China Retail: The Long Term Jumbo Customer

"...You may be disappointed if you fail, but you are doomed if you don't try."

Beverly Sills, 1929- 2007
American opera singer and manager

The recent well-publicized success of an international mutual fund that attracted US$8 billion in the first day it was available should raise quite a few eyebrows. This was the first time that an international stock product was offered into the mainland Chinese market. This was made possible by recent changes in the Qualified Institutional Investor Program or QIIP which allows Chinese domestic fund managers to work with sub-advisors overseas.

The firm in question that benefited was BNY Mellon. Other overseas international stock fund providers are likely to be T. Rowe Price, JP Morgan Chase & Co., Fortis, Deutsche and Soc Gen.

International stocks fill a gap in the Chinese market that local fund companies are not able to fill. Hence, their reliance on foreign sub-advisers. They also offer higher returns when compared to short term fixed income products such as savings accounts which yield over 6% in local currency terms. There is also the argument for the average Chinese citizen to "feel diversified" from their own high octane stock market and to own a piece of Disney or other brand name foreign companies.

Of course, the opening up of the mutual fund market in China is certain to garner the attention of HFoF and single hedge managers. The argument for higher yield and diversified returns remain compelling arguments in the alternative investment setting.

Of course, there are considerable legal and strcutural hurdles that need to be ironed out before the mass of Chinese investors will be able to tap into the hedge fund industry. But when this happens, there will be even more of a premium on good quality, scalable capacity. And at least initially, the advantage may go to these same global fund managers that have already lined up local distribution and that have access to product - whether directly or through some form of "wrapper" or structured note. Expect local executive hirings to increase as the opportunity really is phenomenal for this long term jumbo customer. Mahalo.

Asian Central Banks: A Future Force to be Reckoned With

"He who will not economize will have to agonize."

Confucious

A recent report by the consultant McKinsey highlights the growing financial muscle of Asian central banks. In my opinion this will extend beyond their current impact in the foreign exchange and U.S. Treasury markets where they have been very active.

The report is entitled "The New Power Brokers: How Oil, Asia, Hedge Funds and Private Equity Are Shaping Global Capital Markets".

The size of the issue is as follows. At the end of 2006 Asia's central banks (excluding Russia) had foreign-exchange reserves of around US$3.1 trillion. This compared to US$1 trillion in 2000. Mckinsey estimates that this figure will rise 42% to US$5.1 trillion by 2012 or by a US$300 million pace per year over the next 5 years.

The central banks of China and Japan held US$1.1 trillion and US$875 billion as of end 2006. They were followed by Hong Kong-SAR, India, Malaysia, Singapore, South Korea and Taiwan which together held about US$1 trillion.

As to the likely motivation of Asia's central banks, the report goes on to emphasize the following: that they have few to no set liabilities; they comprise few investors; they can provide stable capital flows with no withdrawals; they have little to no need to generate cash flow; and, they have no limitations on asset allocations.

A key trend of many Asian central banks is likely to be the political decision to use these reserves for government investment funds seeking higher returns. This has already been put forward by China and the experience and approach of Singapore is probably the most advanced.

The growth and size of Asia's central bank liquidity is going to impact hedge funds - either directly in the sense that they themselves invest in single managers (either international or in the region) or indirectly, via fund of hedge funds for their diversified returns. Let's not forget that central banks have, in the past, been investors in firms such as LTCM and Vega too!

Another approach may be to eventually see some of these entities buying into the equity of alternative investment firms in the same way that China bought a recent 20% share of a prominent U.S. private equity/hedge fund of fund operator. Yet another approach may be to buy into the ownership of various exchanges where a great deal of hedge fund levered transactions take place.

Either way, Asia's central banks are likely to increase the demand for ever scarce quality capacity in the industry. They may also supply liquidity justwhen many players want to get some enterprise value at, presumably at or near the top of the market. After all, when did an hedge fund or private equity shop ever not think about timing when it comes to pricing an asset, especially when it is their own firm. Mahalo.

Invest Where the Action Is: Go International!

"Private information is practically the source of every large modern fortune."

Oscar Wilde, An Ideal Husband

An interesting phenomenon has crept up upon as all over the last few years. It is what I will call the benefits of "going international". It is really quite simple: it proposes that investors will be rewarded if they invest in parts of the world that offer the highest opportunities/returns. It is as simple as that. You should be invested where the action is!

This should come as no surprise to people who were early investors/adopters of the BRICs (Brazil, Russia, India and China) together with the attendant macro growth stories that they afford.

Looking in the long-only world proves this point. Consider Lipper data for the period 2000-2007 (through Sep) for US equity mutual funds produced an average annual return of only 4.86% and a median return of 4.50%. This was based upon 10,581 funds. For non-US equity mutual funds would have provided an average return of 7.67% and a median of 6.57%. That means that "going international" in the mutual fund equity world would have added an average of over 280 basis points additional return each year!

Mutual fund investing in Japan for the 2000-2007 (Sep) period would not have benefited most investors. The average return on 62 mutual funds was minus 3.35% and a median of minus 2.83%. But, looking at Asia ex-Japan would have provided a positive return to the tune of 12.10% and a median of 12.24%. Similarly suportive information can be gleaned from investing according to the Pacific Region, Eastern Europe and Latin America. In each case, returns exceeded those from the US-specific investment philisophy.

This simple comparison of returns in the long-only world looking at geographical exposure provides a clear indication that to "go international" matters on a return basis.

I would hazard to guess that the same would be true for hedge funds too. An astute investor should consider very carefully the geographical exposure of the underlying hedge fund manager because this is likely to matter.

Of course, there are other equally important considerations too, namely, what methodology is likely to help direct that exposure to be in the right place at the right time, and what do you do if certain geographies are not necessarily liquid? How does this impact our thinking of hedge funds? All of these issues are very relevant to the hedge fund of fund manager. Sadly, in more cases than not the HFoF simply takes it for granted that the underlying global manager makes the optimal investment decision. It might pay to look at this situation a little more closely. Mahalo!