Expect Slow Trickle Not Flood of Prop Desk Spin-offs in Asia

"You may not realize it when it happens, but a kick in the teeth may be the best thing in the world for you."

Walt Disney, entrepreneur & film producer (1901-1966)

Obama's recent Volcker Rule that aims to restrict risk-taking by banks will face challenges as the legislative process gets underway. The actual rule in its initial form may force banks to drop out of prop trading, running hedge funds or HFoF and even private equity operations for their own account. It might also extend to shops like MS and Goldman, Sachs - traditional prop shop power houses.

But one thing is sure - if U.S. banks and a large number of European ones do follow through on the Volcker Rule then it might spur a large number of spin-offs of current prop trading (equity/fixed income and derivative-related) operations in Hong Kong, Singapore and Tokyo currently attached to these banks.

While the balance sheets of these entities certainly helped to scale up these prop trading operations, a clear implication will be to expect and to see a fall-off in overall volumes of instruments traded either off balance sheet or even on exchanges.

Exactly what the scale of this potential prop trader migration will take is unknown. It will certainly differ from country to country and from firm to firm. Clearly, it will lead to some movement to large multi-strategy multi-national firms like the Och Ziffs and Citadels of the world, although they may already have a stranglehold on the best trading talent in the region. It may also open up a whole new talent pool to the large Japanese banks and brokers looking to build up their presence in these once profitable areas. It might also look a little "bad" if there is a flood of talent given how some of these teams were brought on board at considerable cost in the wake of the Lehman Brothers demise.

Another area where there could be action is likely to be among the HFoF community. A small number of these U.S. banks may still have on-the-ground analysts and marketers in Asia as they look to build globally diversified portfolios along the lines of the JP Morgan Asset Managements of the world.

If there is value out there these FoHFs may become subject to MBOs, M&A activity or they may simply dissolve as key talent runs to other firms. As an idea at to the size of this opportunity, consider that a consultant (Prequin) recently estimated that the 19 FoHF units of U.S. banks account for around $180 billion in AUM. In my opinion, these bank operated HFoFs tend to have been the worse performing vehicles relying for too long on their name brands and distribution channels to move product. The days of the mediocre HFoF in Asia may really be over.

Whatever the result, The Volcker Rule may have implications as far away as Tokyo as the boards of major banks crank out business plans and reports to try and prepare for how they too will try to take advantage of the current opportunities. Expect many implications for current business practices and new ones too that will impact other associated industries like insurers. There is no doubt that consultants and headhunters will be working the phones actively and profitably in 2010! Mahalo.

The New Normal Marketing Hedge Funds in Asia

"Socialism is a philosophy of failure, the creed of ignorance, and the gospel of envy, its inherent virtue is the equal sharing of misery."

Winston Churchill, U.K. Prime Minister during WWII & author (1874-1965)

2010 has just kicked-off and the world of hedge fund investing has turned on its head. The following generalizations are well known but not yet explored as the mass media tries to paint a "return to normal" image of an industry fully recovered from the credit crisis, scandals and gating issues of 2008/09.

Here are some of the still apparent realities in the New Normal world of the hedge fund industry:

• As many as 70% of all hedge funds (approximately 7,000 fund firms) still have not recovered their high water marks following 2008 average losses of 25-45%.

• This one is anecdotal. As many as 50% of all hedge funds, have not been paying staff or partner salaries over the last 6-months as typical hedge fund firm cash "burn rate" accelerated in 2009. This has hit firms with AUM under $200 million and is in spite of the +60% equity market run-up since March 2009.

• A still large number of funds will close as partners throw in the proverbial towel on subsidizing the fixed costs of their funds. There comes a time when enough is enough! Expect more "early retirement" stories over the next 6-9 months.

• A still indeterminate (yet significant) number of investors remain "gated" in illiquid investments following 2008 losses, and they still cannot get their money out. In many cases, investors are still being charged fees on these trapped assets!

• A new and important DDQ question that investors are implementing en masse is simply: Did your fund make a profit or a loss in 2008? If the answer is a loss the fund will not get any allocation. This appears to be a hard and fast (and yet unspoken screening rule) that many institutional investors have been implementing so far since 2009. The bar has been raised.

• The hedge fund of fund industry is in REAL trouble. As a whole, assets are bleeding as investors either sit on the sidelines or go direct to single managers. Considering this category used to make-up over 30% of all investors in single managers you imagine how the typical buyers have vanished from the scene. You can imagine too what this has meant for all those specialist marketing staffers who used to service HFoF, HNWI, family offices, private banks and endowment) niche? You guessed it - they are being let go in record numbers as the underlying fund firms try to find a fresh set of rainmakers.

• To all extent and purposes no hedge funds are closed anymore. None. Provided you are considered deep pocketed and long-term (i.e. institutional). This marks a big change from 2007 and explains why the bigger multi-strategy funds are hiring these gatekeepers to the institutional investors or other gatekeepers (consultants).

• Latin American and Swiss investors have not made any meaningful allocations since the end of 2008. It may take another 12 months before they return. Such has been their collective losses/embarrassment in the wake of Madoff and other scandals. The streets of Rue de Rive and Bahnhofstrasse are quiet. Mahalo.

Regulatory & Tax Arbitrage (Not Markets) May Spark Asian Hedge Fund Industry

"The Secret of creativity is knowing how to hide your sources."

Albert Einstein, physicist (1879 - 1955)

Caveat Emptor. The apparent shuffling of feet you might hear of large global multi-stratregy shops moving back to Asian financial centers is not a direct result of better risk/return investment opportunities unfolding in 2010. This author believes that it is best thought of as a regulatory and tax arbitrage play facing threats from existing centers, and in particular in New York and London.

Asia long-only the way to go? Over the last 4-5 years many global institutional investors have pulled back from hedge fund long/short strategy investments in Asia and have instead sought low-cost beta alternatives such as through ETFs. Returns from MSCI Emerging Market Index +70.31% in 2009 certainly look attractive, but are tempered by the 2.64% return over a 3-year period. Likewise, the MSCI Asia Pacific Index gained +134.46% in 2009 but was -5.01% over a 3-year period and the "dog" of the group, the MSCI Japan Index, returned 6.68% in 2009, but was down -11.15% over a 3-year period.

HNWI and fund of hedge funds have also "abandoned" Asia to a large extent. Many of these investors chsed the +20% returns that many smaller managers boasted. These investors used to be the traditional supporters of new and growing funds in the region and a few years back there were close to 80-90 hedge fund of funds with an Asia-focus. Not anymore!

Sadly, the risk/return profile of many locally-situated managers have been constrained by the realities of: capacity constraints(around $400 million and the typical fund woulkd face stock-borrow "issues"); an inability to produce positive returns on the short-side of their books especially when the markets go down; and, the uncanny realization that being in Asia does not a good hedge fund manager make. There is no extra advantage, unless you are an activist and rely on local connections and ideas to source investments.

With a few large multi-strategy shops opening up in Singapore and Hong Kong some sort of investment renaissance may be underway. This may yet be the case although until we see new funds and a high number of start-ups (which is not yet the case) I believe that it is rather a play to potentially arbitrage existing assets and taxpayers out of potentially "painful regimes". This may be worth looking at closely in the next 6-12 months and should gather steam as the U.S., U.K. and European authorities come down hard on hedge funds as part of their overall promise to the taxpapying public to fix the existing financial regimes.

New instruments, tax breaks & insitutional investors. What really is needed are new hedging instruments, tax breaks to lure in fresh talent, the dismantling of bureaucratic rule to set up a fund and growing allocations by local institutional investors to back local hedge fund talent. Failure to do so will result in yet another wave of temporary not permanent interest in hedge fund strategies in Asia. Mahalo.

Asia Hedge Funds Bounce Back But Still Underperform Long-Only

"The only thing that you owe the public is a good performance."

Humphrey Bogart, actor (1899-1957)

Data from HSBC Private Bank, Alternative Investment Group (Hedgeweekly #53) suggests that a healthy number of Asia dedicated hedge funds ended 2009 on a positive note, although maybe not a relatively high one when compared to long-only alternatives.

By category, multi-strategy players ended the year close to an average of 4.99%, in large part driven by the reinvigorated performance of George Long's LIM Asia Multi-Strategy Fund Class A which through Nov 30 ended up 18.78%. In contrast, the Dec 18 number for Richard Margides' Artradis Barracuda Fund limped in at a -11.92% as his heavily volatility-based strategy back-fired throughout 2H09. When compared to global multi-strategy managers this was very poor as HSBC points to an average return of 16.74% (largley on successful bets in credit and convertible arbitrage instruments).

Diversified equity (which typically implies long/short) in Asia put up a credible 17.94% in 2009. Leading performance managers included Boyer Allan's Pacific Fund Inc (A) which posted a 35.07%, Ezra Sun's The Real Return Asian Fund Ltd was up 37.29% and Richard Chevenix-Trench's SR Global Fund B was up 29.37%. The latter is notable as it is a fund (like Joho) with assets over the billion $ mark. Sadly, the relatively small size of many Asian funds continues to put a cap on their ability to attract significant institutional assets which, by definition, will tend to herd towards the bigger US and European managers that might have Asian exposure through their night-desk operations.

The weakest performers in the HSBC listing in the diversified equity Asia, were Kyung Hwa Park's Corevest Partners Limited at --0.34% through Dec 11 and Alex Lewis' MBAM Pan-Asian Fund Ltd at -0.32%. Both funds had assets just over the $100 million mark.

Among diversified equity Japan managers the performance picture was mixed. Average fund performance through 2009 was up 4.06% led by Bob Macrae's Arcus Japan Fund (Yen) which was up 30.70% as of Dec 29 as well as a solid bounce back year by Mike Hill's Blue Sky Japan Ltd which was up 24.46% as of Nov 30. In contrast, Hugh Sloane's SR Global Fund H - Japan was down -19.25% while Warwick Johnson's Optimal Japan Fund C1 suffered a -9.20% decline. Of note, aggregated assets in Japan among this strategy fell sharply year-on-year and continues a trend that appears to have set in since 2006/07 of bleeding assets as performance slides.

The poor overall performance of Japanese equity markets is worrying on a number of levels - especially as alternative geographies in the region may attracting an increading portion of discretionary portfolio investment assets. As long as many long/short managers in Japan have high drawdowns, investors will be right in questioning the effectiveness of risk management and the ability to short.

In the multi-strategy Asia category, Bennelong Asia Pacific Multi-Strategy Fund Ltd. was down -17.47% while PMA Asian Opportunities Fund was up 6.02%.

Of course, some institutional investors are not blind to the incredible bounce back that stock markets endured from March 2009. For many of them exposure on the long-side through low-cost ETFs via astute tactical allocation paid off handsomely. Just looking at the trough to high point performance of many of these liquid ETFs may in fact tell the real story about Asian hedge funds asset losses through 2009: Japan +149%, Hong Kong +186%, South Korea +238% and India +368%.

For many investors, going long-only Asia (as with emerging markets in general) was the big winning strategy in 2009 and potentially for 2010. Who knows? Mahalo.

The Indian Connection

"India is an abstraction...India is no more a political personality than Europe. India is a geographical term. It is no more a united nation than the Equator."

Winston Churchill, speaking at the Royal Albert Hall, London on March 18, 1931

Churchill's comment was embedded in a colonial era long past. He could not have forseen how the world would change - the English empire collapse in full force by the 1960s and how the tech boom of the 1999/2000 era would vault the Indian economy and its skilled workforce into the limelight.

In the hedge fund space, Indians have become a powerful intellectual and economic force. Of approximately 400,000 or so employees in New York alone in 2003/4, this author estimates that as many as 10-15% comprise American-Indian workers. So they make up an important employee pivot point underpinning the whole industry.

Briefly, Indian's impact in the workforce quickly moved out of the I.T. programming back-office into the trading and dealing arena to running hedge funds by the late 1990s.

Of course, the recent notable illegal trading accusations aimed at the CEO of Galleon, a long short equity hedge fund manager, brought to the fore just how powerful and meaningful the Indian diaspora has become in the industry, especially when it comes to information networking in certain strategic and associated industries.

And given the large number of high qualified Indian graduates emanating from top-tier Indian and western business schools it is not a stretch to assume that over the next 10 years the number of Indians in the hedge fund industry will increase to 20-25%?

This should not and cannot be ignored by those interested in increasing the numbers of highly skilled (and highly paid) workers into a prospective financial workforce. Certainly, every global location should be paying attention, including those locations that are not necessarily on the list today.

Of course, it impacts immigration policy among other things so don't be surprised to see increasing numbers of Indian I.T. professionals getting visas to work in Switzerland. Of course, the Japanese should be doing the same to encourage a "brain/talent-flood " into their own moribund financial industry!

The demographic change ignores the additional impact that India will inevitably have as a source of alpha (as markets continue to de-regulate) as well as being signficant institutional investors. The first stage will be their impact through funneling the signifcant wealth of Indian entrepreneurs, industrialists and foundations and endowments.

We might be talking about as much as $3 trillion in investable assets. The Indian Summer for the hedge fund industry may already be here, with a Chinese version not too far away. Mahalo.