Are Asia-Specific Funds Scalable?

"Glory drags all men along, low as well as high, bound captive at the wheels of her glittering car."

Horace (B.C. 65-8)

Italian poet

Are Asian funds really scalable? By scalable, I mean can they grow to +$10 billion organizations in the same way as a Tudor, Caxton, Millenium, D.E. Shaw, Citadel or Winton? This is the $46,000 question that faces the bulk of managers in the region and the hard reality is: no!

Once the hedge fund is up and running with $100 million or so in assets, the real test moving forward is whether the strategy or strategies are sufficiently "deep" to enable growth of those assets to the $250-400 million barrier. Can the manager still make 1-2% effectively net of fees every month? Is that even realistic? If the answer is "yes" then there is a high probability that the firm will remain a going concern longer than the typical 4-6 year lifespan of the typical hedge fund manager.

However, as the 2008-09 investor experience shows, today there is little appetite for illiquid strategies. This is one of the reasons that many global multi-strategy funds have been pulling back resources from the region, with Citadel in Hong Kong being the most notable recent name.

Whether a manager can build assets up to $250 million is the real issue for many institutional investors. Below that number, there is often little desire or inclination to allocate their typical +$10 million investment slugs. Moreover, now that the hedge fund of fund business model has effectively collapsed, there are few/no allocators on the horizon to bridge this asset gap for the so-called army of new start-up hedge funds that many so-called informed prime brokers say are about to launch in the region. They are amassing like foot soldiers with knives and sticks trying to help institutional investors who seek protection from portfolio destruction in a post-credit crunch world.

Without a consistent supply of investment capital coming from institutional investors - presumably from the west - the long term outlook for the vast majority of single strategy managers looks bleak.

Accept that you will be and should be a low cost boutique operation and you may survive. You may have a couple of quarters or even years when the beta headwinds will be blowing strong behind you so you will grow through investment gains, but this too will attract more speculative inflows rather than long term institutional investors.

Managers need only refer to Exhibit A: Japan in the 2004-06 period.

You cannot rely simply on long/short equity, especially if you do not really ever go net short. Event driven activists grew AUM in this period and then hit the proverbial brick wall of poor publicity, scandal and poor performance, while merger arbitrageurs have never ever taken off due to institutional barriers especially when it comes to foreign interlopers daring to "challenge" local managers who are quick to wave the nationalist flag to protect their interests and voting power.

Macro as a strategy has not really ever taken off in Asia. Many of the best protagonists came out of the the investment banks who had billions in bank capital, access to deal flow and who had a ready-made operational efficiency in place to handle a variety of tasks. On another level too, local Asian markets have never been as liquid and flexible as those in the west in terms of the number of instruments traded as well as in the offering of derivatives or other hedging instruments.

Sparx understood this and has tried to bolt together some of the varying strategies, albeit not in a single product. It started out as a Japan-centric shop and realized in the mid-2000s that this could be an albatross to future P&L generation if the markets did not consistently offer beta, attract investors and ultimately produce returns. This has been tough going. So they replaced one beta market (Japan) with another (China), then added some arbitrage strategies for a better product mix. But even Sparx has found it tough going trying to be the Fidelity of Asia.

Ultimately, Asia is a source of niche strategies with big limitations in terms of scalability so to want to build a $5 billion hedge fund empire based on liquid, alpha-producing strategies may be unreasonable pipe-dream both for the CEO of a growing firm as well as for the biggest institutional investors. Asia is not like the U.S. or Europe, yet. Mahalo.