majority of Asia dedicated multi-strategy funds started. Typically, they were founded by former prop traders at big banks with a strong convertible arbitrage background. Some worked the night desks in London and/or New York or even lived for a time in HK or Tokyo. Another select few came from big global players themselves, with a few making money by informational arbitrages that existed in a Japan affliicted by limited broker-company coverage with price action often spurred by talk, rumor and retail activity.

Today, Asia and Japan multi-strategy single funds exist. They have been around for quite some time and in many cases over 4-5 years now. There are roughly 20 active players according to commerically available databases. Managers are domiciled around the world with the weightiest capital coming from the following locations (in decreasing order): UK, US, HK and Singapore then Australia.

Their combined AUM managed currently run at US$ 4.5 billion. If you add global hedge funds trading Asia multi-strategy then this figure might run as high as US$ 15 billion, depending on market liquidity.

Asian multi-strategy funds come in differing sizes. Some run in the US$800- US$1.5 billion bracket. These have very often been funded/seeded by private banks or other well-pocketed investment groups.

Then there are the other players (the vast majority) which are more often than not the entreprenuerial traders who have started out with friends and family money. They tend to be stuck in the AUM "no-mans-land" of US$70-150 million. This group must grow to justify the typically extra resources needed to effectively run their operations vs. that of the plain vanilla Long/Short Equity shops.

It appears that those managers that have enjoyed successful and rapid AUM growth have managed to find and secure the backing of financial groups who perhaps are not established in the region. Also, they might also have unlocked the key to big institutional investors whether in Canada, US endowments or Swiss lifers and pension plans who crave diversification that is global and not correlated to certain passive benchmarks.

What about performance? If you look at data that runs up to May 2006, dedicated Asian multi-strategy funds have posted annualized returns in a -0.43% to 219% range. If you take out outliers and look instead at an equal weighted average, annualized performance of these funds is roughly 12-14%.

On volatility, annualized SD for many of these funds comes in a wide range too from 2.81% to 59.39%, with an equal weighted average of 7.5%.

The good news is that Asia multi-strategy funds do seem to effectively produce a positive risk-adjusted returns with Sharpe Ratios ranging from -2.18 to 2.20, with an average Sharpe of just over 1.2.

On correlation, many Asia multi-strategy managers exhibit a range of correlations to the Nikkei 225 from negative to 0.40.

How does Asia multi-strategy stack up against global multi-strategy single managers? According to the CS/Tremont Multi-Strategy sub-index annualized performance, vol and Sharpe (through May 2006) are: 9.65%, 4.32% and 1.03. This means that Asia can give the investor an additional 3.0%-4.0% greater return but also almost 2 X the volatility for roughly the same Sharpe. Of course individual managers are exceptions to this gross generalization but perhaps the most interesting finding is that smaller multi-strategy funds might be the favored vehicles as the larger ones move closer to the "norm" risk/return" profiles.

So there really are a whole range and variety of choices for an investor to make in terms of understanding the risk/return profile of available managers. And believe it or not Asia multi-strategy appears to exhibit sub-classifications at least in terms of their demonstrated risk/return profiles and correlation characteristics. So, not all Asia multi-strategy managers are alike!

It is not only a case of understanding the attibution of his past profiles but how the manager seeks out alpha when liquidity alters in specific Asian markets or instruments (like converts) which will be the key to successful investing. It is a pity that recent conference attendees did not open their eyes and note the not so now secret habits and performance of Asia multi-strategy managers. They exist with many capable ones out there.

Perhaps the biggest hindrance to their greater recognition and acceptance among investors is what strategy bucket they fill - they are not really Long/Short Equity (Asia or International) and they are not really Global Multi-Strategy? Perhaps they should be viewed as a fairly new type of cross-over trading (geographically and strategically) in order to "fit in" to conventional classifications.
Mahalo!

Thursday, November 09, 2006

How Big Is That Asian Hedge Fund Industry In The Window?

"If you see a bandwagon, it's too late."

Sir James Goldsmith
founder of industrial, commercial and financial enterprises

Asia's hedge fund industry has been growing and growing fast. Assets are piling in like there is no tomorrow with India and China attracting attention together with Japan, South Korea and Australia.

Today, one can estimate that Asia's hedge fund industry stands at roughly US$215 billion or 16% of total global hedge fund capital. If you add in global managers who adopt an opportunistic approach to investing then Asian hedge fund capital might easily account for 20% of industry capital!

Interestingly, Japan would account for just over 40% of Asian hedge fund capital, compared to about 77% of Asian hedge fund capital in 2003. So, the "importance" of Japan is clearly falling in this bigger picture.

If you look instead at the narrow and restrictive universe of Asian hedge funds (like most commerical databases) then Asia's industry size is approx. US$130 billion or only 10% of global hedge fund capital.

If Asia's hedge fund industry retains it phenomenal growth rate then bottlenecks are likely to become more apparent.

Everyone from managers to investors to service providers will be impacted. Here are just a few of the ways in which the Asian hedge fund industry will have to adapt and change: serious prime broker challengers in the region (and not just MS or GS) will need to offer truely multi-currency products and services; exchanges will need to provide greater access to derivative products and across different time-zones (which suggests further mergers and JVs); there will inevitably be increasing competition among centers to attract new and emerging managers; investors will need to be educated about the returns and risks to be associated with the growing array of financial products and strategies; and, the authorities will need to look into various issues of regulation and supervision (probably on the manager side) as hedge funds head towards the mass retail marketplace.

All in all, the Window is getting bigger every day. Competition is going to stiffen. Mahalo.

Monday, November 06, 2006

Japanese Pensions Remain Positive on Hedge Funds

"The person who is devoted to paperwork has lost the initiative. He is dealing with things that are brought to his notice, having ceased to notice anything for himself. He has been essentially defeated in his job."

Professor C. Northcote Parkinson (1909-1993) author of "Parkinson's Law"

The pension consulting arm of a prominent Japanese broker speculated that as of 2006, Japanese institutional investors held approx. US$50 billion in hedge fund product (single managers, fund of hedge funds and structures). That is an ambitious number considering that an estimated US$7-10 billion of hedge fund product may have been redeemed over 2005 by financial institutions in Japan due to worries surrounding BIS (Bank for International Settlements) treatment of the equity exposure in hedge fund products and the impact that would have on their balance sheets.

The survey examined attitudes to alternative investments and the results pointed to a big difference among Japanese financial institutions and pension plans. The former are typically invested in REITS, private equity and CDOs and CLOs, while the latter prefer hedge funds.

The real eye opener was in terms of Japan's pension fund exposure to hedge fund product. Over 36% of pension plans have between 5-10% of their total assets in hedge funds while 27% of them have over 10%. This compares with a relatively low 1-2% exposure by US pension plans. Even the early adopter public pension plan CalPERs has only 2% in hedge fund product to date!

What does this mean? Clearly if we assume that 500 pension plans currently have exposure to hedge funds and the total universe size is 4,000 ( in reality is is 6,500) then there is still a great wave of pent-up demand in the pension fund market waiting for scalable products to invest in; especially if the average fund has somewhere between 8-14% of their assets in hedge fund products with the bulk of the single manager investments falling into equity market neutral strategies followed by long short equity strategy and less than 10% in other types of strategy.

Equally important, the survey pointed to the fact that many pension plans consider hedge funds as a substitute asset class to JGBs or domestic fixed income. Over 60% of pension respondents expect a return of 5% from their hedge fund investments. These facts suggest that Japanese investors are still relatively keen on stable, modest returns on their hedge fund investments as they have always been, and so hedge fund managers and promoters of product would be wise to remember that. On the other hand, financial institutions have a slightly different view, including higher return expectations - with over 50% of them expecting returns from hedge funds in the 5-10% range and 12% in the 10-20% range.

In reality, Japan's pension market probably soaks up over US$20 billion in product so far but the growth potential is phenomenal- not only for HFoF but single managers too. Until recently, a problem has been the relatively low level of research, education and conflicts facing distribution channels to that market. Many trust banks have legacy relationships, more often than not exclusive with US and European based product providers, which can lead to a feast or famine type of situation that Sumitomo Trust and Banking experienced following their fateful adherence to FRM products. In the beginning the products flew of the shelf, and when performance headed south redemptions hit them in waves. The consultants are now setting up to sell and market products. The interesting thing will be to see which approach they take, one that is indpendent or one that is married to particular hedge fund products?

Building trust is not an easy thing when fee paying relationships are involved. Just ask the CIO of any Japanese pension fund. Mahalo.