2010 Through the Asian Looking Glass

"Always bear in mind that your resolution to succeed is more important than any one thing".

Abraham Lincoln (1805-1865)

16th President of the United States

Bear with me...recently, as I do this time of year, I put down a few random thoughts on the upcoming year and the hedge fund industry in general and send it to a few close colleagues for critical feedback. The beauty of making forecasts is that you can keep on making them, just like speculating on the weather. Anyway, I am taking the broad ideas and liberally applying them to the Asian hedge fund industry - which I sense is undergoing a radical shift.

1. Asset Growth. Global hedge fund industry assets were estimated at $1.55 trillion at the end of September 2009, rising to $1.87 trillion at the end of December (source: Lipper). This number is likely to grow to $2.16 trillion by the end of December 2010, implying a growth rate of 15.34%. As the rate of Asia assets has tended to be in the 20-25% range we can expect assets to grow from about $450 billion at the end of December 2009 to $510 billion by the end of December 2010. Asian assets fled at a faster rate in 2008/09 due to the "hot money" mentality of many investors and their high exposure to Madoff feeders.

2. Managed Accounts Emerge. Managed accounts with single managers will double for the global hedge fund industry in 2010. Assuming December 2009 assets at $300 billion, it is logical to expect growth to $600 billion by the end of December 2010. It is the marketing pitch du jour among hedge fund of funds and this will permeate down to the single manager level keen to gather lumpier and stickier institutional hedge fund allocations. A similar growth of demand among Asian institutional investors is more than likely given their respective experiences getting caught in "gated" fund situations in 2008 and 2009.

3. Hybrid Product Proliferation Challenges Hedge Funds. We are already seeing globally, a big push by mutual funds launching "hedge lite" products; the proliferation of leveraged-ETFs; and the rapid growth of UCITS III-compliant fund vehicles. These will increasingly compete with hedge funds for the attention and allocations of institutional investors in Asia. An ongoing issue for Asian based managers continues to be one of proving that they do indeed offer alpha and not simply liquidity-driven and leveraged beta. The days of simply opening up shop and waiting for the cash to come rolling in are over!

4. Global Hedge Fund Investor Mix.I predict that the future high growth investors will be corporate, public pension plans, insurance companies, banks, smaller endowments, Asian private banks, and Australian institutions, and Scandinavian institutions. This is pretty important as institutional investors tend to focus on capital preservation, non-correlation and to a lesser extent absolute performance. I also expect a rebound in family office buying interest. In contrast, the so called low-growth allocators will be HNWI, fund of funds, big endowments and beaten-up Swiss private banks. The “swing” investor remains the Japanese pension plans and what direction they go in during 2010.

5. Demise of Hedge Fund of Funds. The Hedge Fund of Fund Supertanker (comprising approximately 33% of global assets) that hit the 2008/09 Iceberg continues to Sink. I expect a continued slow bleed of AUM as business model flaws exposed e.g. no real diversification; access to underlying managers not an issue today; how to justify double layer of fees…expect drop from being 30-40% of total AUM to under 25% in 2010; this will have a BIG impact on how product is marketed. Fees have already been compressed to 50-75 bps with no performance.

6. Multi-Strategy Funds to Find New Ways to Succeed. On the one hand, we can look to a loss of assets and some institutional support from those that gated investors in 2008/09. There is also the issue that many investors are now keen to de-correlate portfolios and so move away from illiquid sources of alpha.

On the other hand, many of these names remain the only ones big enough to absorb lumpy allocations across a concentrated set of strategies. Many of them also tend to outperform their peers in various hedge fund indices to the tune of 250 bps per year, while the best multi-strategy funds have tended to outperform average hedge funds by as much as 650 bps each year.

We have already seen an initial phase with those firms that understand they will not be able to remain persistent out-performers moving into the long-only space, as well as launching hybrid products as they chase the opportunities provided by closer relationships with their institutional investors or even going after retail. Remember that many of these mega-sized multi-strategy funds have lost substantial cost of capital advantages that demised with Lehman and the whole prime brokerage business back in late 2008.

Regrettably, there are very few Asia-specific multi-strategy funds and these are needed if significant assets will again flow into the region.

7. Portfolio Construction Changes. Expect more concentrated, non-correlated portfolios to be the best/highest performing absolute return vehicles e.g. Paulson. Also, look for counter-party risk to become a key variable in portfolio construction.

8. Strategies. Equity beta (especially international) will continue to be powerful in 2010, which means equity long short, event driven and macro should outperform, as will commodities and energy. When short-term rates start to move up fixed income arbitrage will again emerge from obscurity and gain significant AUM inflows.

9. Plain Vanilla Out – Niche In. The bigger institutional investors are already typically diversified so to make an allocation to hedge funds they will focus on niche/uncorrelated strategies.

10. M&A Will Step Up. Long-only investment firms will buy hedge fund/HFoF managers or bring in teams (PIMCO) to diversify their mix of products e.g. absolute return marketing “fad”.

11. There will be high profile big fund closings and numerous small new fund openings and if the equity markets continue to climb then look again for hedge fund IPOs to make a comeback (even though many of those managers typically have not been the best performers). It never real took-off in Asia although that does not mean that it may not become a source of activity among certain names...

12. The Role of HF Seeders will Grow. Demand for hedge funds continues to out-strip supply of “institutional quality” funds so seeders will grow in importance as intermediaries acting on behalf of these investors to achieve critical mass to absorb the still massive amounts of institutional assets that need to be put to work in ways that are not correlated to the global equity markets e.g. Arrow Hawk.

13. Performance: the average hedge fund performance will be 13-16% CAGR with average annualized vol. of 8-10% over calendar year 2010 which will I predict lag traditional equity market benchmarks as they have done in 2009. Investors will realize why pay fees to a hedge fund that produces 20% return if I can buy the ETF and get 30% even though the risk/return profile of hedge funds will remain intact. Mahalo!

The Missing Link: Big Single Managers in Asia

"Sometimes one must travel far to discover what is near."

The Treasure, Uli Shulevitz, 1978

Moreso in 2010 than at any other time in recent memory, Asia lacks it own big hedge funds. Big hedge funds are important. They tend to spin-off successful smaller managers that tend to start out themselves fairly big (e.g. Treeline Capital from LIM Investments); they are immediately attractive to institutional investors; and, they are important to the long term sustainability of liquidity in Asia's equity markets.

The fact is that there are well over 100 funds with an excess of $3 billion in assets under management globally ex-Asia. In Asia alone this number shrinks to less than 10 funds and that includes private equity, activists and arbitrageurs. Since 2008 that number is starting to dwindle too. This is not to defend a big-is-beautiful-thesis but the fact remains that smaller funds tend to be susceptible to greater business risks, especially if a given investment stategy sours (see recent performance of Artradis Barracuda Fund...)

In Asia, the hedge fund industry needs "leaders". Good performing leaders should have an array of strategies and "product wrappings" (absolute return and long-only), they should be attractive to Asian and western institutional investors; they should have the capability to raise $5 billion in order to be classified as "big"and they should have a pan-Asian investment focus. To many managers have realized late in the day that being only Japan-only is not going to help you raise more than a few hundred million dollars in assets - and if you can, then there is a tremendous geographical concentration risk you are imposing on opportunities and in so doing the risk/return that can be generated.

The good news that end 2009 pan-Asia long short equity managers have been able to generate an attractive average return of 17.80% (HSBC Private Bank Equity-Diversified strategy covering 17 funds). The bad news is that in the recent bullish run this still lags many long-only ETFs, which also do demand 2-2o in fees!

Perhaps the wave of the future will be large private equity shops in Asia evolving into hedge funds. Also, there may yet be a role for the region's SWF entities to build up internal operations and ultimately spin-off those entities through MBOs in order to "create" the next wave of Asian hedge fund behemoths. The clock is ticking. Mahalo.

Big Choices In Store For Asian Investors

"We shall not perish as a people even if we get our money supply wrong - but if we get our human relationships wrong, we shall destroy ourselves."

Rt. Reverend Robert Runcie, b. 1921 (former archbishop of Canterbury)

Heading into 2010 Asian institutional investors face decision time when it comes to hedge funds.

Who are we taling about? When one refers to the category of Asian institutional investors one refers to Japanese pension plans, insurance companies, agricultural coops and to a lesser extent city-banks, regionals and HNWI. Outside of Japan, we can include South Korean insurers, a few corporate pension plans, Taiwanese broker-dealers, Singaporian SWF entities, Hong Kong family offices, the HKJC and other foundations and last but not least Aussie supra-annuation funds - all in all probably close to $100 Billion in buying power back in 2007/8.

How bad was/is "the hit"? Trying to understand and quantify "losses" in hedge fund investments is very tough at the best of times. We estimate that approximately 40% of buying power was lost following the Volatility Shock of 2008/9. This has taken th ebiggest toll on the hedge fund of fund business which this author belives represented as much as 30% of total hedge fund of fund assets. For this reason, the hedge fund of fund business is in trouble. As many investors in Asia also had exposure to Madoff feeders and other notable blow-ups (e.g. Russell Investments FoHFs, Petters ABL product).

What next? Typical hedge fund products that have sold in the past have been "big brand names" offering risk/return profiles that can compete favorably with fixed income - nothing fancy, simply good, consistent positive yield, if possible sans-exchange risk. But the choices today are limited, either through the fact of gating among many so-called brand name funds in 2008/09 but also because even though global equities have rocketed since March 2009 the ficed income markets have become tough places to find yield without going out in duration or further along the low quality curve. Should investors now risk investing in long short equity strategies? Are the equity markets due to dip again short term? Is the U.S. Treasury market bubble about to burst? These are very relevant and tough decision that Asian investors have to consider, and are considering.

A new reality? The fact remains that the first half of 2010 performance is likely to be led by traditional long-only products are they have been in 2009. The fact is that even with average hedge fund performance up around 20% over 2009 this will lag the bounce seen across a number of long-only asset classes. This begs the question that hedge fund managers should be asking which is, can their strategies we repackaged in a way that takes advantage of long-only markets to offer greater upside potential without taking high-risk, concentrated bets. The answer is yes! Expect the new reality to include a new set of absolute return products that straddle the mutual fund and hedge fund worlds - ones that offers up different risk/return profiles and even different levels of leverage and fees too. many progressive firms are already marketing such products to U.S. and European institutional investors and they will no-doubt land in Asia very soon.

Exciting times indeed. Mahalo!