The Incredible Shrinking Asian Hedge Fund Industry

"Everything's got a moral, if only you can find it."

Lewis Carroll, 1865 from Alice in Wonderland

The incredible shrinking Asian hedge fund market saw combined assets drop to around 9% of estimated US$1.2 trillion in global industry assets as at the end of 2008. This is in stark contrast to about 15% of global hedge fund assets that Asia represented in late 2007 (when industry assets topped US$1.87 trillion).

The scary thing is that the Asian hedge fund industry may shrink to under $80 billion by 2010 as the number of hedge fund "corpses" continue to pile up; especially if many long/short equity managers do not learn how to profit from short positions! The possible losses would take the Asian hedge fund industry back to late 2004- early 2005 asset levels.

Latest data from HFR confirmed this longer term negative trend.

It started once international investors started to flee Japanese markets in 2006. Equity Long/Short strategy alpha proved fleeting and illusory, while the so-called activist theme broke down when a number of high profile managers were exposed in legal difficulties. Institutional investors started to sour on Japan, quickly followed by the rest of Asia as the "levered beta factories" collapsed in stunning correlation with the region's equity benchmarks.

Japan was important as it was the first to crack; it also offered the deepest equity market so once that went it was a matter of time for the rest of the region to tumble lock-in-step. Bad sentiment in one geography can easily lead to highly correlated liquidity issues across many geographies.

The hedge fund asset pullback picked up steam from mid-2007. This was due to a drop in Chinese and Indian equity markets that chased away a number of fund of momentum (hedge fund of fund) investors.

Meanwhile, a broader theme of de-leveraging, a reversal of the carry trade and a flight to quality led to a massive pullback in global portfolio investments in so-called "risky" assets in Asia. The bubble had burst and and money pulled back into the most liquid, and "safe" instruments - U.S. Treasuries.

Volumes on regional stock exchanges plummeted and continue to so so as retail investors have also been forced to delever, either directly or indirectly.

All told, this makes Asia a pretty barren trading environment these days for active long/short equity managers. Fundamentals are not shaping out too good as the U.S. and European consumer markets reduce demand for Asian exports while a number of local currencies remain undervalued, with the Chinese Yuan being the obvious miscreant.

Sadly, the short term outlook for the overall industry in Asia remains bleak. Hedge funds will continue to close at an alarming rate; capacity from quality managers will continue to shrink as liquidity remains tight across many asset classes; and, as long as the cost of doing business is remains prohibitive, multi-strategy single managers (the big boys) may stick to opportunistic night desk investing in Asia out of London and New York rather than in expensive Tokyo or Hong Kong outposts.

One man's pain can be another's opportunity. It is time for the region's financial and commodity exchanges as well as their respective monetary authorities to seize this moment to save the industry. Even after accounting for all its high profile "faults" the hedge fund industry plays a positive role in the efficient movement of capital through an economy. They can provide liquidity to markets across various time periods and they can also act to ensure that the management of public companies act in the interest of shareholders - by keeping a vibrant voice on board level policy. Enough of the old style waste and politic-ing.

Greater co-operation and coordination among Asian partners would be an important step to increasing the attractiveness of the region once the industry starts to grow again. This would mean a greater number of high quality derivative instruments to trade, to hedge and speculate in; lower transaction costs and the removal of unnecessary bureaucracy involved for start-up managers; tax breaks to encourage rather than discourage exchange-related activities and trading; and, greater coordination when regulation finally takes shape.

It makes sense to nurture the hedge fund industry as a valuable addition to the region's service industry employment; to retain talent and ultimately to secure a greater number of high value investment opportunities for local institutional investors. The alternative will be Asians relying on Londoners or New Yorkers to continue to manage their trillion dollar pension and insurance assets; an unsavory thought for Asian patriots and Asianophiles like me. Mahalo.

Japanese Investors "Ran for the Hills" September 2008

"The greatest mistake you can make in life is to be continually fearing that you will make one."

Elbert Hubbard (1856 - 1915)

September 2008 marked a watershed in Japanese investing in hedge funds. Single managers and hedge fund of funds alike report that virtually all categories of investors from insurers, to banks to regional banks and trading companies put in redemptions en masse.

Rather than vilifying all Japanese investors as representing "fast money" the fact is that they were doing what virtually any other institutional investor has been doing around the globe. This author contends that out of an estimated US$30 billion, as much as US$21 billion or roughly 70% came out of hedge fund of fund vehicles, and the bulk of that negatively impacted mainly U.S. based operations.

Who suffers? A large number of so called multi-billion dollar brand-name HFoFs clearly took the biggest hits. The list is likely to include many well-known multi-strategy shops like FRM, GAM, UBS, Ivy, Arden, Optimal, Weston and a few others such as EACM. For many of these managers, Japanese investors typically represented between 10%-25% of total AUM.

It is perhaps the mid-tier FoHF operations, previously with around US$1 billion in AUM that are likely to have suffered the most. For them, the short term impact of the current liquidity crunch has probably put back their AUM growth back 2-3 years. In order for their business model to survive they must now step up marketing in the U.S. market - already damaged by the Madoff fiasco - or else look to merge/roll-up with other middle-market FoHFs. It is the lack of critical mass that might force them into irrelevancy when institutional investors ever come back to investing with them!

The reason for the unanimous fear and departure from hedge fund strategies is well known. For many of these Japanese institutional investors (who operate like well-oiled, slow bureaucracies) senior management meetings all occur around the same time in Tokyo. Typically, they all face the same challenges and tend to move as a group in order to not stand out. This means that when the larger operations make a decision on investments all of the smaller operations will tend to follow.

The question remains, where have these funds gone? The double whammy of investment losses and potential US$ currency losses will no doubt frustrate senior managers back in Tokyo. But, the choices are very slim these days so it is almost sure that some of these funds will eventually be back - probably once the bottom in many markets is already "in". Unfortunately, the reputation of Japanese investors as "hot money investors" may not recover quickly a fact that might worry a number of single hedge fund managers going forward. Mahalo.