Arguably, 2007 was the most important year for hedge funds in Asia since GFIA started researching the Asian hedge fund universe in 1998. First, it was clearly a good year for returns.
Arguably, 2007 was the most important year for hedge funds in Asia since GFIA started researching the Asian hedge fund universe in 1998. First, it was clearly a good year for returns. The Asiahedge composite was up 9.2 per cent in US dollar terms, roughly twice Libor, while the more representative Asia ex-Japan and Asia including Japan indices were up by 24.6 and 21.1 per cent respectively.
The GFIA-managed fund of Asian hedge funds, the Wittenham Asia Core Fund, returned 30.2 per cent from a highly diversified portfolio. The exception was, of course, Japan, where the corresponding Asiahedge long/short index was down 2.6 per cent, again in US dollar terms. Over the year, GFIA made money from its Japanese allocations, but only just.
Secondly, in a global context, the hedge fund industry demonstrated conclusively that its risk management processes were much more effective in aggregate than those of the banking system. The global banking system wrote off at the very least USD100bn of shareholder value, with more of those losses probably lurking within the system, while the global hedge fund industry – assuming a size of USD2tn, and applying the HFRI composite fund index return for 2007 of 10.2 per cent – created more than USD200bn of investor value.
Clearly, spreading risk management across a broad spectrum of economically empowered specialists is far more effective than letting risk management sit with employed agents within a small number of large banking institutions. This lesson will sink in deeply through 2008, and lead to a new level of respect for the hedge fund industry.
Finally, for the larger managers that have for some time been involved as direct liquidity providers to issuers, their main competition – the banks – fell away in the second half of the year. Some of the larger hedge funds in Asia that specialise in direct liquidity provision told GFIA that the environment had become very friendly for them toward the end of 2007, as the deal flow increased significantly because of the banks’ absence.
Relatively speaking, the crippling effect of the sub-prime crisis on commercial and investment banks has resulted in a significant increase in the share of global funding provided directly by the hedge fund industry. It’s very difficult to quantify this, but GFIA’s best estimate is that during 2007, the Asian hedge fund industry’s share of capital markets activity, outside exchange-traded transactions, may have doubled.
One side-effect of this is that the quality of returns of the hedge fund industry may strengthen still further. One manager that provides direct credit to medium-sized Asian companies told GFIA that, while spreads have not widened hugely, the increased number of deals they’re seeing allows them to cherry-pick much more than six months ago. In other words, the quality of the credit in their portfolio is strengthening.
For these reasons, we feel that 2007 will be seen in hindsight as a watershed year for the hedge fund industry globally, and this was very much reflected in the Asian experience.
However, at the end of 2007, the market environment changed very clearly. One of the larger (USD1.7bn) Asian long/short managers told us that between October and the end of 2007, the average liquidity of its large-cap equity portfolio had roughly halved, having approximately doubled over the preceding 19 months. Investors were on the sidelines, not taking any bets.
The following week, markets fell violently across most of the world on heavy volume. Volatility has already reached a new high plateau. A long volatility manager with which GFIA is invested made twice as much money in the blip of November 2007 compared with the market disaster that was January, because the absolute price of volatility had already increased so much.
Central banks are making dramatic interest rate cuts. Predictions are dangerous, but in February it appears clear that we are in a bear environment for most equity markets, that at best the world’s developed economies’ growth is already slowing, and that some large pockets of the financial sector are already under severe stress that is beginning to leach into parts of the real economy.
However, this is likely to be a good year for the emerging market hedge fund industry. Why?
Most of the world’s emerging market corporates and consumers are underleveraged, and in fundamentally good shape. In particular in Asia, the memories and lessons of the Asian crisis of 10 years ago are very real, and balance sheets, corporate and personal, are generally conservative. The pain of a US recession will not be disastrous for the majority of the developing world. In relative terms, if not absolute, the emerging world presents a fundamentally much stronger proposition.
The policy reaction will inevitably create another bubble somewhere, quite possibly, given the growing sense of geopolitical change in the world, in the developing world. It’s not impossible that the US dollar will become a cheap funding currency, while the generally strong sovereign balance sheets and prudent policies of much of the emerging world creates an environment for currency stability if not appreciation.
Volatility, as deleveraging fights liquidity and the appetite for cheap assets fights the fear of further losses, will continue, and volatility is generally good for hedge funds.
Some of the pain will be felt globally. For example, Asia is already seeing bankers being fired, often as part of a global headcount reduction. But generally the distress will be felt in the more leveraged economies of the US and Europe, and less so in the developed world.
Emerging capital markets, in the face of major structural economic changes, changing liquidity patterns, and investor uncertainty, are likely to continue to be inefficient, providing a good opportunity set for hedge fund managers.
Hedge funds are likely to be a key beneficiary of the relative strength of emerging economies. The extreme volatility we’ve seen will have reminded investors of the attractions of returns two or three times Libor, as an approach to participating in the growth of the ‘new’ world without taking simple market beta.
Some of the likely winning strategies include credit, for the reasons described above, and macro, as the changing world creates major currency and interest rate shifts. These have been under-allocated strategies in Asia and therefore capacity remains fairly readily available.
There remain some headwinds for the Asian hedge fund industry this year. Amid the recent volatility, the dispersion of returns across managers has been high, and 2008 is likely to see a continuation of this, winnowing the wheat from the chaff. GFIA believes that one result will be a high rate of manager attrition, as the entrepreneurs who have entered the industry over the previous two or three years, exit, leaving the universe more concentrated in managers with a genuine investment focus.
Investor risk aversion is likely to remain high, and while we are certain that the industry will show growth in 2008, investors are likely to look even harder at operational and organisational strength. This will favour managers with existing critical mass, but it will be a hard year for smaller firms without this backbone.
In the near term, the overall deleveraging of the investment landscape is likely to mean slower flows in at least the first quarter of the year.
In a bear market, a classic net long equity long/short fund will find it hard to make money. While overall GFIA is excited by the potential for returns in 2008, the source of those returns will be different from sources in 2006 and 2007. Many allocators are substantially weighted in Jones-model equity strategies, and this may constrain their performance.
Finally, until and unless the Japanese economy wakes up – which is probably a function of the domestic political environment – there is likely to be a continuation of the outflow from Japanese hedge funds in aggregate.
But overall, we suspect that the Asian hedge fund industry will continue to experience good asset growth this year. On the likely assumption of continued volatility, returns should be good, although perhaps not as good as in 2007. The key variable, we feel, is the flow of liquidity into the region, and this will be a tug-of-war between recession-mitigating global liquidity inflows, and deleveraging and risk aversion on the part of global allocators. On balance, we believe liquidity will win.
Peter Douglas, CAIA, is principal of GFIA, Asia’s oldest hedge fund consultancy, researching Asian and Latin hedge funds on behalf of professional investors, and advisor to the Wittenham Asia Core fund of funds