China's Wall of Money

"There's a saying in the United States that the customer is king. But in Japan the customer is God."

Tak Kimoto, Sumitronics Inc.

Flashback to mid-July 2007: global equity markets all appeared headed into a collective selling abyss. Such was the "fear" initiated by the Subprime Syndrome and investor aversion to risky assets. Surely the emerging markets like China would also be affected? After all, don't Chinese banks hold oceans of U.S. bonds and other assets including those infamous toxic AAA rated CDOs that had exposure to subprime assets?

So while European, U.S., Australian and Japanese bank stocks and broader equity indices took a beating China and Hong Kong actually stood relatively firm. In fact, global stock market performance dispersion has been wide and notable. For example in the month since July 16, 2007 the DJIA returned -7.92%, the S&P 500 returned -8.92%, TOPIX returned -12.12%, the FTSE 100 returned -12.52% and the CAC 40 returned -14.40%.

Over the same period the Hang Seng returned -9.94% while China's A-Share Shanghai and A-Share Szechzen Indices returned 24.75% and 30.21% respectively. This is hardly the earth-shattering collapse hinted at even by illustrious circuit-speakers like former Fed-Chairman Alan Greenspan not too many moons ago. And by the way, looking at August alone the Hang Seng recovered to be up 3.52% month-to-date. What happened and why the apparent decoupling with the rest of the subprime infected financial world?

The Wizard of Oz in this story happens to be the Chinese government. Kudos for pulling off what they did when they did! Co-incidence? I do not think so.

Every indication suggests that Chinese bank exposure to the subprime mess has been substantial - just how much of it is brought out in the open is up for debate. And it should be too. The Bank of China said that it had minimal exposure of US$8.965 billion in U.S. sub-prime mortgage-backed loans by the end of June; Industrial and Commerical Bank of China held US$1.22 billion and China Construction Bank held US$1.06 billion.

That said, it was strangely good timing that just when the finger was about to be pointed in all sorts of directions with hedge fund short-sellers primed to go after China's banks the rules of the game suddenly changed.

The Chinese authorities suddenly relaxed a previous restriction placed on mainland Chinese to invest in the Hong Kong markets. This led to a wall of money suddenly chasing Hong Kong-listed Chinese stocks as the long-discussed arbitrage between "A" and "H" stocks suddenly became a reality. So, not only has this money inflow supported and lifted the Hang Seng but the one condition that the authorities also included in this incredible relaxation in investment strategy was that Chinese residents are now allowed to buy Hong Kong shares only if they leave investable sums with a bank approved by the Bank of China. What an inventive way to "direct" deposit inflows and at the same time keep the markets supported.

The Subprime Syndrome has clouded the masses in the U.S. and Europe with regards to this masterful act which was under-reported when it took place a little over a week ago.

What it did do, was to ensure that aside from a recession risk, Chinese equity markets are likely be decoupled from any renewed Subprime revelations in the U.S. and Europe.

Expect the record breaking markets there to roll on favoring local hedge fund managers anxious for a piece of the momentum driven market. Investors might be wise to look again at BRIC-oriented ETFs if they seek a low-cost piece of this action which should continue for quite a while. International hedge fund managers take note.
Mahalo.

Japan's Loss of Alpha?

"Have regard for your name, since it will remain for you longer than a great store of gold."

The Apocryphia, Ecclesiasticus 41:12

Latest talk in Asia has it that the allocation arm of the region's most prestigous prime broker has redeemed all of its exposure to Japan hedge funds. Who would have thought that! The same institution had managed accounts with negotiated lower fees and capacity with several big name Japan hedge fund specialists back in 2002/03 - a time when Japan was not yet the "ninki-mono" or popular investment vehicle on the global investment block.

Then, when the Nikkei 225 took off those managers insisted on higher fees and their own capacity terms. The famed investor and its clients were effectively given their marching orders as the whole world's investment community led by American and Swiss-based fund of hedge funds piled in.

That was then. Today, Japan Long/Short managers face another problem - poor returns especially as neighbouring markets like China, Korea and others have been doing well.

A quick glance at the Bank of Bermuda/AsiaHedge Japan Long-Short Equity Index and an average of mutual fund returns adopting a regional focus of the Pacific Basin (courtesy of Lipper)illustrates the dilemma.

On a calendar year basis, the hedge funds had higher absolute returns in 3 out of last 8 years, but they underperformed the last 4.5 years. This last fact points to the problem that many investors faced. They allocated to hedge funds in Japan at a time when they would have been better served focusing on mutual funds with a broader regional allocation mandate.

For the period Jan-2003 through Jun-2007, Pacific region mutual fund returned an average of 25.83% each year, with a 12.16% annualized vol for a 1.56 Sharpe. This compared to Japan Long-Short Equity Index (US$) which returned 9.50% on 5.95% vol. and a Sharpe ratio of 0.73. Clearly then, it paid on an average absolute return basis and on a risk-adjusted return basis to have been (and to be now) nvested in mutuals and not hedge funds.

This factor alone has "chased" the most sophisticated institutional investors out of Japan Long-Short Equity strategy and into making broader regional allocations. In this light, it is hardly surprising that Japan Long-Short Equity continues to lose supporters and assets.

And there is no favorable near term prospects in sight, which again suggests that hedge fund managers will do best if they broaden their investment horizons beyond that of simply being in Japan. Until investors understand that Japanese equities actually have a valuation argument depressed returns might continue. But then, the contrarian in me is beginning to think that just when investors are starting the bail out is probably the "safest" time to step in. Japan may be in for a long-awaited rebound...and even GS may have made a mistake in getting out at the wrong time! At the end of the day though we all know the economy has to perform which it has not.
Mahalo

Notice Period D-Day

"Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing"

Sentinel Group website, August 2007

Fear and panic still appear to make good, and at times, lurid headlines. We are now led to believe that investors and hedge fund managers are now vacillating between the mental states of psychosis and neurosis. That is what the drive-by media has been focusing on the past few days as it relates to a number of high profile losses and the likely investor reaction today, August 15th, one of the key redemption notice days for hedge fund investors. It is the time when they can officially notify a manager that they wish to withdraw their funds for the end September deadline.

First, how big is this issue. This author managed to look at a sample universe of about 100 of the biggest single manager funds - many closed and many not reporting to commercially available databases. The average fund assets were about US$2.7 billion. Interestingly, offshore fund terms were similar to their onshore fund terms. 55% of these managers are global in geographical approach (so that includes Asia) and 35% were described as US-focused. 39% of the universe is multi-strategy, with other large strategies covered including distressed securities, convertible arbitrage while only about 6% were statistical arbitrage (quant-driven).

Second, the notice periods. Among the 100 funds the distribution of notice periods ran from 1 day to 1 year with major notice period buckets as follows: 30 days 22%; 45 days 27%; 60 days 20% and 90 days 19%. So, it does appear that the largest number of hedge funds do have the 45 day notice.

Third, estimating the potential "redemption outflows". If we assume that 27% of the assets associated with these hedge funds are candidates to redeem and out of that approx. 20% of them will actively do so (the avg annual turnover in a typical FoHF portfolio) then out of the observed universe that amount coming out would be approx. US$13 billion. Wow!

But, is it realistic to assume that those funds will indeed redeem all of their funds beginning with the Aug 15th notice date? Absolutely not! Life does not work that way. D-Day is not the beginning of the end. And here's why...

First, not all of these funds have suffered losses. This is hard to imagine given the medias' penchant for schadenfreuden. One can assume that only the losers will be candidates to be "panic seller" candidates.

Second, a lot depends on when the investors started investing in their funds. If they were in during 2005 for many quant funds then even recent falls might leave them in positive performance territory. Clearly though, if you invested in 2007 at the start of the year then things could look ugly right now.

Third, a lot of institutional investors, often working with consultants, have prescribed "poor performance pain barriers" below which "sell-out" orders are enforced. Who knows what those pain barriers are? -10% decline, -20% or -30%? Who knows? The 15th has come up so quickly that data on peer groups is probably only scant at best. One would typically have to wait another week for those holes to be filled. Plus unlike Amaranth, recent cases do not appear to be cases of outright fraud in which case it is an easy decision as to what to do next.

Fourth, there is almost always a lot of institutional inertia on the part of pension fund allocators. They take years to invest and it could take many months before they get out of investments. Investment committees have to meet, boxes ticked, reassurance offered by consultants and fund of fund executives. They tend to invest over a 3-5 year horizon and so it becomes difficult to sell out, especially if you are dealing with established blue-chip names. It is rather like many passengers on the Titanic whispering to themselves the mantra "surely my investment is too big and too prestigious to fail"!

This leads naturally to headline risk. Some institutions might not want to be associated with some of the recent"bail-ins". This is a tough one to quantify but certainly explains why some investors stepped up and showed resounding PR support for Goldman's hedge fund quant fund mis-steps (to the tune of US$3 billion). This is similar to the approach that Warren Buffet undertook with Salomon Brothers in the late 1990s - only then, top managers responsible for investment failings were fired...

Fifth, some of these investors may have side letters or special terms to get in and out of their investments and who knows the extent to which the biggest investors have negotiated this type of out-clause. In short, no-one knows what the damage is likely to be and how it will impact the markets.

So I will step out on a limb and say that the ultimate redemption totals that one might expect from the 100 or so biggest funds may amount to US$3-4 billion. And if we assume that Asia-Pacific geographical exposure is around 15% for some of these global funds then about US$800 million might risk coming out of Asian funds at the end of the 3Q07.

But then again that is just my best guess and like any discerning equity market neutral manager, 50% of that might be right and 50% wrong. Remember too that over the fateful 1998 time period when the summer drawdown of hedge funds stood around -14% the calendar year performance of the funds was down -0.35%.

Interestingly, the recent travails of single managers might become yet another opportunity for the growing legion of fund of hedge funds that can now pretty easily explain the benefits of their business model that is properly diversified and that offers (in most cases) a smoother return profile.
Mahalo.

Don't Panic! July Asia & China-Focused Funds Perform Well

"I don't play the game by a particular set of rules; I look for changes in the rules of the game."

Anonymous Global Macro Manager

The early winners in July are Asia and China-focused hedge funds! You might also include those lucky few that stuck to their guns and aggressively sold those firms with toxic sub-prime exposure.

Data returns from HSBC Private Banking covering approximately 250 hedge funds tell an interesting story that appears to be unravelling since the late mid-month sell off in the MSCI World and S&P 500 indices (down 7% and 6% respectively from their mid-month peaks).

The story this month is NOT that "the sky in hedge fund heaven is falling". In fact, as cyclical macro-economic changes made themselves felt we are likely to witness wider performance dispersion between winners and laggards over July.

In some cases performance was lower than expected but in others it was signficantly higher.

There were NO financial bloodbaths (other than Bear Stears and a few others with isolated exposure to sub-prime debt through levered CDO type structures). It was NOT as bad as the popular media would have us all believe...it never is!

I have highlighted just some of the overall findings pointing out some of the performance winners and laggards. The YTD performance is net of fees and equal weighted so there may be a few distortions. Most performance numbers were as of 7/27 or 7/31:

1/ Fixed Income Arbitrage. One would have thought that this strategy would have been battered like a rag- doll by a combination of the credit spread blow-out and a sickening housing market but results point to pretty decent returns YTD of 5.99% with outstanding performance from MKP Opportunity Offshore (+6.75%) and Obsidian (+4.17%) through 7/27. Clearly, the Cassandras got it wrong here.

2/Macro Diversified Systematic. Yikes on this strategy! Expect a high number of negative numbers this month (as there were earlier in the year). These players were clearly undermined by the severe volatility across most equities, currencies and commodities. YTD average performance is still positive at 6.31% but some of the laggards include: DKR Quantitative Strategies (-5.82%), Eagle Global (-6.26%) and GLG Global Futures (-4.89%). Some of the leaders include: JWH Global Strategies Financial and Metal (+9.55%), MAN AHL Diversified (+5.00%). It was the non-trending nature of some of these strategies, typically that act on medium or longer term signals that were punished. The shorter signal models did well - and, again, a fairly mixed performance bag.

3/ Distressed Securities. The universe is very small here though the YTD performance remains positive at 7.22%. Most managers had a negative month with the standout laggard being Turnberry Capital International (-9.10%). Youch!

5/Multi-Strategy Global. Overall mixed results with the YTD still positive at a very strong 11.72%. One standout winner appears to have been Harbinger Capital Partners Offshore Fund which put up 14.47% through 7/27.

6/Credit Global. Sure there were some negatives this month, but this picture was not completely negative with YTD average performance at 7.41%. GLG Credit Fund (A) was down (-7.71%) although Moore Credit Fund (A) was up 5.98%.

7/ Asia Equity Diversified. This was the sure-fire winning strategy this month with average performance up 21.05% with big gains from 788 China fund (+7.01%), Hamon Oriental Long-Short Fund (12.21%), Sofaer Capital Asian Hedge Fund (+6.15%). It was interesting that this part of the equity world has not caught the U.S. sub-prime flu.

8/ Emerging Markets. This continues to perform well too with a YTD return of 14.14%. Everest Capital Emerging Markets +9.70% and SR Global Fund (G) Emerging Markets +5.85% were clear winners in this sub-strategy.

9/ Global Equity Diversified. They performed relatively well across a number of well-known names including Lone Pinon (A) which returned +5.44% for the month and SCP Ocean Fund at +6.29% ending 7/31.

10/ Japan Equity Diversified. The big winner this month was John Zwanstraa's Penta Japan Fund (C-1) which returned 27.60%. This puts his YTD performance at 65.28%. Wow! This is all the more incredible given that he is doing it with a pretty large AUM of a reported US$890 million. As has been previously stated, it is believed that this has been achieved in the broader geographical context and not simply Japan-related. But as we are looking somewhat at Japan the underlying story continues to be tough going for some managers like Rosehill which returned (-5.94%) and Odey Japan & General (-4.16%).

11/North Amercia Equity Diversified. Up to now a solid YTD performing strategy at 9.79%.The sharp market whipsaw in the month end almost certainly caught many players by surprise including Galleon Captains Offshore (-10.52%), GLG North American Opportunity Fund
(-6.58%) and Hayground Cove Overseas Partners (-6.14%) and the widely reported mis-step by Tudor's Raptor Global (-9.02%).

12/ Global Statistical Arbitrage. YTD performance 0.72%. Tykhe Portfolios returned-7.91% through 7/31 while Ventus Fund was -6.26% through 7/27.

13/ Global Diversifed. This broadly describes the global macro strategy and judging by the YTD performance of 6.35% and despite the wide performance dispersion even here the underlying strategy is still on course to do relatively well this year. In terms of winners, Conquest Macro gained 11.83% (7/31) and Landsdowne Macro Fund +8.17%. On the other side of the coin: Gam Teleos Macro returned -4.49%, Harmonic Global Fund -8.19% and Graham Absolute Return Fund -7.85% all of which far outpaced that of Caxton Global Investment which was -2.91% (again picked up in the popular press).

Overall then, some big winners and a few poor performers across many hedge fund sub-strategies. There have been cyclical changes in many markets rather than earth-shattering secular ones.
Mahalo.

Liquidity Risk Traps Aussie Bank

"Leaders aren't born, they are made. And they are made just like anything else, through hard work. And that's the price we'll have to pay to achieve that goal, or any goal."

Vince Lombardi, American football coach (1913-1970)

Earlier today wires reported that Australia's Macquarie bank, has warned that 2 of its funds invested in the extremely toxic securitized loans have suffered in July's credit derivative re-pricings. The bank's write-downs are likely to exceed the US$250 million barrier. In short shrift, the share price fell a precipitous 11%. Yikes!

There are no real surprises here. Curiously, this is not the first Australian financial institution that has been dabbling in the high levered, sub-prime arena. It almost certainly will not be the last. Look for astute long/short equity managers to be doing some intensive due diligence in coming days and placing bets as to when the next domino will fall. There will be some very interesting shorting opportnuities developing over the short run. And, I would not be surprised if lesser Japanese financial institutions eventually come clean...

While global hedge fund performance has been phenomenal over the last 12 months (up over 16% through June 2007 according to the Credit Suisse Tremont Hedge Fund Index), look for some choppier performance waters over the next half of the year.
Mahalo.