Asia's Financial Stocks Drop on Credit Woes

"In the struggle for survival, the fittest win out at the expense of their rivals because they succeed in adapting themselves best to their environment."

Charles Darwin
Naturalist and author, 1809-1882

The Financial Stock Shock is hitting Asia with full force. Investors are reassessing balance sheet risk, downgrading dividend yields and running en masse from global bank stocks.

In the latest sell-off Chinese banks have taken the heat. Apparently, the Bank of China (the number 2 bank in the country) will write-down a significant portion of its US$7.95 billion in U.S. subprime assets. One may recall that when the whole Subprime Syndrome bandwagon started rolling last fall the authorities claimed that Chinese bank exposure to such toxic assets was minimal. Then, subprime amounted to 3% of US$775 billion in total assets so only US$473 million had been set aside for portfolio writedowns.

As a result, Chinese and other Emerging Market banking stock outperformed their Developed Market counterparts in the U.S. and Europe.

Clearly, the goalposts are now being moved to reflect closer with reality.

Certainly the fact that bond insuers too are being downgraded may have ripple effects on a definition of quality assets that stretch beyond simply subprime tainted CDOs. This will inevitably lead to more surprise writedowns by banks throughout Asia including the current equity market "ragdoll" of Japan.

Just think about how the downgrading of bond insurers could cascade through the financial system as it applies to re-grading across all bond holdings including munis. And, now more than ever banks have become very sensitive to Basel II capital adequacy requirements.

In China, hedge funds and other investors will now focus on the changing storylines that emerge from other major banks like ICBC and China Construction Bank. Look for continued selling of their stocks until at least 80% of their respective subprime exposure is captured in reserves (US$6.4 billion for the Bank of China) - until then the spread/pair trade between developed and emerging market financial equity stocks will tighten for now.

One subtle implication might be the emergence of a political voice among the Chinese population against foreign financial institutional investments - a theme among global SWFs in recent months. Indeed, there are indications that is already the case in some local media circles.

As investors, it is now time to ask your China and pan-Asia hedge fund manager how he/she is taking advantage of this deepening crisis and how that translates in monthly P&L attribution. If the answer is not clear or positive, the advice must be to get out!

The best long/short managers should now be making healthy profits on their short book; these managers forsaw this trade last year and should now be reaping the benefits as they are adaptable. The others will suffer just like the traditional market benchmarks. Mahalo.

2007 Asia Hedge Fund Performance

"Take the loos - I've always believed industrial democracy starts in the lavatory".

Sir Peter Parker
former chairman of British Rail

With the final tally of 2007 performance all but in, the first Investment Fund Performance Review of 2008 produced by HSBC Private Bank plus listings of Bank Syz, Hedge Fund Advisory Group painted the expected final picture for the calendar year.

Per HSBC data, out of approximately 300 funds across all strategies and geographies 4 of the Top 20 "Winners" based upon absolute performance (20%) had an Asian focus: this compared with none in 2006.

For Bank Syz, the Asia impact was more startling accounting for 9 out of their 20 top performing funds for the year!

Those winning HSBC listed funds for 2007 included: 788 China Fund Limited (114.74%), Eastern Advisors LLC (85.30%), Alphagen Tenro Fund Limited (58.32%) and Boyer Allan Pacific Fund Inc. - A (52.06%).

For Bank Syz (that tends to have a greater Indian contingent of managers) the winners included: Golden China Fund (96.95%), Kotak Indian Mid-Cap Fund (86.72%), Boyer Allan Greater China Fund A1 (77.38%), Boyer Allan India Fund (68.77%), India Capital Fund A2 (68.42%), LG India Fund Limited (62.15%), Tree Line Asia Fund (60.33%), WF Asian Smaller Companies Fund (48.19%), and Acru China & Absolute Return Fund (46.14%).

In terms of "Losers" (measured in terms of absolute performance) the list showed that again 4 out of the bottom 20 performers were Japan-focused funds. Although no moral victory, this did represent some form of improvement over calendar year 2006 in which 12 out of the 20 Losers (60%) had a Japan focus. The bad news that a couple of the funds displayed persistence on the downside appearing again on the list of losers (Blue Sky and Melchoir).

Those losing HSBC funds for 2007 included: Blue Sky Japan Class A (-35.11%), Odey Japan & General Inc USD (-25.82%), Melchoir Japan (-16.28%) and Henderson Japan Absolute Return Fund Limited (-10.18%).

For Bank Syz listed managers 9 out their top 20 worst performers were Japan strategy or Asia strategy managers.

Clearly, expect investors to maintain a "hands-off" approach to Japan long/short equity managers UNLESS they can demonstrate an ability to produce alpha in the current tough market conditions. In that case good, experienced Japan managers could easily raise assets and would do well to open new strategies too. The demand will be there.

One might also expect some flexibility among existing managers in terms of the fee arrangements (for example lower fees or fees tied to benchmarked targets in some cases) as they struggle to maintain their current investor base.

Expect too that investors in the US and Europe will probably rotate funds out of Japan into more pan-Asian exposures, a trend which has been going on anyway throughout 2007. A number of institutional investors in the U.S. including pension funds have been doing this.

In contrast, those Japan-focused funds that do produce alpha and great returns might expect to garner a lot of funds in 1Q08 , to close very quickly and to have the benefit of fee-setting inelasitcity. 2008 should be another interesting year with excellent performance prospects given the emergence of volatility across a number of markets. Mahalo.

Wanted in 2008: Japan Long/Short Equity Managers with Shorting Experience

"This [poor Japanese equity performance] seems to reflect that our country is losing its attractiveness as a place of investment, while 'oil money' and other huge excess funds flow around the world."

Atsushi Saito
CEO, Tokyo Stock Exchange

Right out of the 2008 trading gate the Japan's Nikkei 225 Index lost 4.03% (616.37 points) to stand at 14,691.41. This follows on from the minus 11.1% performance the equity index posted over calendar year 2007.

While the comments from the head of the TSE (see above) were decidedly negative, it has become increasingly clear that, despite claims to the contrary, having your domestic stock market at the "investment mercy" of overseas professionals (and a number them hedge funds to boot) is not healthy. To claim that the market is offering value as a number of broker like to hype at this time of year is naive.

The real issue is to look at the composition of the players and to understand their motivations and the market value proposition to them.

"Value" to a Japanese institutional investor is not the same definition as "value" to a western institutional investor. And data shows that Japanese institutional investors have not been buying their market despite the decline of the market towards cheaper levels in 2007. Something is out of whack when your hometime institutions do not buy their own market!

Some hedge fund managers believe that "locals" will only start buying once the Nikkei 225 Index has dropped to the 12,000 mark. This means that Japan's equity markets have another 18% fall potential. Yikes.

The good news is that the CEO of the TSE, Saito-san, is apparently not content to sit on his laurels and senses the acute fragility of Japan's marketplace. Lets hope that the FSA, BoJ and others appreciate the situation too. We need a series of investment catalysts and not mundane broker-speak "Japan is cheap" prognostications. Good luck catching a falling knife.

In the good old days Japan Inc. would have imposed rigidities on the equity markets to make shorting more difficult. Ironically, what is needed is to impose the reverse, to cut taxes on transactions, capital gains and corporate profits and to make subtle changes to the legal system so that inefficient Japan Inc. management teams can no longer "hide" from prospective rabble rousing activists.

The TSE should also step up its international program of JVs and tie-ups with markets and exchanges overseas so as to capture some of the trading volumes in those growing markets. Further the local markets probably need an "extreme makeover" with new instruments (e.g. niche oriented ETFs) for investors both retail and institutional.

For family offices and hedge fund of fund managers, Japan in 2008 represents a conundrum of sorts. It is underweight in a lot of their portfolios on the passive side (many owned the ETF, EWJ).

A further worry for investors is that today's Japan long/short equity managers are either too big and unwieldly to get in and out of positions or simply do not and have not any credible ability/experience where hedging is concerned. This must change and soon!!!

If Japan long/short equity managers cannot generate alpha on the short side of their often long-biased book I anticipate more serious net outflows from investors. Even onshore bank products that claim to have a shorting methodology will lose assets as local Japanese investors "head for the matresses".

It might be a good time for some shrewd hedge fund manager to raise money for a short-bias Japan fund and I am sure that quite a few hedge of fund managers might just be interested enough to take a punt. Mahalo.