After 2011 being such a tough year for hedge funds, 2012 needed to be better to alleviate investors’ concerns. This was true both globally and for Asian managers. 2012 was another choppy year but in the end most Asian markets put on strong positive returns.
Asian equity markets rallied strongly in the first few months of 2012, only to give up their gains in the subsequent correction on macro concerns. However, they did rally into year end with regional equities returning between 16.5% and 22.5%, depending on whether we consider local currency or dollar returns and how we weight Japan.
Asian credit markets were solid throughout the year as investors chased yield with a more muted impact from macro turbulence. They returned between 14% and 23%, moving from investment to sub-investment grade. This is a combination of coupon, spread tightening and falling interest rates. Local currency government bonds, excluding Japan, had a total return in dollar terms of around 8% which is a combination of coupon, currency appreciation and falling rates.
Currency was the notable exception, especially in the case of the Yen that weakened nearly 13%. Broadly, most of the other Asian currencies continued to appreciate modestly except for India and Indonesia.
Asian hedge funds did generate reasonable positive returns over this period. The widely reported indices indicate returns of between 8% and 10%. They tend to include many small high beta managers and many of the large managers are not included. We believe a more representative return of a diversified Asian hedge fund portfolio, which excludes higher beta managers, would be around 6% to 7%. We think this could have been achieved with a relatively low beta of around 0.16 to the equity markets. Therefore, this return is around 50% beta and 50% alpha. However, we do recognise the low observed beta of credit strategies can flatter the alpha.
To look in more depth at the returns by strategy we are going to use what we refer to as “typical returns achieved” in 2012. There is no good index data that adequately includes the more significant managers; therefore we are using an estimated average return for the larger managers excluding outliers. We also exclude higher beta managers with net equity exposure of over 50%.
Asia-Pacific Long Short From mid-2011 to mid-2012, Asia-Pacific Long Short had, in aggregate terms, generated negative alpha as markets were adversely affected by the Euro crisis. They have generated some strong alpha in the second-half of 2012, beyond just the beta move. Longer term average manager beta levels had been around 30%, though by mid-2012, shorter term levels were even lower. Therefore, for 2012 they did move back into overall positive alpha; by individual manager, the alpha was quite diverse.
Many managers struggled because a relative value approach based on GARP principles was not rewarded. Managers were rewarded for picking long term leaders in their industry almost irrespective of valuation, especially in the consumer staples area. This differentiated performance as some managers had this thesis while others tried to short it with little success. Some of the other key sectors for identifying winners were in Internet and technology. Macau gaming offered some of the more volatile investing opportunities. Only towards the end of the year did we see a reversal of the winners into cheap cyclical stocks.
Most managers failed to fully exploit the high dividend trade which was a core strategy for many retail investors. This can be seen in the heavy outperformance of the REIT markets over the broad equity market. They tended to get dismissed by the more fundamental investors on a weak long term growth criteria.
Resource stocks were probably a net detractor of value. Many failed to fully appreciate the vulnerability of these stocks to the combination of a China slowdown and tight credit markets, especially stocks that had yet to reach production.
Japan proved a good source of shorts, especially in the consumer electronic sectors. However, it did become dangerously consensus driven and reversed heavily late in the year.
China A-shares underperformed heavily for most of the year and were a drag on many managers’ performance as they build positions with no ability to hedge. This did come back very strongly in December.
Japan Long Short With the market up around 18%, the performance of managers was disappointing. However, we recognise that most of the managers are fairly tactical and market neutral. In aggregate, the neutral managers were fairly flat for the year. In fact they have been fairly flat for two years after being some of the better performing long short managers over the global financial crisis. Historically, these managers had produced very consistent alpha with minimal beta. The long bias fundamental managers faired a bit better, returning around 6%, though that was mostly beta. Many made a lot in the first two months only to lose it all again and recover only towards the end of the year. Again alpha was not high.
What we observed was that global and Pan Asian managers more remote from Japan actually did better trading it on both the long and short side. They seem to have more objectivity on the macro issues. Purely Japan-focused managers seem to have become overly tactical and short term.
Asian Credit Asian credit proved the most stable Asian strategy in 2012 similar to the situation for credit within global hedge funds. Even as the equity market panicked at various points in the year, there was not the same degree of contagion into credit markets.
The liquid credit managers tending to stay cautious most of the year, yet they made reasonable returns on relatively hedged portfolios. Quite a bit of alpha has been derived from credit specific events and good primary deal flows.
The less liquid credit managers focused more on distressed and direct lending. Opportunities have been abundant in the tight credit environment. The nature of the strategy means reported returns appear steady unless there is a specific credit event. Asia enjoys a healthy spread between the perceived risk or access to capital and the real underlying business risk.
Asian Macro The broad category of Asian Macro covers two fairly different styles of manager. One style focusses more on local currency and rates with a strong relative value bias. This has been a very steady returning strategy for a number of years on very low correlations to the asset markets. 2012 was still positive but a little below recent years.
The other style is more directional and produced highly variable results. The equity markets were challenging most of the year. For most Asian currencies the scale of appreciation versus the relatively volatile macro environment made gains difficult. Two of the bigger Asian macro themes were the China slow down and Japanese “reflation”. Most looked at the commodities and commodity currencies as the best way to play the China slow down. Results were very variable as commodities equities worked better than commodities and commodities currencies didn’t work well. The Japan “reflation” had a lot of false starts but ultimately played out at the end of the year and proved the biggest trade. Most played it through the currency or equity markets.
Asian Multi-Strategy Given the opportunities in the equity and credit markets, the return from multi-strategy funds look modest. This is mainly due to two factors, the first being the tendency to be more heavily hedged than the other strategies and in hindsight most would acknowledge that they were probably over hedged. The second factor is that multi strategy funds tend to be fairly correlated with capital market deal flow. In 2012 the Chinese IPO window remained largely shut and the number of secondary blocks was modest.
Multi-strategy funds also tend to be active in convertible bonds and equity events. The relatively cheapness of legacy convertible bond portfolios has generated reasonable returns. However, modest issuance has limited the degree the strategy can be scaled up. Equity events have been challenging in the resource sector which is a significant portion of the regions’ M&A. One of the challenges is extremely high break risk when such deals fall through. Towards the end of the year, there were a number of good deals outside the resource sector which had favourable improvements in terms.
Summary of 2012 If we had to score Asian hedge fund returns for 2012, we would describe it as “fair”. We recognise managers now run significantly less beta than they did prior the financial crisis and downside risk management is much more robust. Therefore, we need to be realistic in our expectations of the level of participation in a strong up market. The nature of the markets meant that strong risk management had a significant cost. We hope 2012 proves a transition year to a more normalized market.
Outlook for 2013 We still live in a world that is very far from normalised as the developed world grapples with their fiscal issues and the developing world addresses imbalances. However, we hope markets are moving into a phase of more rational interpretation of the underlying fundaments. That is a world where disciplined investment decisions get rewarded.
We still see several strong long term alpha drivers in place for the region:
As Asia growth rebalances there will be significant differences in the fortunes for many companies which should make fundamental stock selection attractive. Growth in market sophistication will provide more hedging tools. Strong balance sheet of market leaders and industry consolidation should support M&A. The region will still need significant capital to fund growth supporting an active capital market. The withdrawal of European banks and cautious bank regulators will lead to an expanded bond market and opportunities in private credit and distressed. Gradual currency liberalization will expand the macro tool kit.
Perhaps the biggest challenge will be talent. As proven managers reach capacity, the current talent pool may only support a few significant launches each year.