Divergence driving returns in Asia
The Japanese rally which started late 2012 rescued Asian hedge fund returns in 2012 but the overall result of the year was at best, fair. This was relief after a poor 2011. However, hedge funds have been overdue showing a better level of outperformance and 2013 is showing promising signs for Asian managers.
It is estimated that a diversified portfolio of Asian managers, excluding high beta managers, is up around +8.5% in the first half of 2013. During this period, the regional equity markets were relatively flat in aggregate terms but divergence was very high. Japan was up 31.8% and China’s onshore market was down 12.8%. Local currency bond markets were down nearly 3% in USD terms and credit markets were down 3 to 4%. This is certainly the best alpha seen in recent years. Manager returns in Asia are around 3% better than global peers, despite the fact that many of the developed country markets have outperformed emerging markets.
For the previous three years, there was a risk on / risk off market. All risk asset classes seemed to move together. There was both a lack of divergence and major reversals which were hard to navigate. Now the whole world and Asia, in particular, are on more divergent paths. There are many examples of this at both the macro and micro level.
At a macro level:
Japan is entering an unprecedented easing cycle. Yet at the same time China, through its clamp down on corruption and administrative measures to control credit growth, is in a tightening cycle. A combination of China’s slowdown and fear of US tapering has hit emerging markets hard. This is in part due to the weaker market for their resources and to unwinding of the emerging market carry trade. For the deficit countries, this has had an impact on their cost of funding. A theme now in the market is good versus bad emerging markets. A good emerging market has surpluses and is gearing to a developing world recovery. A bad emerging market has deficits and relies on selling resources to China. Now a country’s economic fundamentals start to matter again.
At a micro level, some of the relative performance in China is most extreme. Traditional industries with excessive overcapacity have been sold off heavily, yet at the same time the internet sector has shown dramatic performance. The new economy versus old economy is a major theme in the market. Even within an industry, we are seeing consolidation favouring the better run businesses. In Japan, even within a sector, the currency has created winners and losers based on their business models. This creates opportunities to reward good analysis and modelling.
There have been positive returns across all regional strategies. Globally, the environment has been difficult for CTAs but given they operate as global strategies, there is not really a regional subset. The five major regional strategy groups are Asian Long Short, Japan Long Short, Asian Credit, Asian Multi Strategy and Asian Macro.
Asian Long Short The average manager return for H1 2013 was around +6.5%. This was slightly better than the region’s equity markets which were flat in aggregate terms so alpha was fairly significant given typical betas of 0.3 to 0.35. It was clear in the first quarter that most managers had neutralized much of their China portfolios and increased Japan and ASEAN markets.
Favourite markets included Thailand and Philippines. Managers were much more cautious in the countries with deficit issues such as Indonesia and India. Some gains were given up in the May and June corrections, but the exposure to the severe Chinese sell off was modest. Many also trimmed their ASEAN positions on the fear of raising US rates. Much of the Chinese exposure was in the internet related sectors which rallied against the broad market trend.
Japan Long Short The average manager return for H1 2013 was around +15%. This may not seem that high given the market was up over 30%, but given about half the managers are market neutral, the alpha was significant.
The managers have traditionally been very low beta with many either making gains or mitigating losses in 2008 and 2011. The neutral managers returned around +8% in H1 2013 and the long biased typically over 20%. Almost every manager was up to the maximum net exposure. By early May, the rally became over extended and the inevitable correction came.
Net exposures reduced quickly but most were happy to rebuild the net once the market showed signs of consolidating. Stock selection alpha was generally good. Some of the strongest gains were made in the real estate sector which traded up to levels implying valuations in excess of the underlying physical properties.
Short alpha was challenging and managers had to be tactical. A company that looked to be on the verge of bankruptcy one year ago has now been given some breathing space due to the currency move. Many such companies have rallied strongly even though their structural problems have yet to be addressed. Asian Credit The public market managers are mostly around flat, whereas the private lending managers have accreted +3% returns. Most managers started the year with a cautious outlook on Asian public credit markets. The feeling was spreads were too tight and there was the risk of a supply overhang.
The withdrawal of European banks from the syndicated loan markets and the restrictions put on many of the domestic banks to curb credit growth had reduced to ability to access bank finance, increasing the need to go for bond issuance. There was also a fear that the demand side might contract in a rising rate environment. This kept more of the liquid credit managers focusing on relative value, shorter duration and special situations. Opportunities were more abundant in the illiquid credit space, especially in the area of direct lending. Managers are continuing to see opportunities to earn very high IRRs on senior secured lending deals.
Asian Multi Strategy The average manager return for H1 2013 was around +8.5%. After a few dull years for multi strategy managers, it was good to have an opportunity for them to opportunistically move capital around. We saw a significant move of capital into Japan. Many of the trades were equity related through increasing the long short strategy or more directional plays expressed in futures and options.
The Japanese convertible bond market is now relative small but there were valuations spikes as the market became fully valued. There was also a significant increase in capital markets activity in the regions as a whole. Many companies used the better market environment of the first quarter to raise capital. There was an active market in secondary equity blocks in which the multi strategy funds are typically very significant players.
Asian Macro The average manager return for H1 2013 was around +10%. The Asian biased macro managers have significantly outperformed their global peers during this period. This is in part to avoid some of the trades global managers have found challenging such as the US yield curve, USD and EUR, and in parts due to the abundant opportunities in the region. Most managers exploited the Yen move and the related Japanese equity move.
Most spotted the China slow down and played it either in the Australian dollar or in commodities, and either made money or avoided losses in the emerging market sell off on the back of tapering fears. Given the significance of the policy moves in Japan and China, there was a particularly rich opportunity set within the region.
The Outlook The first half of 2013 was a strong period of alpha generation for Asian managers, even though it is clear that opportunistic Japanese beta contributed significantly. But managers also deserve credit for handling the Chinese slow down well. While it is hard to predict such significant moves in the second half of the year, key policies in certain areas may be significant:
Japan – What are the next steps of structural reform? China – What level of growth is the new regime comfortable with and how will it stabilise the economy? US – What is the trajectory of tapering and eventual rate rises?
Once these questions are addressed the market impact will be significant. They should continue to drive divergence in markets. Divergent market conditions are much more favourable for hedge fund performance than the “risk on risk off” world which looks less likely to prevail.