Discovering Asia’s idiosyncracies
To investors outside the region, Asia presents an opportunity to access both enormous growth potential and relatively uncorrelated and idiosyncratic sources of return. It also creates a challenge given investor unfamiliarity with the various political, economic, tax, regulatory and legal regimes across the region, as well as the tyrannies of distance and time zone. The difficulties can be somewhat alleviated, of course, by on-the-ground presence and experience.
Asia is anything but a homogenous region. It houses both the second and third largest stock markets by capitalisation in the world. One, China, is in an economy emerging rapidly as a key driver of global growth. The other, Japan, has been wallowing in decades of stagnation and is now not only facing what seems an insurmountable demographic decline but is also coping with the aftermath of an earthquake and a tsunami. Asia also has the world’s largest democracy, India, a vibrant hotbed of entrepreneurialism, set amidst a chronic lack of infrastructure and an overbearingly bureaucratic government.
Drivers of economic growth vary considerably across the region. Some local economies are driven by technological expertise and exporting prowess, some by low cost manufacturing, and others by outsourcing and service industries. Each has its own style ranging from the command driven economy of China to the “socialist” capitalism of Japan to the raw drive of India. Each locale has its own form of government. Each has its own legal and regulatory system and breadth of access to capital markets. Accounting standards and corporate governance vary dramatically from jurisdiction to jurisdiction.
Investment and Operational Expertise are Required
For the hedge fund investor, it is thus vital to understand the framework each manager has for investing across the various markets. Stock borrow, for example, is readily available in the more developed markets such as Australia, Japan and Hong Kong but less so in other markets. In India there is a vibrant and liquid single stock futures market as the principal source of access. Taxation and regulatory regimes, in markets as diverse as Australia, India and South Korea, often mean funds have to access both longs and short via “swap” from investment banks. Different national Capital Account regimes can also provide hurdles to hedging foreign exchange exposures. Corporate bond markets are at different stages of development with local currency issues typically locked away (i.e, bought as new issues and generally held to maturity) while G3 issuance (local bonds denominated in dollars, euros or yen) is widely traded. Credit Default Swaps are almost exclusively limited to the investment grade sector. In terms of assessing hedge fund managers in Asia, this all means that the ability to choose good investments is not enough; a thorough understanding of the context of those investments and a strong operational framework in which to execute them are equally important aspects of the manager’s investment process.
It is however this very heterogeneity and these barriers to entry that create the opportunities for a strong and well-resourced manager. Having access to restricted stock loans in Taiwan or QFII quota in China can present a distinct advantage. The differing types of capital accounts and consequently yield curves present both arbitrage and directional opportunities for fixed income managers. These range from the closed accounts of China to the pegged currencies of Hong Kong, the managed basket system of Singapore and the more open accounts of Australia and Japan.
There are other opportunities that have a distinctive “Asian twist.” The plethora of structured products in the region, particularly in Hong Kong, Singapore and South Korea, leads to anomalies in the volatility space. These are compounded by the high retail participation in many markets, both cash and derivatives. Other relative value opportunities can be found in dual listings such as between the Hong Kong listed H-shares and the Shanghai listed A-shares in China, between London and Sydney listed shares in large mining companies such as BHP and Rio Tinto, and between Thai foreign and local shares.
The hedge fund universe in the region is probably less developed and sophisticated than that in North America and Europe, but again this can be a positive. The closure of investment bank “prop” desks in many cases means that strategies are less “crowded”. We see particular opportunities in the quantitative equity market neutral, event driven equity and volatility fields at the moment. However, for investing in Asia-focused hedge funds to be successful, manager due diligence must also incorporate knowledge of the differing regional features and market structures.
David Walter, MA is a Director in PAAMCO’s Portfolio Management Group based in the firm’s Singapore office.