Small Asian Hedge Funds : Facing The Dark Night Before A New Dawn

13 April, 2012

If somebody ever wrote a book titled 'History of hedge funds in Asia' in 2030, I can bet every dollar in my pocket that he (or she) shall refer to 2010 & 2011 as the defining years in the evolution of the industry in this part of the world. Or let us say that hypothetically there was a hedge fund manager with over a decade of experience in fund management who closed down his hedge fund in Asia in 2009 and shifted to Antarctica. If he returns today to start another hedge fund in Asia, he would be faced with totally altered dynamics and shall be as lost a new trader starting out. The irreversible trends have emerged in Asian hedge funds over the last few months are expected to completely change the industry landscape in the years to come.

INDUSTRY OVERVIEW

According to some estimates, there are around 1300 Asia-focused hedge funds in the world today with around $125 billion assets under management (AUM). That makes the average size of an Asia-focused hedge fund close to $96 million which is less than half the size of an average hedge fund in the US.

Some more startling facts are:

Forty per cent of the hedge funds in Asia manage less than $20 million.

If you arrange the funds in decreasing order of their AUMs, the top twenty per cent manage eighty per cent of the total assets.

According to Securities & Futures Commission (SFC), twenty funds manage fifty-six per cent of the hedge fund assets in Hong Kong which has more five hundred hedge funds.

Clearly if you are a small hedge fund in Asia, the going is rough. But this is not without reason. A lot of investors have bad memories of fund managers taking various measures to halt redemptions during the financial crisis in 2008. These include 'tactics' like putting up gates, side pocketing etc. and many hedge fund investors felt ill-treated at that time. Consequently they don't feel secure parking their money with new hedge fund start-ups and prefer the bigger and MORE established names. Asian fund managers on their part refute their allegations stating that despite steady performance investors chose to withdraw their money and 'treated them like ATMs'. Most claim that they didn't change the terms and conditions of the original agreements on redemptions during that time.

Whatever the truth may be, the reality today is that hedge funds in Asia which aren't backed by a big asset management firm (like The Blackstone Group) or seeded by a hedge fund of fund (like Brummer & Partners) are having an extremely tough time raising and scaling their assets. Yet there were 125 new hedge fund launches in 2010, up from 78 in 2009. Clearly in a world in which the US is battling recession, EU has debt woes and the Middle East is facing civil unrest, fund managers see great potential in Asia. And that is not without reason. At the most Asian countries are less leveraged, politically stable and have strong companies that make good products for an aspiring middle class.

Major developments in Asian hedge funds over the last 12 months:

BIG BOYS COME TO ASIA: Fortress Investment Group opened an office in Singapore in October 2010. They follow the footsteps of other industry titans like GLG Partners and Soros Fund Management. Global managers are setting up shops in Asia mainly for two reasons. Firstly, there is strong demand for Asian exposure from their investors. Secondly, they realize that in order to succeed in Asian markets they need to have on-ground relationships and dialogues with companies, boutique investment banks, and regulators. However their focus and presence in Asia is only making it more difficult for smaller hedge funds to raise assets.

ASIAN HEDGE FUNDS ESTABLISH PRESENCE IN THE WEST: This is not an attempt by Asian hedge funds to get back at the global managers from the West but a logical step in scaling up. Eighty per cent of their assets come from non-Asian investors with the US & EU accounting for around three-fourths of these. No wonder that many home grown fund have opened marketing offices in London and New York and are trying to raise fund citing their 'local knowledge' advantage.

CLOSURE OF SOME HIGH PROFILE FUNDS: Even though there have been some high profile start-ups in the last few months, inability to raise funds and/or lack of performance has forced many 'star' Portfolio Managers to close operations.

REGULATIONS:

Dodd-Frank Act: President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) on July 21, 2010. According to the Act, funds which manage over US$ 25 million for 15 or more American-based clients will have to register with the SEC by July 21st 2011. As a result they are going to face higher costs due to these increased compliance requirements.

The irony couldn't have been greater for Asian managers. While West is looking eastwards for growth and opportunities, Asia-based funds find themselves being pulled in the opposite direction due to these regulations that directly impacts them.

Volcker Rule: The Volcker Rule bans banks from proprietary trading and investing more than three per cent of their capital in hedge funds. In order to comply, banks have disbanded their proprietary desks and spun-off their funds.

This is not necessarily a bad thing for hedge funds. Most of the proprietary traders who lost their jobs have either been absorbed by them or have started a fund their own. In fact one of Asia's most highly anticipated hedge fund launches is the $1 billion Azentus Capital founded by Morgan Sze, the former head of Goldman's Principal Strategies Group, their proprietary trading unit. The talent pool in the hedge fund universe has increased in quality and quantity as a result of this regulation.

THE WAY AHEAD

Going forward I foresee the following trends to emerge in Asian hedge funds :

Increased importance of Compliance Officer: Historically Asian funds have been smaller than their western counterparts. Consequently most of them had the Portfolio Manager or COO doubling up as Compliance Officer to save on costs. But they may have to do away with this practice soon as (a) it may not be permitted under Dodd-Frank (b) a designated personnel would be required on a full-time basis in order to cater to the regulatory and compliance burden that is going to be placed on these funds. Apart from costs, funds are going to find it extremely tough in finding suitable candidates for this role as Asia lacks people with the required experience and skill-set.

Super-demanding investors: Between 2003 and 2007, Asian hedge funds start-ups inside a small room with a Bloomberg terminal and two analysts were able to raise hundreds of millions of dollars from investors. That is not going to happen anymore. Investors have smarted from their experience in the past are want to see risk-management systems and operating infrastructure in place even before they agree to meet the fund manager. This is big change in mind-set for Asian managers and puts them at a direct disadvantage to bigger funds that benefit from economies of scale.

Opportunity for fund of hedge fund (FoHFs): The Madoff scandal almost killed the fund of hedge funds industry overnight. They still remain a dirty word in the US. However I feel they have a big role to play in Asia in the years to come. The reasons for the same are not hard to miss. Consider the following:

-Only twenty per cent of the assets in Asian hedge funds are from Asian investors.

-The number of new hedge fund start-ups has gone up by sixty per cent in the last one year and the average launch size went up to US$ 40 million from US$ 33 million in 2009.

It is not that Asian investors don't want to invest in hedge funds. However the large amount of information asymmetry that exists between them and the fund managers at a new start up prevents them from doing so. That is where I feel FoHFs can step in and add tremendous value for both investors and smaller funds.

Asian domicile for hedge funds: For now Asian hedge funds are chained to regulations made in the West but this dependency might reduce significantly as China further opens up its financial market. In such a scenario, Hong Kong is ideally positioned to be an Asian domicile for hedge funds. However I don't expect this change to take place in the next 2-3 years.

In conclusion, while big fund names don't necessary have better performance than smaller ones, a combination of many factors is going to make the next 12-24 months extremely challenging for the latter. The ones who manage to survive this phase and deliver good returns for their investors are going to stand out. All the famous hedge fund managers, from Julian Robertson to Paul Tudor Jones to Druckenmiller to Paulson have been from the West, the next name might well be from Asia.


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Small Asian Hedge Funds : Facing The Dark Night Before A New Dawn

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