A new reality for hedge funds and their investors
This year’s showing by hedge fund managers has been solid in light of the overall mood amongst investors, and we are now seeing the redemption pressure ease. The industry now has less than half its assets under management and investment banks have withdrawn most of the capital for proprietary investments. The markets have been through a period of panic selling and more recently panic buying which has created a high level of mis-pricing. Any less liquid asset still trades at excessive liquidity discounts. All of this points to a period of outside returns. However, the barrier to entry to be credible manager has become a lot higher so it may be a relatively smaller group with the critical mass that will reap the rewards.
In 2008 Asian hedge funds lost on average around 20% in performance but also lost over half their assets to redemptions. This performance is worse than most global funds albeit only marginally but redemption levels have been much more brutal. The fundamental view to this poor performance was the perception that Asian markets significantly underperformed many of their global peers despite lower levels of leverage in the Asian economies. “Decoupling” failed to protect the region’s markets, though some argue that it has helped them outperform in 2009.
Some of the reasons the Asian markets failed to perform better could be put down to:
- High export dependence giving global cyclical characteristics
- Immature domestic investor base creating overdependence on foreign flows
- Global nature of the financial sector contagion
- Japanese banks cross shareholdings compromising their capital base
Many Asian hedge fund managers were bearish or, at least cautious, on the global economy in 2008 but most failed to see the scale of the impact on the Asian region. Many were too slow to mitigate risk and were caught out as markets started to slide and ultimately collapse post the Lehman Brothers failure. Credit spreads became highly correlated to equity markets and convertible bond and credit related strategies experienced similar draw downs to equity related strategies.
2008 is one of the worst years for hedge fund performance and we should question if such performance is acceptable, or at least understandable. Some argue that hedge funds are supposed to produce absolute returns and therefore they question how losses in the region of 20% can be acceptable. Unfortunately many had started to market hedge funds as a “cash plus” product and even applied leverage. For them hedge fund investing has been disastrous all because the initial promise was wrong. In contrast, one could argue that the long term goal of hedge funds is to produce “equity type” returns with “bond type” volatility. This does not mean they always outperform bonds short term, but they should in the long term. It does mean that they should have significantly less down side than equities, which although the return was disappointing, they achieved to some degree. 2008 would rank as a poor year but it should not undermine the long term argument for hedge funds.
The majority of funds with an Asian focus have a long bias so when we assess returns we need to recognize some form of relative equity performance. We effectively have two populations; one where funds which are really an equity proxy and the other group which focus on downside mitigation. To reflect this dual nature we sometimes look at equity participation on the upside versus participation on the downside. Compared with the underlying Asian markets including Japan, we can say hedge funds gave 130% of the market upside in 2007, 50% of the downside in 2008 and 81% of the upside in 2009 to May. While that seems good, it is driven by Japan performing badly during this period. The few surviving Japanese focused hedge funds actually performed relatively well having got used to a very difficult market. Pan Asian managers either marginalized Japan or used it as a source of shorts. By that argument there was significant alpha just by the way Asian managers reduced their Japan risk. If compared only to Asia ex Japan equity markets, the results look less compelling. Hedge funds got 52% of the upside in 2007, 40% of the downside in 2008 and 39% of the upside 2009 to May.
Fund of hedge funds have underperformed the broad hedge fund indices. In many respects fund of funds indices can give a more accurate picture as they reflect real invested cash and get less distorted by small funds and survivorship bias.
Long Short Strategies
Long short still represents the region’s largest strategy and has a strong influence on the overall index returns.
Last year, most global long short strategies were down at least 20% and Japan stood out as one of the better performers. This is partly due to a very difficult 2006 which forced many Japan focused managers to reduce their long bias and amount of small cap equities, as well as forcing many weaker players to shut down. Therefore, Japanese managers were more prepared for 2008 than any of their peers. Over this period since the end of 2006 Japan is down nearly 50% yet a core of surviving managers are regularly producing positive returns.
It is almost the complete opposite with Asian long short managers. In 2007 they were almost giving the full participation in the market upside ex. Japan even though many were mandated to do Japan. In 2008 they suffered about 50%, or more in the case of China and India focused funds, of the market downside. The more top down managers mitigated risk quicker as they were more tuned into global macro deterioration. More bottom up managers did not get the feedback coming through their company visits until it was too late. The managers that performed well fall into a few categories; the genuine low or viable net exposure managers and the managers that can run to cash quickly even though they can be long bias most of the time. The bounce in 2009 has caught many by surprise. While returns have been positive, they have lagged their usual level of participation in the equity market upside.
For Asian focused managers the composite return is misleading as this combines two very distinct types of manager. The long biased managers do need a different measurement metrics. While many of their draw downs were higher than an absolute return portfolio would want to suffer, they have performed well relative to long only managers. This may be due to a combination of better stock picking skills and the benefit of not being benchmark constrained. 2008 has helped identify a group of managers that has demonstrated their ability to manage the downside.
Multi strategy (including Convertible Bonds)
A core strategy for many of the Asian strategy managers is convertible bonds. There are also a number of pure Asian convertible bond managers. To the naïve, convertible bonds as an asset class is a product with embedded long volatility and this should benefit in a falling and volatile market. In practice they are heavily held by hedge funds, their credit risk can be correlated with equity down side and the exact opposite can happen. With the Lehman liquidation and investment banks panicking over prime brokerage collateral, the market could not take the selling pressure and prices spiraled downwards. Asia was hit even worse that many less credit worthy markets. By October 2008 the prices were extreme and many managers had to take liquidity measures e.g. suspension, gating, side pocketing, etc. to delay redemptions and stop the forced selling. This stabilized the market and buying started to emerge from the corporates and private banks.
Many of the managers have produced 15 to 20% returns for a number of years. For 2008 many ended down 20 to 35% with many getting redemption notices for over 50% of their fund. With convertible bonds it is mostly true to say that if you don’t sell them before the crisis, you may as well wait till the next cycle as you will only be able to sell them at the wrong price. This was the most unjustified mispricing and therefore, one of the fastest to correct. Most managers are up 15 to 25% this year. It has proved a very good example of how gates, suspension and restructurings can help to protect investor value until the market normalizes. The few multi strategy managers that did relatively well in 2008 tended to avoid convertible bonds and had focused on OTC and listed options.
For the survivors with enough critical mass we see a very attractive opportunity set going forward. There will be a lack of competition from investment banks and corporate funding needs will support many attractively priced deals.
There have never been that many credit managers in Asia; a few distressed specialist, a few liquid credit traders and in recent year a growing number of direct lending funds. Most are now facing a challenge as there are great buying opportunities as valuations attributed to illiquid assets are exceptionally low and may still go lower as the investment banks continue to reduce inventory. The funds have found that their investor base split into two very distinct groups; part want their money back and need liquidity, part see the opportunity and are happy to lock their capital up to participate. Many funds have had to create splits between their redeeming investors and those staying. We are seeing many new structures emerge which try and match the liquidity of the underlying portfolio.
The withdrawal of investment banks from this market has resulted in a number of talented traders looking to set up new funds. However, many of the traditional fund of fund seed investors have lost significant capital, so we are seeing a much higher barrier to entry for new launches.
There is a small but growing group of Asian or Asian biased macro managers that generally made money in 2008. This has proved one of the few uncorrelated strategies and they are now being extensively used by Asian fund of funds for diversification. For global portfolios there will always be the question as to why you would use an Asian macro manager rather than a global macro manager.
Some managers focus on pure discretionary directional and while other focus on the growing market in local currencies and their yield curves. Both these strategies worked well in 2008. Conversely the less liquid and more leveraged relative value strategies performed poorly as they widen with deleveraging, stopping out many players.
Changing government and central bank policy will make this strategy attractive for a few years. However, leverage can only be used on the most liquid produces.