The more things change the more they stay the same
We have just passed the one year anniversary of the great financial crisis of 2008. An event marked by the print and television media with a series of “in-depth” retrospectives. To my mind, all of these reviews seem to have struggled to portray the events of late last year as a watershed moment in the evolution of the financial services industry. Twelve months down the line, how much has really changed for the hedge fund industry in Asia and has any good come out of this crisis?
It is quite hard to identify change in our industry. The waters have closed over Bear Stearns and Lehman Brothers but their ghosts live on at JP Morgan, Barclays and Nomura, jostling for space in the investment banking world with the giants of yesteryear - Goldman Sachs, UBS, Morgan Stanley and Credit Suisse.
If anything, change in the investment banking world has been to the detriment of the hedge fund industry. There are fewer players, market share is more concentrated and so the prime brokers have more control over market practice and pricing than ever before.
Immediately after the crisis, we were promised swingeing reviews of the way in which brokers used and held a fund’s collateral, re-hypothecation risk, legal structures for custody and the segregation of client assets (particularly cash). Work began in a flurry of well intentioned activity spurred on in part by the threat of regulatory change coming from the US. Working parties were set up to discuss OTC derivatives clearing and how we might finally start to standardize dealing terms in these markets and bring some order to an area of complexity that, in part, brought about the downfall of companies like AIG. A year later and the initial impetus for change in these areas appears to have dissipated.
As markets have recovered and as the banks have righted their capital structures and begun to be highly profitable again, the desire to make radical change has leaked away. The core structure of the hedge fund industry, its DNA, remains unchanged. Prime broking agreements are still wordy and largely unintelligible, the OTC market is still paper driven, legal structures for holding client assets continue to be fragmented and are inadequate for protecting client assets. If change is to come it will be driven out of the US by the regulator. Whether they can win out against Wall Street remains to be seen, but the omens are not good.
Other much-trumpeted changes have also foundered; some quite rightly so. Changes to short selling rules, extending the scope of the registration and authorization of asset managers, imposing the need for independent administration on funds have all failed to surmount lobby group opposition of one form or another. The EU proposals for hedge fund regulation are hopelessly mired in a bog of poor drafting, conflicting goals and political interest. They will go nowhere fast.
The financial crisis firestorm, which was meant to clean away the dead brushwood leaving the way clear for a better industry, was stamped out before it really got going. Maybe this was necessary, as the fire threatened to destroy everything in its path. But the net result is that we run the risk of throwing away a once in a life time opportunity to make radical change.
For those hedge funds that do remain in business, times have been hard. Leverage is tough to come by and so some strategies have become inoperable. Assets lost through redemptions and market movement could not be replaced as clients all but disappeared for a year, either, on strike disappointed by poor returns and even poorer treatment by the managers (gates, side pockets etc) or, due to problems within their own businesses.
However, these conditions also brought with them the promise of change. Investment banks closed down their proprietary trading desks and stopped competing with their clients, many non-Asian based multi-strategy funds quietly closed up shop and slunk back to their home bases. Investors withdrew 20% to 30% of their invested capital. For the survivors this left a very benign investment environment, where competition for investment ideas had all but disappeared.
This too, may prove to be a short lived illusion. Anecdotal evidence suggests that the international multi-strategy funds are beginning to hire again. They have cash to invest in the markets and have concluded that Asia represents good value for them. Having laid off their staff, the wheel has now turned full circle. There are also signs of life in the investment banking market, where again re-staffing appears to be taking place.
So what has changed? The most positive development is undoubtedly the rise of the Asian-based hedge fund investor. Two years ago, 80% of all subscriptions into Asian-based hedged funds came from outside of the region. In the last 12 months I would estimate that over half of the (admittedly very low dollar number) flows into Asia have come from Asia.
Secondly, those start-up hedge funds that have managed to launch have usually been funded by local investors; family offices, high net worth individuals or institutions. This is very good news. The extreme volatility of our hedge fund industry is in part caused by the lack of indigenous investors. Money washes in and out of Asian hedge funds dependent upon what is happening in New York, London and Geneva. If our industry can establish a solid foundation of local supporters, this volatility can be dampened. As volatility declines managers can develop longer term investment strategies, be less driven by market correlation and build better, more enduring business infrastructure. This will set in place a virtuous circle of better businesses, better performance and more investment in-flows.
Why have Asian investors begun to take an interest in Asian managers? Firstly, they now perceive that Asian capital markets represent potentially better long term capital gains than European or North American markets. But secondly and more importantly, the withdrawal of the overseas investment houses and investment banks has left the ground unoccupied. What was a space previously dominated by international groups is now vacant and this has not gone unnoticed. Asia’s investors have a golden opportunity to reclaim territory from which they were previously excluded. If nothing else changes, this development alone will make the pain of the last 12 months worthwhile.