Through Mid-March 2008 Asian Hedge Fund Performance Sustains Black Eye

"Give an account of thy stewardship; for thou mayest no longer be steward."

The Bible, Luke 16:2

In contrast to the first quarter of 2007, this year's performance numbers for Asian hedge funds are shaping up to be pretty ugly. The U.S. Subprime Syndrome has impacted investor global risk aversion and emerging markets. That, together with the fact that China and India had overextended market valuations at the end of 2007 has seen Asian markets suffer steep pullbacks.

According to Banque Syz data through March 13, 2008 11 out of the bottom 20 performing managers (55%) had an Asian geographical focus; with India suffering particualrly hard. For HSBC Private Bank data for the week ending March 14, 2008 7 out of the bottom 20 (35%)performing managers had the same Asian focus. What a complete turnaround from 2007.

Based upon March 20 2008 data from the HSBC Private Bank list of hedge funds some of the strategy level numbers for the managers they cover are worrisome indeed. For example, Asian multi-strategy was up 1.71% YTD (for funds with combined assets of US$2.6 Billion); for Asian equity funds the YTD return on an equal-weighted basis was minus 6.86%; and, for Japan equity funds representing AUM of US$7.92 Billion) the YTD average performance has been minus 7.28%. Again many constitutents have returned negative performance in the double digits.

Although only a sub-set of all hedge funds in Asia the author has noted that for the first time combined assets of hedge funds dedicated to Asia (often ex-Japan) now exceed those for Japan.
Japan authorities take note, investors appear to be leaving Japan hedge funds as well.

Asset Flee Risk? The recent disappointing performance pullback is particularly irksome when one considers that many hedge funds are in the minus 15% to minus 20% area on a YTD basis with the negative outliers in the minus 55% to minus 33% range.

A further consequence of this is that it might also dampen somewhat any talk of true global decoupling on a corporate performance level of Asian funds when compared to the hedge fund performance of the U.S. and Europe. Maybe we are not quite there yet.

Third, it might also say a lot more about the fact that liquidity and momentum still fuel many of these markets, at least on the equity side. It again puts managers there under the microscope in terms of whether they do in fact have the ability to generate alpha.

What the poor performance and ancedotal evidence of investor redemptions do suggest is that a clearing out of hedge fund managers is underway. With assets in a a number of funds now close to or indeed under US$100 Million those firms must now shortly make up their minds if they can afford to continue. When assets are so low the firms in question must go back to square one to find investors, especially as institutional investors are bailing "en masse".

Investors are now in stomach-churning-mode. Based upon steep YTD losses or shrinking AUMs or some combination of both a number of Asian hedge funds are likely to be susceptible to some form of "re-organization". This might include suspended redemptions, rolling the failing fund into other more sustainable products within the same firm or it might mean outright fund and firm closure. The risk now exists for a sustained reduction in investor assets in Asian hedge funds. It has been happening in Japan the last 18-24 months. Tough times are ahead.

The survivors will have larger assets, institutional infrastructure, different product offerings and a convincing story to pitch to investors.

And, until a U.S. recession becomes a reality on a global basis this might be precisely the time to take a look at some of these battered markets and decide how to re-allocate assets among the Asia regions most talented hedge fund managers...especially those that know how to short.
Mahalo.

JGBs & Global De-Leveraging Hits Hedge Funds

"A man in incapable of comprehending any argument that interferes with his revenue."

Descartes,
philosopher 1650

The latest in a growing list of hedge funds that have hit the proverbial performance skids took place a few days ago. A London-based operation called Endeavour Capital with assets of US$2.88 billion has fallen 28% in value so far in March 2008 on levered exposure to the Japan Government Bond market in a relative value trade that backfired.

Endeavour was trying to execute a relative value trade in which it simultaneously buys and sells two sets of securities in the hopes that a previously stable statistical relatoinship would transpire. In many cases this type of trade is mean-reverting. Strange as it may sound this was the same theory behind the infamous Long Term Capital (Mis) Management firm back in the go-go 1988 era.

How could bright individuals with impressive professional track records garnered at the global fixed-income department at Salomon Smith Barney have fallen victim to such a terrible trading disaster. Surely their risk management should habve alerted them to the risks involved? This is more so confusing when they wrote in documents to investors that they would limit losses to 20%.

In another example of how past performance is no way a solid indicator of the future- Endeavour made 11% in 2007 then in early 2008 fell victim to credit-spread volatility that hit Peloton and other shops when the value of the collateral (AAA agency paper) fell sharply and prime brokers started to execute margin calls. The plus was pulled. This case comes across as being on the wrong side of a volatile market, the JGB market.

The lesson: investors should be particularly vigilant when backing funds where there is excessive leverage, and also where there is a liberal application of off-balance repos and swaps; instruments that are subject to prime brokerage liquidity issues.

It is also incumbent to be on top of weekly performance estimates and to ask very serious questions if more than 5% losses suddenly appear. The explanation might be simple as the manager does not know what he/she is doing and might dial up leverage to make up for performance deficit. Ask about independent marks applied to illiquid instruments including who does it, on what criteria and how frequently it is done? This is the time to ask questions, and for managers to provide the answers.

How big is the global relative fixed income issue if all funds were to blow up i nthe US$1.79 trillion hedge fund industry? Conservatively speaking, if you assume fixed income arbitrage and a proportion of global multi-strategy and event driven managers are 'in the game" and if you apply a modest 15 x leverage ratio to their capital, then the equity at risk for the banks comes up to be approximatley US$6.5 trillion. Mahalo.

TCI Fails to Slay the Japan Inc. Dinosaur

"Unless you are willing to drench yourself in your work beyond the capacity of the average person, you are just not cut out for positions at the top."

J.C. Penney
former chairman, J.C. Penney

Recent comments from U.K. based hedge fund, The Children's Fund, in the Nikkei news media were marked by anger, scorn and regret - kind of like a teen's reaction to the outright rejection by the belle of the local high school.

The point of contention was JPower, a leading electricity utility in Japan. The Board of JPower apparently decided that it was not going to kowtow to pressure from TCI to up its dividend. Since TCI built up its stake in the firm it has failed to bring to Japan the same sort of investor activism that has made is successful in Europe. Reality bites and when it does it can hurt. In this case the pain could run into quite a few million Benjamins!

So where do they go now? And what is the future of investor activist tactics in Japan? The news is not good. TCI executives railed the decision of the Board and announced that it would recommend all foreigners to sell their equity holdings in Japan Inc. (which they have been doing anyway the last 2 years), and, that European regulators should not allow any Japanese corporation to take more than a 10% stake in any European companies - tit for tat retaliation - another school playground strategy!

The fact is, investor activism and M&A tactics in general have not taken off in Japan. The country remains deeply suspicious of anyone, let alone outsiders, telling them to focus on shareholder value. It is a generational issue. Old geezers never conducted business that way and are not likely to change in the short run.

As a result the best that a typical value-investor could achieve was to 1) coax senior management by enriching them personally with a "new strategy" 2) embarrassing senior management with public revelations about the activities of Board Members 3) "gang tackling" by taking equity in the company along with other friendly hedge funds.

However, in terms of responsible management practices Japan continues to rank near the bottom of most league tables ranking international markets. The legal system favors the incumbent management (however inefficient) and practices are opaque and critical of foreigners. The fact that there have been a number of illegal activities by so-called activist practitioners did not help to restore investor confidence in the system either. All of which is a shame.

At just the moment in history when radical change is needed within the industrial framework in order to tackle many serious issues it resorted to its Dinosaur Practices of YesterYear: obfusticate, hide, caojole, protect, screen and allow the status quo to remain just that. Ironically, what is needed is a shot in the arm.

The stock market recognizes this and has underperformed over the last few years in recognition of this. And it will continue to underperform. Until the very framework changes Japan will remain the short of choice among global hedge fund managers, unless they are looking to buy a car or exercise on a WII game. In the good ole days Japan Inc. offered innovative technological products, industrial best practices and cheap sources of capital. Not anymore, these have become commodities. Mahalo.

China SWF Defends Alternative Investment Acquisitions

"You only learn who has been swimming naked when the tide goes out - and what we are witnessing at some of our largest financial institutions is an ugly sight."

Warren Buffett
Chairman, Berkshire Hathaway Inc.

Defense. EVP and Chief Risk Officer of China's US$200 billion SWF, China Investment Corp. recently commented that recent purchases of stakes in western financial operations with a heavy dose of alternative investments was "good".

There has been growing criticism domestically in China that the value of those purchases continues to fall, both in $ terms as the greenback continues to slide and also in the list prices of those assets: 1) CIC paid US$5 billion for 9.9% of Morgan Stanley. 2) CIC paid US$3 billion for 9.3% of Blackstone Group LP's IPO

Of course time will tell whether these investment will play out. Assuming that the financial markets do not go up in flames then the probability still remain favorable that they will in fact work out well. How well and when will be the real issue.

What next? I speculate that a few options will now drive the investments of a heavily capitalized SWF. These could take it away from investing in firms or funds that have potential exposure to subprime and its derivatives: a) A global HFoF operation with a blue-chip name and limited exposure to illiquid securities (a Bridgewater-type of business) 2) An Asian specialist in Distressed Debt 3) A global commodity player (like a Cargill?) and/or 4) A major mining operation. Time will tell which approach will be followed. Mahalo.