Asian hedge funds in 2011 – Review and outlook
2011 is a year most managers will wish to forget. As hopes of a December rally faded, many settled for a very defensive position to mitigate further losses. However, given the extent of losses in the underlying equity markets, the returns for Asian hedge funds have not been that bad.
Up to November the underlying equity markets were down 15% to 18% depending on how Japan is weighted and the approach to currency hedging. If we adjusted the benchmarks to reduce the weighting of markets that cannot be hedged, the result would be even worse. Over this period we estimate the larger Asian managers returned on average -5%. If we exclude the long biased managers with average net exposures of over 50%, the loss reduces to -3.5%. These averages are heavily skewed by the disproportionately larger number of long short equity managers. We believe a more diversified Asian hedge fund portfolio could have returned -1% to -2%. This reflects a maturity in risk management we are now seeing in the Asian hedge fund industry. In 2008, the industry was suffering losses of around 50% of the drop in underlying equity markets.
Asian managers will always face a challenge as the available strategy mix is very “equity-centric”. It is hard to find many strategies that do not correlate or correlate negatively with the underlying equity markets. No significant long volatility managers have survived the last few years. The most reliable negatively correlated Asian strategy is macro with a focus on Asian currencies and rates. Some positive returns have been made in these areas and even better returns made by more directional macro managers. Some of the more equity market neutral strategies have also proved fairly uncorrelated such as equity trading strategies in Japan and Australia and quant market neutral in Asia.
Two of the areas that suffered most were Asian equity long short and events. Many long/short managers had enjoyed strong stock selection alpha up to the end of July, but the severity of the correction caused many of their winners to suffer major reversals. Although many managed their net exposures aggressively, most underestimated the extent of individual stock reversals. Many managers with a value bias shorted the consumer staples and defensive sectors without much success. This created a fairly divergent set of manager’s returns with the overall average return down 4.5%. Equity event managers also suffered as Asian events tend not to be hard mergers, being more corporate restructurings. In a stressed environment these assets can get orphaned and not react even to hard catalysts.
The multi strategy managers in the region tended to keep risks very tightly managed and kept losses to very modest levels. This was despite their exposure to mainly equity related strategies such as long/short, event, convertible bonds and high yield credit. We saw similar discipline from many of the liquid credit managers who managed to keep losses to a minimum. The illiquid credit managers doing direct lending and distressed assets had fairly flat returns as strong accreting returns were offset by portfolio mark downs.
In the past, the Asian hedge fund industry was dominated by long-biased long/short managers who typically had a net exposure averaging above 50%. Although many did actually produce better alpha than their long only peers, the appetite for the strategy seems to be waning. Investors want a clear distinction between what goes into their hedge fund portfolio and what goes into their equity portfolio. This is due in part to the growing institutionalisation of the investor base, especially among pension funds.
As many of the higher beta managers are still captured in a lot of the published hedge fund indices they make the industry appear more equity sensitive than an institutional portfolio needs to be. They may report losses in the year to November of 7% to 8%, which still shows close to a 50% sensitivity to the equity downside. If we were to evaluate the performance of the lower net Asian managers of an institutional quality, we would have a very different view. They have kept losses very modest in an extremely challenging environment.
Growing institutionalisation has had a significant impact of the flows into Asian managers. Asia used to rely heavily on the European fund of funds that raised capital from high net worth and retail sources. This business was hit hard after 2008 and has shown no signs of recovering. Most of the hedge fund asset growth is now coming from institutions directly, especially from North America. The institutional fund of funds that have remained strong will now typically run a segregated mandate for an institutional client rather than have the money invested in a comingled fund. These factors have made it much harder for a smaller manager to raise capital.
Institutions will often only invest in established managers and their ticket size is such that would preclude them looking at funds less than $500 million. As a result, the larger managers have benefited from most of the inflows. The vast majority are finding the fund raising environment extremely tough. It also appears that the larger funds are enjoying much more stable capital and significantly lower redemption levels than smaller managers.
This has also raised the bar for new launches. Any fund launched with less than $50 million will have a difficult path to success. To launch above this size, a manager will typically have had experience with existing hedge fund or the internal hedge fund activities or proprietary trading at a bank. We have tracked around 22 such launches since the 2008 crisis. Even with the right credentials the chances of getting up to a good institutional size is maybe only 50:50. These managers will also need a much more robust infrastructure from inception and a senior COO. This has forced to local industry to rise to an international standard.
At present there are around 30 Asian managers managing over $1 billion. There are probably around another 20 managers that have the potential to get to that size. Realistically, we expect only a few launches each year that have the potential to achieve this level of scale.
This doesn’t mean the end of the smaller manager but it does make it a tough place to be. Investors in this area tend to be very short term and it will be a challenge building a stable business on a highly variable asset base. Increased regulation and investor demands have also added to the cost structure raising the level of assets to breakeven. Therefore, we expect manager failure rates to rise.
Experienced hedge fund team’s fund launches in Asia 2009-2011:
|$1 billion +||4|
|Around $500 million||5|
|Around $250 million||4|
|Still to get momentum||6|
|Failed and wound up||3|
As we look into 2012, it is hard to see conditions improving anytime soon. Most managers expect modest growth in North America, a recession in Europe and a slowdown in Asia. Asia with the exception of India has seen the worst of inflation and we are moving towards an easing cycle. Most do not see China having a hard landing but many fear an ugly credit cycle in India.
We hear both bull and bear arguments as to how this will play out in the markets. The bulls point to the low valuations and the easing cycle. Historically 12x forward earnings have been an excellent entry level for investing in Asia. The bears point out that as the developed world saves; the deficits will shrink which in turn will shrink Asian reserves and liquidity. This will expose the misallocation of capital, which is prevalent in Asia.
Valuation is misleading as the banking sector appearing cheap and profits as a percentage of GDP being too high. However, most managers are letting strong risk management disciplines override their macro views so we do not really see significant positioning for either outcome.
There are some areas of opportunity we think will offer attractive risk reward whatever the equity markets do:
Japan long/short alpha has proved very robust for many of the neutral managers. In an uncertain world it is a good source of return where we see little downside and potentially high upside.
We think that the Asian currency and rates area offers opportunities for uncorrelated returns. The various Asian countries are at different stages of the easing cycle so there will a broad range of opportunities. This may prove quite a dynamic area as the European crisis plays out.
We like opportunities in the illiquid credit space. There are two factors that should drive opportunities. The withdrawal of European banking capital will lead to both selling assets at stressed prices and companies struggling to refinance. The second driver is the poor ability of the local banking system to finance SMEs, acquisitions or other unusual situations. While the opportunity set is attractive we recognise the external market will affect the recovery period and valuation of the portfolios.
We think it is a reasonable time for a multi strategy approach as the opportunity sets will vary greatly. There will be periodic opportunities to enter solid credits at very high returns, interesting dislocations in convertible bonds and other relative value relationships, and backlog of corporate fund raising.
The harder area to assess, yet the largest part of the Asian hedge fund industry, is the outlook for the Asian long/short managers. If the challenging conditions persist it will be difficult for managers to make money in a down market, despite increased confidence in the manager’s ability to mitigate the downside. While that may represent alpha versus the underlying equity market, it will still not be an absolute return. We believe there will be an alpha recovery on stability as many prices appear dislocated and value has not featured in recent stock performance.
In summary we think a diversified portfolio of Asian managers can stay fairly flat even if the European situation continues to grind on dragging global markets lower; there is still is a European crisis scenario that no assets class will be immune from. However, with any stability, we believe the region could produce reasonable returns creating a favorable asymmetric trade.
The real question is whether another year of flat to modestly negative returns will keep institutional allocations flowing. Ultimately this will be decided at global level, mainly by North American investors. In early 2011, hedge funds won the contest of “least ugly” versus bonds and equities. Globally they have disappointed a little this year, especially long/short equity managers. We sense some investor fatigue in this area but an overall constructive attitude to the assets class still prevails. Asia may still remain a beneficiary of growing diversification of global portfolios.