China Exposure Yes; Public Markets No.

"I choose the likely man in preference to the rich man; I want a man without money rather than money without a man."

Themistocles, 527 BC - 460 BC, from Plutarch, Lives

Interestingly, many investors continue to ignore the data and facts when investing in China. Like in any emerging market one is often best served in buying the MSCI Emerging Market Index rather than adopting a single country focus. For equities, it is often the case that the long/short equity emerging market manager (with a single country focus) has a very high correlation to the MSCI EM Index but at a significantly higher cost and more risk (as it is by definition not as diversified).

So what should the discerning global investor be looking at when emphasizing exposure to China? First, this is often best done through a fund that has a combination of access to "hot" issues (IPOs), illiquid PIPEs and other illiquid deals. This is typically where real wealth is created in nascent economies and where the value is originated. Of course there are issues such as transparency, independent inventory valuations, and the dubious rule of law when there are disputes.

A second way to get exposure to China is through the private equity/venture capital route often via the U.S. There a number of companies that are situated in the U.S. that focus on the China opportunity and that offer exposure to that part of the world. In recent months the big names such as Blackstone have moved in too.

Third, one can focus on those countries and industries that derive a good portion of business from China. This means Singapore across a number of sectors as well as Indonesia via their mining product exposures that are often exported to energy-hungry Chinese industries. These are often the cheaper ways to benefit from the China Story without buying into the risk and volatility of their local stock markets.

It should come as no surprise that investors need to incorporate China into their portfolios in an explicit way. As ever, the real decision making process needs to understand fully the risk/return profile. The informed investor could be best served by using cost-effective, passive beta vehicles (like ETFs) rather than investing in a hedge fund that doesn't really hedge at all. Mahalo.

Endaka & Nikkei Put Options Obvious Macro Plays in Japan

"Promises that you make to yourself are often like the Japanese plum tree - they bear no fruit."

Francis Marion (1732-1795)

Japan Inc. is back in play. But not in the 2003 recovery story kind of way. This time, it is the story of paparazzi waiting outside the emergency ward at a hospital with their scythes (and not cameras) sharpened up, ready for another blow to the body of a weakened economy.

The bulk of the paparazzi is comprised mainly of foreigners (security companies, insurance companies, asset managers and hedge funds). As TSE/Osaka stock market volumes continue their multi-year long declines retail investors have joined their domestic institutional counterparts turning their backs on Japanese stocks, especially FX-sensitive exporters.

Curiously, the % of trading value of stocks traded on Tokyo, Osaka and Nagoya markets by foreigners has increased to over 50%. Looking at TOPIX alone, the foreigner component is holding steady around 50-55% since 2008 (data: DIR Investor Guide, July 2010).

The macro trades du jour consists of buying the yen against all currency pairs and buying put options on the Nikkei and TOPIX stock indices. The trades are largely directional and foretell a particularly negative view on a country that used to lead global production of high value autos, consumer durables and was the envy of the world for high growth and high tech.

Korea and China Inc. have taken up the technological challenge and in many cases beaten their Japanese competitors to market with products for western consumers. Sony is now an after-thought for the bulk of post-recession, over-leveraged global consumers.

Expect bank and real estate equities to be picked apart if markets do in fact fall back to the lows of 2002/03. At that point, authorities would be best served to open up the economy in a new and radical way to allow inward investment by neighboring SWFs. That means that the time may be close at hand when one of the biggest banks in Japan may be owned by the Chinese. Sounds crazy? The world is changing fast.

In the meantime, expect macro funds and multi-strategy players (mainly out of NY, London and HK) to continue to make directional plays on Japan especially if there is a further 20% decline in the Nikkei Index and a move in US$/Yen through the 79.75 all time high. At those levels central bank intervention is anticipated and likely, although for it to be effective will require the cooperation of the Bank of China and other entities that have been big buyers of yen and JGBS in recent months.

All told, the long-biased long/short Japan equity hedge fund is in for a rough final performance stretch in 2010. Expect asset losses.

When the Nikkei is close to 7,000-7,500 one might start to see again some of the world's biggest global investors including SWFs and petro-dollar investors pile back into Japan. The authorities would be wise to start preparing road-shows to encourage inward investments over the coming 12-18 months. Going long is about to be the right strategy in Japan - just not right now. Mahalo.

China Diversifies Global Portfolio with Tilt to Asia

"Patience is the best remedy for every trouble."

Titus Maccius Plautus (254 - 184 BC)

Since the start of 2011, China Inc. has gotten quite serious about where it parks its excess capital. Recent data points to the act that the Chinese have been heavy buyers of Korean bonds and stocks over the past months. According to the Korea's Financial Supervisory Service, China has doubled its holdings of Korean Treasury bonds since the start of 2010.

China’s holdings of Korea Treasuries stood at Won 3.9 trillion (US$3.3 billion) as of late June, up more than 100% from Won 1.8 trillion at the end of 2009. China has also piled into corporate bonds buying Won 2.45 trillion over the first 6 months versus Won 2.76 trillion by the U.S. As of end July the Chinese entities held about 6% of outstanding Korean fixed income paper.

The impact of this may have long term impacts - some good and some not so good. Consider that the Chinese were widely considered to have been the most aggressive buyers of U.S. Treasuries since 2003/04.

This coincided with a time when global interest rates were already trending lower. It resulted in a continued period of low rates in the U.S. which went a long way to pumping up the demand for mortgages and so demand for housing and one of the biggest asset bubbles ever seen. Of course, what goes up must eventually come down, so that all of those negative NPV projects spawned by the low interest rate environment have had significant reverberations around the world.

So we can expect similar distortions to impact Korea's domestic rate environment. How can it not happen? Chinese entities are currently buying more than a net Won 300 billion of Korean Treasury securities on average (3-year and 5-year treasuries) every month. Knowledge of this buying pattern has resulted in higher demand, an increase in prices sending yields down. Local institutional investors such as insurance firms and asset management companies are jumping on the bandwagon too hoping to buy before the Chinese, driving yields down further!

As of Aug. 20, the 5-year Korean Treasury bond was down 0.11% to yield 4.13% marking the lowest yield since Apr-2009. The Korean 10-year bond was also 0.09% down to yield 4.55% while the 20-year was 0.08% lower for 4.66%.

This yield action is coming amid an environment in which BoK is expected to hike rates to cool down the strong economy. Remember, this how the story went in the U.S. with the Fed not really understanding why U.S. rates remained so low.

The culprit here is China's SAFE or State Administration of Foreign Exchange which effectively manages the country's vast and growing FOREX reserves.

China is the largest foreign holder of U.S. treasury securities,keeping a reserve of US$843.7 billion as of Jun-2010. These holdings decreased from US$900.2 billion in Apr-2010 to US$867.7 in May-2010.

With further dislocations in local interest rates coming, it looks like a safe bet that hedge funds should now aggressively start to trade Asia's sovereign and corporate fixed income paper. Mahalo.