In Asia, like in the Rest of the World, Hedge Fund Performance Matters

"Maturity is a bitter disappointment for which no remedy exists, unless laughter can be said to remedy anything."

Kurt Vonnegut, 1922-2007
Author

The number of global hedge fund managers will likely stagnate this year as smaller firms struggle to raise assets. This should come as no surprise. And guess what? The challenges facing firms will also impact Asia.

According to Eurekahedge, the database and third party-marketer, there were 628 Asia-focused firms managing 1,170 hedge funds in April 2008 versus 183 firms in 2000.

This author "guesstimates" that the combined AUM of hedge funds is still around US$200 billion although this is believed to be down 10-15% from 18 months ago.

It is worth remembering that the global diversification of the big, often-closed long/short equity, multi-strategy or relative value players that typically weigh in with the biggest assets in the regional stock markets.

As in the U.S. and in Europe (why should Asia be no different?) institutional investors, having suffered a performance battering ram in the first quarter of 2008, are now fishing for those big, behemoth single managers and fund of hedge funds that are most likely to "survive" and satisfy their institutional infrastructure demands.

While new fund launches are down in Asia, closures are almost certainly up (attrition rates running at 15% per year vs. an average of 8.5% globally from 2000-2006) - especially in Japan.

As long as performance continues to disappoint the trend is likely to continue. Eurekahedge data suggested that Asian hedge funds were on average minus 5.9% year to date versus minus 1.1% year to date for their global fund index.

The reality is that getting to the US$250 million mark for a start-up manager is probably necessary in order to garner institutional assets (from pension plans, the largest fund of funds, endowments and the like).

Performance, or the lack thereof, still dominates the decision by insitutional investors in their "invest or don't invest" decision in Asia. Frankly,when returns are sub-10% gross (which certainly was not the case in 1Q2008), people complain about 2-20 fees and rightly so. In any region of the world, it is the simple math which is drawing attention to the whole business model of hedge funds and forcing investment committees to ask: "are these strategies really worth it?"

For example, back to the 10% gross returns 10-2=8 8-1.6 equals 6.4%. And if the returns are up at 15% gross then the return to the investor shifts to 10.4% (15% gross - 2% = 13, 13-2.6 is 10.4%). So if managers can't generate at least 15% then the net of 10% is troubling, especially if the broad indices are up 8-12% in that time frame. Remember too that long managers have a better tax efficiency.

Maybe this is the reason that some of the money that might be fleeing hedge funds is flowing back into 130-30 products, index enhanced strategies and other low cost alpha generating products. For beta, there may be more cost effective ways to get exposure in the region.

So called "experts" tend to forget a simple practical fact that performance expectations for Asian investments tend to be higher than in other markets due to the reality of higher perceived risk facotrs. So even a 15% bogey (performance target) might simply not cut it for many types of investors given that the overall market volatility is so high.

On the bright side, there appear to be good opportunities in Asia investing in distressed assets, asset-backed lending to mid- and small companies, in M&A, in investor activist ideas, in infrastructure project financing and in market neutral strategies. And yes, many of these strategies might involve tying up capital in illiquid markets or strategies. But isn't that the M.O. of the big, largely successful managers in the rest of the world? You will need to go more illiquid and accept a longer lock-up in order to participate in the perceived 20%+ returns that exist in Asia.

All this assumes that the authorities do their collective part and not impose direct or indirect restrictions on hedge funds and other financial entrepreneurs. Mahalo!

Deciphering Global Hedge Fund Statistics

"The secret of staying young is to live honestly, eat slowly and to lie about your age."

Lucille Ball
Actress (1911-1989)

One of the biggest problems in the hedge fund space is data mining. Aside from the crazy assumption that historical data and returns can extrapolate into the future, many users of commerically available databases somehow think that they have discovered or uncovered rare secrets from within a mystical hedge fund black box. This is hubris.

Take the latest example unleashed on the world by Pertrac. There are a vast litany of negative concerns related to hedge fund data including self-selection bias, sample selection bias, survivorship bias , backfill bias, and infrequent pricing bias.

Added to these, there are additional very serious classification issues that exist when you have two or more totally different databases with their own labels and you try to fit them together. For instance, where does one put an ABS fund in the HFR database, MSCI database and the Lipper TASS Hedge Fund Database? Is it a fixed income arbitrage fund, a multi-strategy fund or a relative value fund? No-one really knows. But where you put it will certainly impact the data results of risk and return across a number of strategies.

Perhaps the biggest "problem" leveled at databases is that of self-selection bias. While critics point out that only the better funds tend to provide their data to the outside world a reverse argument (and equally legitimate one) is that the best funds do not report to the same databases and so perhaps there are under-reporting biases that should be considered.

Of course, you don't hear much about these funds whenever a news releases comes out!

Which brings me to the case in point. Pertrac, recently analyzed hedge fund data reported to a large number of databases which are consolidated in their analytics package. They claimed that hedge funds report their best performance in their first 2 years. They claimed that a track record of less than two years produced, on average, 11.7% while performers over 2 years produced 10.2% return - a difference of 1.5% on average annual performance.

What the study did not point out was quite a lot. Namely what about the risk-adjusted performance? What about the fact that the smaller funds probably had significantly lower AUM and so in simple numerical terms starting from a lower base their performance was over emphasized. And what about all those closed big funds out there which are not in the databases? The Kensington Global and Medallian Funds of the world...what happens if you include this data into the results?

In fact in an alternative view of the data world a recent comment at a forum in Hawai'i by a academic pointed out just how much of a gap in our understanding of these big closed funds might be out there.

In the presentation covering 20 of these large single manager funds with AUM of over US$6.4 billion there was a definitive performance advantage favoring larger funds. How much? Apparently, an average of over 2.50% per year and for the top performing single managers (top quartile) the number was a staggering 6.00% outperformance per year since 2003!

The reference point for these returns was over the Credit Suisse-Tremont Hedge Fund broad hedge fund index, and, if true, it points to a very significant advantage of big over medium and presumably small too.

Data mining too? Could be. But it might at least shed some light on why the biggest institutional investors in the world are willing to pay higher fees and take on longer lock-ups in order to get access to such funds. It might also explain once and for all the key competitive advantage of the best performing fund of hedge funds - real estate- or simply being invested in the right funds.

And if one wants to focus on age then the average age of those best performing big funds was 13 years. So maybe as Lucille Ball and Marlene Dietrich would have said size and experience matters too. Mahalo.

Owning Up to Sub-Prime Losses May Spur Rally in Bank Stocks

"The power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas."

John Maynard Keynes
Economist (1936-1973)

Is the worst over for Japanese banks? Recent data out of Japan suggests that may be the case. According to data for the financial year ending March 31, 2008 Mizuho Financial Group reported losses in the U.S. subprime sector of US$6.14 billion (Yen 645 billion). It also reported an 80% increase in profits to US$5.31 billion (Yen 560 billion) including a share buyback program amounting to US$1.42 billion. Mizuho had been one of the worst afflicted by the Subprime Syndrome so the latest news is welcome.

Other banks may also be signalling that tough times may be over. Sumitomo Bank, one of the biggest, reported that net profits rose over 20% to US$95 million due to a fall incredit costs while Aozora Bank forecast that its profit would increase to US$42 million as it recovers too from subprime exposure.

Implications? First, expect a short term rally in the equity markets. Aside from the fact that subprime had been weighing down balance sheet growth recent growth numbers out of Japan point to a still bouyant economy, helped in large part by export-driven business out of the BRICs. Second, with greater clarity and transparency now in place one might expect big foreign investors to be lured back into the beaten up Japanese stock market. This should lift the second quarter performance of a number of Japan long/short equity hedge funds. Mahalo.

Korea Readies Hedge Fund Market Opening

"A race horse that can run a mile a few seconds faster is worth twice as much. That little extra proves to be the greatest value."

John D. Hess

Late last year, various "voices" representative of political circles and the financial authorities in Korea announced that a proposed opening up of the alternative investment market would be brought forward from 2012 to 2009.

The motivation: to increase the efficiency and effectiveness of Korea's financial markets.

This could potentially be a BIG boost to Korea as a financial center, not so much because it will soak up investments otherwise directed at India or China but rather because it will probably compete closely with the region's number one laggard economy, Japan.

Korea stands to attract considerable attention from budding hedge fund managers because of the relative size of the financial markets; the vibrancy of its winning world-class brand name industrial concerns whether in autos, consumer durables and trading companies; the potential gains from a Korean perestroika from the opneing up of its northern trading partner on the penninsula; and, the arbitrage of the Korean Discount as political calm takes hold. In fact, it is worth remembering that Korea's financial markets held one of the lowest PE valuations in Asia (behind Thailand).

Of course, all it is not clear sailing for Korea to make massive strides. There is still a hint of insularity, opacity mixed with a strain of "national pride" associated with any attempts by foreign investor activists (Lone Star anyone?) to exert some shareholder responsibility on the still-closeted industrial face. This must change, if Korea is to succesfully vault ahead of Japan in terms of hedge fund market activity.

It is possible that Korea would be like Japan was in 2004. Then, hedge funds capital amounting to US$32 billion was evident in the markets, mostly in equities. However, then, Japan-specific long/short equity funds amounted to about US$28 billion. Today, most hedge fund assets trading Korea comes from global long/short equity shops, multi-strategy shops or those managers with a pan-Asian investment allocation approach. In the case of Japan, assets grew at a phenomenal 30% CAGR every six months through 2006.

The changing climate and attitude to alternative investments should also serve as a powerful signal to brand name HFoFs and private equity shops. Come and sell your wares! There are many deep pocketed insurers, financial institutions, trading companies, brokers and even pension funds that will be eager and willing product buyers.

Korean investors could be very signficant players in the global marketplace. Consider that Japanese institutional investors have over an estimated US$45-50 billion in global hedge fund product buying power. Expect marketing teams to stop off in Seoul, and prime brokers to show off their relationship "wares" in the very near future. Although, if 1Q08 hedge fund performance continues to disappoint one might see immediate demand for private equity, real estate and commodities on the Korean alternative investment shopping list. Mahalo.

Japan Trading Companies Trawling Hedge Fund Eco-System

"It really gets my adrenalin flowing to hear the ping of the cash registers."

Stanley Kalms, b. 1931

One of Japan's largest trading companies, Mitsubishi Corporation, recently paid US$40 million for a 19.4% stake in the fixed income arbitrage hedge fund Aladdin Capital Management LLC.

Aladdin has approx. US$17 billion in assets under management many of them wrapped up in funds and a bevy of structured products, some of them that turned toxic towards the end of 2007 in the midst of the credit-crunch and the subprime meltdown.

A number of Aladdin's clients (mostly in Japan, and probably including Mitsubishi) were on the sore end of that trade. So what happened recently may indeed be the decision taken from one of these firms to "get closer" to the product manufacturer in the hope that once the dust settles they may be able to return to the fore attracting sizeable institutional allocations.

Unfortunatley, we live in times when labels themselves have become toxic. Institutional investors, including those in Japan, will not go near anything called fixed income arbitrage, relative value or even structured product or note. The fact is that association with these strategies has led to losses, and we are talking about big losses over the last 6-12 months.

Investors are not going to allocate to them for the time being. It is time for "wait and see".

Another trading company, Itochu, has a slightly different approach. They, too, started out as distributors in the early 2000s, initially using exclusive distribution contracts to share in the fees generated from selling these products to Japanese investors through their domestic broker-dealer network.

Itochu is famous for an initiative launched by Saito-san in the U.S. to expand into the seeding business. According to urban legend, Itochu gave CEO George Hall of the Clinton Group US$1 million in return for equity in his business model. This is how he started. Once this fixed income arbitrage operation had grown to US$5 billion, George bought out his Japanese seeder for around US$250 million. Saito-san was hailed as a genius and reported back to Tokyo in a senior management position.

Since then, Itochu is believed to have followed up its seeding initative with about 4-5 managers (mostly in the U.S.) with the model being to offer a slug of investment and working capital (US$10-25 million) in return for equity and exclusive distribution rights throughout the world - all this in the hope of finding the next George Soros or George Hall-manager.

They also bought out a hedge fund of fund operation in New York back in 2002 called Acam Advisors. All told, Itochu probably has exposure to hedge fund assets (single managers and fund of hedge funds) of approximately US$2.5 to US$3.0 billion.

Yet another trading company, Sojitz has also been active in the hedge fund business. It was originally a hedge fund of fund operation jointly owned by Nissho Iwai and Nichimen. Unfortunately, it started out with a focus on Japan and Asian fund of hedge fund product - an area that has been producing poor returns over the last few years. It probably has exposure to hedge fund of fund product to the tune of US$400 million (and falling).

Other major Japanese trading companies including Sumitomo, Marubeni and Mitsubishi, have all been active in the hedge fund business either as principal investors or as product manufacturers and distributors. It is believed that taken toegther this group may have a combined exposure of up to US$8-10 billion.

Given that Credit Suisse/Tremont broad hedge fund index has produced negative 2.01% over 1Q2008 one can expect internal pressure to mount within these trading companies to trim their portfolios, reduce exposure to volatile strategies and even to re-structure units if losses are steep enough.

Ultimately, some firms may be soon be forced to pull out of the business altogether, especially if end-buyers in Japan decide that now if not the right time to buy hedge fund product. A bumpy road lies ahead for many of these players. Mahalo.