The challenge to deliver China exposure
China's hedge funds have come under close scrutiny from various quarters of late. AIMA's Singapore chapter hosted the publication of a detailed report by Melvyn Teo from the Singapore Management University, and AIMA chapter head Peter Douglas has also recently returned from fact-finding in China.
Douglas observes that transparency has improved immeasurably since his last study four years ago. "We've had our most jaw-dropping due diligence moments looking at Chinese hedge funds, and I still believe that Asia's next hedge fund fraudster will come from that universe. But managers are now used to the demands of international allocators, and as forthcoming as their counterparts elsewhere in Asia. The only manager who was even remotely defensive about disclosure was a well-known American-owned Hong Kong firm who declined to let us check out their analyst in Beijing.
"A couple of years ago, had you asked us about China hedge funds, we'd have said it was imperative to use a fund sitting on a known platform rather than an indigenous boutique, purely for operational safety. I don't think that's the case any more. The quality of the managers, relative to the sophistication of the underlying markets, is very high. While risk management techniques are generally pretty simple, it's a given that the better fund managers have a reliable sense of where the market is at any given time. That will change: already one manager remarked that the footprint of the billion-dollar hedge funds was beginning to be visible in China. Eventually they, and the increasing sophistication of domestic money managers, will make life more difficult.
"Given that QFII [qualified foreign institutional investor] remains a constraint, capacity must soon be an issue, certainly for any manager claiming to have an edge in onshore securities."
It is often argued that hedge funds investing in emerging Asia are simply closet indexers that deliver high beta and no alpha. A paper prepared by Melvyn Teo, an associate professor at the Singapore Management University, with the assistance of Fullerton Fund Management, has addressed this issue.
The study shows that between 2000 and 2006, the market betas for hedge funds investing in Greater China were similar to the historical market betas for hedge funds investing in the US.
Furthermore, the study shows that the alphas for top performing Greater China hedge funds cannot be explained by luck alone.
Teo states, "These results are particularly relevant to investors who are considering an allocation to hedge funds in emerging Asia. It is clear that the region is poised for an explosive surge in hedge fund activity. At the same time, there are concerns that the under-developed nature of these markets may hinder the proper functioning of various hedge fund strategies. For example, the classic equity long/short strategy requires a well-developed market for short selling, ie, the presence of cheap and abundant shorts. In the absence of short-selling opportunities, equity long/short funds may simply mimic long-only funds and load up on market risk.
Consequently, from an asset allocation standpoint, the portfolio diversification benefits of holding such hedge funds are minimal. [In reality] Greater China equity long/short funds are able to minimise their exposure to the China market by short selling overseas listed Chinese firms. Hence, they effectively circumvent the short-sales restrictions imposed on domestically listed Chinese firms.
"A similar story prevails when we investigate the distribution of individual hedge fund betas. We find that between 1995 and 2006, the median US hedge fund beta hovers around 0.5. This coincides with the median Greater China hedge fund beta of about 0.5 for the 2000-06 period. Indeed only when the US enters a secular bear market (eg, 2001-03) do we find that the median US hedge fund beta falls to about 0.25. One view is that U.S. hedge funds time the market and reduce their market exposure during bear markets. Nonetheless, for the most part, the distribution of Greater China hedge fund betas mirrors that of US hedge fund betas.
"The number of Japan, Asia inc Japan, Asia ex Japan, Greater China, and India equity long/short hedge funds has grown significantly over the January 2000-December 2006 period. The number of Japan equity long/short funds has grown from 28 funds to 251.
"Hedge funds in Greater China appear to be reaping significant alpha during market downturns. Consistent with the idea that hedge funds are good hedges against the market, the Greater China fund portfolio performs very well in equity market downturns (eg, 2000-03, based on the MSCI China Index) and reasonably well in equity market upturns (eg, 2003-06, based on the MSCI China Index).
We note also that the returns of the Greater China equity long/short hedge fund portfolios appear to be more correlated with the returns of the HSCEI and MSCI China Indices than with the returns of the Dow Jones Total Market Index. This suggests that many Greater China hedge funds are buying into China via Chinese firms listed in Hong Kong. Access to the domestic market requires a QFII licence, which is limited. Relative to the approximately $1trn market capitalisation of the Shanghai and Shenzhen markets, the current quota is only $10bn. There is talk that an additional $6bn quota for foreign investors to buy Chinese A-shares is being considered.
"To investors, Greater China hedge funds are relevant only if they generate alpha or positive risk-adjusted returns. It is not enough that they have low market exposures. One can easily construct portfolios of equities that have zero alphas and betas of less than one. Therefore, it could well be the case that the GreaterChina hedge funds while maintaining low market exposures (at least relative to those of US funds) do not deliver alpha at all."