Only the strong survive
In September 2004 we opened our first Asian office in Hong Kong and invited a number of our clients on an Asian road trip. The plan was to travel round the region, visiting managers in their offices. Early in November 2004 we travelled from Singapore to Hong Kong, Shanghai and, finally, Tokyo. Over the two weeks, a group of 10 of our clients and a few of our colleagues saw 44 funds. At that stage the main challenge was trying to fit that many people into an Asian hedge fund’s office.
We selected a broad representative list of the more prominent managers in the region. We concentrated mainly on funds which were open and new launches of existing managers. Although it is only 26 months since the road trip, we have been surprised at what has happened with this group of funds. There are lessons about the industry which get lost in headline returns.
Our group of funds returned 9.7% pa over the 26 months. This assumes no reinvestment of failed funds. If we assume they were able to reinvest at the overall average return it would be 10.8%. Fairly acceptable? No. Not, if we look at EurekaHedge indices. The indices suggest that the funds should have returned 15.6%. The EurekaHedge Asian
fund of fund index made approximately 12% annually for the same period, again lower than the single manager index.
Part of this is explained by how indices are compiled:
n New start-ups can often inflate indices. They make high returns on very small assets and often only start reporting numbers when these start to look respectable.
n The past two years has seen a proliferation of single-country China and India funds. Without the large participation of these and on the back of strong markets in China and India, the higher returns could not be achieved.
n Poor performing funds have a tendency to stop reporting their numbers. Surprised?
n “Walking dead” funds often produce their best returns once all external investors have withdrawn their money.
An important intellectual exercise took place on the penultimate evening of our road trip, which provides some clues of what could have been predicted. Over an evening meal of shabu-shabu and Japanese beer, we held an informal straw poll amongst our clients and ourselves ranking each manager. This was never a formal grading process, but it does provide a snapshot of experienced global hedge fund investors’ first opinions on the funds. We have updated this for 26 months of returns and can now reveal the quality of the ranking exercise.
without reinvestment with reinvestment
Quartile 1 13.0% 13.0%
Quartile 2 11.3% 11.7%
Quartile 3 7.2% 9.4%
Quartile 4 5.2% 7.2%
It is pleasing to see the collective intelligence of our group did add value. It is also easy to understand why the average fund of funds returned 12%. They probably had a fairly similar view of the better managers and may have had the benefit of having a few existing closed managers and adding extra China and India funds.
Death of a hedge fund
Thirteen of the 44 managers, or 29.5%, are no longer managing the same fund. In three cases, the manager moved the investment team and strategy to another company. Two of these funds still exist, albeit with new portfolio managers, while the third was shut down. For the purposes of analysing these returns I have followed the portfolio manager, not the actual fund.
With the other 10 cases, or 22.7%, these are essentially “dead”, although a few are technically “walking dead” - the funds still exist, but in reality are only managing staff and friends’ money. Often this is a period of radical style drift and concentrated bets. We have tried to exclude such unrepresentative performance.
The main reasons for the demise of these 10 funds can be summarised as follows:
Cause of death Number
Alleged insider trading 1
Suspected rogue trader 1
Aggressive risk 1
Asset starvation with losses 3
Asset starvation without losses 4
In only two cases, it is estimated that investors lost around 20% but this is not confirmed as reporting is not available to non-investors. Only two of the 10 made headline news; one of these will probably go to court and be rigorously defended, while the other has gone very quiet.
In fact, the average return from investing in the
10 funds is around +3%. If we ignore the one
which had performed very well until it fell foul of regulators, the result is still marginally positive.
The major cause of death is a slow loss of assets, which we have referred to as “asset starvation”. In most cases this comes as a result of modest losses or dull returns.
It is actually fairly normal to see 10% of funds shut down each year. In Asia, the number is probably higher as the funds we visited on the road trip tend to be larger. It would be fair to say that many small funds never really get off the ground.
Looking back to our informal ranking exercise, the highest-ranked fund which failed was number 20 on the list. Therefore, the risk of fund failure can be mitigated but never removed even by a good selection process.
Life after death
It is always interesting to see what happens to hedge fund managers once funds die. Our analysis for the 10 managers would be:
After death Number
Walking dead 4
Part of team re-launched themselves 2
Re-launch pending 1
Termination of JVs 1
Back to long-only 1
Left the region (unknown) 1
Interestingly, most of the individuals involved have not given up and are either continuing to manage their own money (“walking dead”) or are looking to or have re-launched themselves.
Fifteen funds, or 34.1%, suffered a peak-to-trough drawdown of more than 10% in the 26 months. One of these suffered two drawdowns of 10% and two exceeded 20% in a single drawdown. In the two cases that exceeded 20%, the funds failed to survive. This suggests that it is difficult to survive drawdowns of this magnitude. However, if we look at Japan last year, some managers have survived 20% drawdowns but only because they had built up many years of solid returns and goodwill.
Ten per cent drawdowns have had a much more mixed response from investors. Of the remaining 13 funds, we would classify their current situation as follows:
Walking dead 1
Alive but struggling 4
There is no doubt that many investors do “stop loss” a fund once it draws down by 10%. However, investors may be more forgiving if the funds have generated strong performances in the past.
Looking back at our informal straw poll exercise, only one of our top quartile ranked funds had a 10%-plus drawdown, and which is impressive.
However, seven of our top 50% of funds suffered 10%-plus drawdowns, which is not much different from the bottom 50%, which is much less impressive. Did our collective intelligence fail us or are 10% drawdowns a fact of life in many Asian strategies? We are inclined to think that it is the latter.
So what worked?
The overall distribution of returns was:
Compound returns Number
0-5% pa 6
5-10% pa 16
10-15% pa 6
15-20% pa 3
20%+ pa 7
If we look at the 10 funds that compounded at better than 15% returns it is clear this did not come without risks:
Strategies Number Drawdowns > 10%
Asia Pacific L/S 1 1
Japan L/S 1
Greater China L/S 2 3
India L/S 1
Asian Property L/S 1 1
Japan Activist 2 1
Asian Event 1 1
Asian Macro 1
Only four of the top performing funds avoided 10% drawdowns. Of the six suffering 10% draw downs, one suffered this twice. This is also indicative of the fact the returns did not come without a reasonable degree of beta, which is inherent to many of these strategies.
However, when we look at the six funds that returned a decent but more modest 10-15%, we see only one suffering a 10% drawdown.
Therefore, the lesson is clear. Asia offers no magic as there is a strong correlation between risk and reward. Another important observation is the lack of any relationship between funds that did well in 2005 and those in 2006.
Sixteen funds made better than 15% returns in 2005 and nine in 2006, but only two achieved this in both years. Ten of the 16 funds that made 15%-plus in 2005 lost money in 2006.
Three of the nine funds that made 15%-plus in 2006 lost money in 2005.
Once again the collective intelligence of our straw poll put three of the four managers returning over 15% without a 10% drawdown in our top quartile and also both of the managers that produced 15%-plus returns for two years consecutively.
We think that many of these issues are a fair representation of the Asian hedge fund market. Therefore, some of the lessons drawn from these managers can be applied more widely:
n There are very few “managers for all seasons” in Asia. Many still have a large beta component to their returns.
n It normally takes a reasonably diverse portfolio of Asian hedge funds to stabilise the overall risk.
n Chasing prior performance is normally not a good measure of future returns.
n Fund failures do happen at around 10% a year. Luckily these rarely are that expensive.
n Trying to operate a 10% stop loss on Asian funds is fraught with practical difficulties. It is probably a 50:50 bet whether it is the right decision and some qualitative factors should be considered.
n A good selection process can mitigate but never remove these risks.
We have spent the article focusing on the outcomes of the 44 funds we visited, but we should also consider how the broad market place has changed in these 26 months. We suspect the Asian manager universe has doubled during this period.
One major change had been the arrival of large global multi-strategy funds that have carved out Asian-only funds. These now represent some of the largest funds in the region and to date they have proved themselves to be much more “managers for all seasons”.
No recent comment on the Asian hedge fund market would be complete without mentioning that 2006 was a year for the New York-based Asian hedge fund managers. For the previous few years, the Asian-based managers looked good as they exploited small caps better.
However, in 2006 the New York-based managers proved much more adept on the short side and overall much better at managing drawdowns. However, success now means they have become very large and very demanding on investor lock-ups.
We have seen a proliferation of single-country funds with a heavy long bias, especially in India and Greater China.
As it becomes harder to capture alpha in a strong liquidity rally, many investors have been happy paying hedge fund fees for beta, especially when it has been so abundant. The very same money that jumped into Japan in 2005 was switching into China and India in 2006. It is a little disturbing to see a ’beta-based” selection process picking hedge fund managers.
Everything looks great at the headline return level but we feel more challenging times will be ahead. Too many managers, especially in China and India, have never had to prove themselves through difficult conditions like those Japan experienced in 2006.
This will provide an opportunity to differentiate managers, but unfortunately it will not come without a lot of pain.
Richard Johnson is a principal of Albourne Partners, based in Hong Kong