Global Investors: Give Me Alpha (Plus a Premium) for Asia

"Competence, like truth, beauty and contact lenses, is in the eye of the beholder".

Laurence J. Peter (1919 - 1988)

Fact number one: the hedge fund industry has been bleeding AUM over the last 6-9 months and the downtrend is not yet done. For example, a recent Lipper Hedge Fund Asset Flows report for 1Q09 pointed to a loss of close  to US$115.7 billion -  the second worst quarterly outflow since 1994. A good portion of that was due to poor performance in addition to outflows from Asia due to risk-aversion among global investors. 

Fact number two: a key, and forgotten point, has been the makeup of investors fleeing the industry en masse. The bulk of the investor base which amounted to as much as US$400-500 billion, came from hedge fund of funds (HFoFs) and high new worth individuals (HNWI). This author estimates that as much as 75% of the capital that flooded Asian hedge funds from the early 2000s came from this fickle investor base. For example, in 2005/06 there were an estimated 75 HFoFs with an Asian focus. Many of them are now closed due to poor performance and heavy redemption losses and they will not be coming back.

Fact number three: Asia-specific manager performance shows a high correlation to beta indices that are liquidity and momentum driven. This is again, a proven fact. Once liquidity (i.e. exchange turnover/transaction volume) declines then the ability to generate alpha also tends to decline as over 70% of strategy assets tend to be driven by the directional moves of the region's equity markets.

Fact number four: non-equity related strategies are capacity constrained. If you accept the previous point then it becomes clear that you will not get large single manager funds with $4-5 billion in AUM. And, these are the AUM you need in order to be attractive to larger institutional investors. It also means that the vast number of currently "profitable" hedge funds are likely to make impressive monthly % performance gains on low AUM, which is always a red flag.

Fact number five: if, one is of the opinion that the global equity markets may yet see more volatility on the downside, then Asia presents further risk, and whereas in the past hot money investors sought approximately a 5-10% premium on returns for going oversea, that might actually rise now that the recent Volatility Shock environment has shown global investors how correlated the equity and credit markets  can be. 

As a result, all the hot air about new strategies and new managers setting up in Asia should be taken with a large dose of indigestion pills. Global institutional investors are not enamored with alpha from Asia but rather with the beta potential, especially as it relates to growth in small and mid-cap stocks. The region's bond markets are still too small and illiquid while other strategies will tend to have a strong correlation to the overall global credit market conditions. This is why, unless there is a regional push to finance locally established firms, Asian managers will remain the poster children for orphan beta generators for institutional investors and for HNWI the opportunities will only be tempting if the manager can generate 2-5% net of fees per month. Mahalo.