Asia hedge funds still run less money than before 2008, but they increasingly do so locally and in a broader range of strategies. Shirin Ismail and Tricia Sum survey how the industry is evolving to meet the needs of Asian and global institutional investors
The Asian hedge fund industry has been challenged over the past decade. According to a recent AsiaHedge report, total assets in Asia-Pacific hedge funds amounted to $144bn (€110bn) as of June 2012 – still some way off the peak of $192bn seen in December 2007. By comparison, the decline in the number of funds has been more muted, down by only 12% from the peak in December 2009.
The number of funds has held steady, in part due to the dramatic migration of assets to the Asia Pacific region. According to data from AsiaHedge, a staggering $112.2bn, or nearly 78% of the industry’s assets, are now run from Asian centres. This compares with 74% in 2010 and around 50% in 2000, when the industry’s assets were largely managed by UK and US-based Asia managers.
This shift reflects an ongoing and greater commitment to Asian offices by international managers, who are finding it increasingly effective to have a local presence, as this allows for better understanding of and execution in the Asian markets.
For example, an Asia-based manager in the Chinese credit space can exploit his team’s connections, access to various channels and accumulated experience with the investment community. The credit investment process is hence built upon a proprietary framework of political, economic, financial and social factors. In addition, Asia offers a more favourable tax environment for hedge-fund investing; and lastly, rising Asian affluence provides a pool of latent demand as investors seek diversified sources of returns.
A notable development in the Asian hedge fund industry is the growing breadth of fund strategies. Just five years ago, long/short equity funds made up close to two-thirds of the strategies available. This dominance has now been whittled down to just over a third as a result of the increase in volume and range of financial instruments traded on various exchanges. This has provided managers considerable flexibility to explore and execute their chosen strategies.
At the same time, investors have also been keen to allocate to emerging strategies like credit-focused, systematic market neutral and special situations, which are perceived to be less crowded than traditional long/short equity strategies.
Credit funds, in particular, have gained prominence over the past two years, alongside the maturing of the Asian credit market. Issuance has surged, driven by record-low policy rates globally and yield-hungry investors. Out of the $100bn worth of bonds issued year-to-date, China/Hong Kong and Korea accounted for half of this supply, with more expected to come from Chinese banks, state-owned enterprises and Indian banks.
In Singapore alone, the SGD corporate bond market was about SGD357bn (€224.5) in 2011, with over 120 issuers, of which more than half were domestic entities, including quasi-government agencies, financial institutions, property-related corporations, manufacturers and conglomerates.
Another strategy gaining prominence is the use of a fundamental systematic approach to equity investing. Experienced managers have successfully executed such market neutral strategies in Asia, achieving annualised returns of 9-10% as fundamental factors are increasingly being rewarded. For this strategy to work, cross-sectional dispersion needs to be high and stock correlation low, with reasonable liquidity. Recent data suggests that stock-to-stock correlations have been falling, which provides a constructive environment for this strategy.
Performance alone is not sufficient to attract institutional flows. Global institutional investors typically prefer to allocate to managers or strategies that are scalable. According to EurekaHedge, as of July 2012 funds with less than $20m account for 42% of the Asian hedge fund industry, while funds with more than $500m only make up 6%. This implies limited options for global investors, hence the bias towards mega-launches. From our own due diligence, we find that large pedigree launches might not necessarily be the most ideal investments.
Increasingly, institutional investors like pension funds, sovereign wealth funds, insurance companies and endowments are requiring, if not demanding, higher standards of governance and controls. Hedge fund managers in Asia must deliver institutional-quality services to convince these investors to invest with them. According to ‘From black box to open book – Hedge fund trust and transparency’, a PwC report from April 2012, institutional investors are increasingly adopting a ‘trust, but verify’ mentality. Allowing investors to check performance, asset information and operational controls has become a ‘hygiene factor’ to attract institutional clients.
The collapse of Lehman Brothers in 2008 and, more recently, the bankruptcy of MF Global, have brought issues of counterparty risk and asset protection to the fore for hedge funds.
There was substantial growth in prime custody following the crisis. A study by BNY Mellon and Finadium revealed that hedge fund assets in prime custody jumped to $684bn in August 2012, up 40% from 2010. Managers in Asia had been slower to embrace prime custody, compared with their counterparts in North America and Europe, due to a lack of resources to set up a fully fledged custody or prime-custody relationship. However, this is rapidly changing because of the growing sophistication of investors.
There have been other constructive developments in the Asian hedge fund industry.
Regulators in Asia have been playing a large role in encouraging hedge fund managers to improve their infrastructure to make the industry more attractive. In Singapore, for example, a new category of registered fund management companies (RFMC) was recently introduced to replace the previous exempt fund manager (EFM) regime. The EFM regime permitted smaller hedge fund companies that met specific criteria to be exempted from licensing requirements. The new rules, which took effect in early August 2012, require fund management companies (FMCs) with assets under management not exceeding SGD250m and no more than 30 qualified investors (no more than 15 of which may be funds or limited partnership fund structures) to be registered with the Monetary Authority of Singapore (MAS). Apart from the above-mentioned category of FMCs, all other FMCs are required to be licensed by the MAS. Under the new rules, all FMCs will have to meet the enhanced competency, business conduct, and capital requirements.
The opening up of the Chinese market is also a significant development in the Asian hedge fund industry. The qualified domestic limited partner programme (QDLP), a pilot scheme to be launched by the Shanghai municipal government’s financial services office, will permit qualifying foreign hedge funds to establish subsidiaries in China to raise RMB-denominated investments in their vehicles through private placements. The money raised must be invested in foreign markets. The Wenzhou Pilot, another initiative, will also allow residents of the city to invest funds overseas. In addition, changes to the existing qualified foreign institutional investor (QFII) quotas will also benefit the industry.
More recently, China is considering allowing ‘sunshine’ private trust funds, a prototype of hedge funds, to list on the Shanghai Stock Exchange, as part of a broader drive to curb the domination by retail investors. China’s private trust-fund assets, according to the China Trustee Association, totalled RMB192.2bn (€23.6bn) as of 3Q 2012.
We continue to expect positive developments in the Asian hedge fund industry and the growth outlook remains compelling. However, it is important to distinguish between managers who possess unique skill-sets from those who have just been opportune in their taking of market risk. In this regard, having local market knowledge, relationships and on-the-ground due diligence is key.
Shirin Ismail is head of absolute return strategies and Tricia Sum is AVP, client services and communications at Fullerton Fund Management, a boutique asset management business wholly-owned by the Singaporean sovereign wealth fund, Temasek