Research

Overview

Asia Pacific markets make up 15% of the world's market capitalisation but Asian-strategy hedge funds represent only 6.5% of the world's hedge fund market by assets. However, the robust growth seen since 2000, is a definitive indicator that this disconnect is continuing to close. Asian-strategy hedge funds have witnessed a strong growth since 2000, with assets increasing 35% per annum and Asia is also home to some world-class managers who typically still have capacity unlike in more developed markets.

Why Asia?¹

In 2004, the economies of developing Asia and the Pacific achieved their highest growth since the Asian financial crisis of 1997-98 as their aggregate GDP expanded by 7.3%. The robust performance was underpinned by a combination of a highly favourable external environment and a buoyant domestic demand, in particular as a result of the significant strength in business investments in many economies in the region. In spite of the robust growth for the third consecutive year and the burden of persistent, high oil prices, average inflation remained subdued in 2004, although inflation started to trend up in several countries in the latter part of the year, triggering some tightening of monetary policies. On aggregate, the region continued to register a significant current account surplus, of 3.7% of GDP, though this was lower than in 2003.

The strong economic momentum in most regional countries, together with a continued favourable external environment, augurs well for income growth over the forecast horizon of 2005-2007. There will be some moderation in growth since the cycle probably peaked in 2004, but average GDP growth is projected to be 6.5-6.9% over the next three years. While export demand from the major industrial countries might subside a little, intra-regional trade should remain buoyant as China's economy seems set to achieve a soft landing and the forces of regional integration intensify. With inflation projected to remain moderate, macroeconomic policies should continue to support domestic demand.

Performance

I. By strategy

The risk-adjusted rankings for 2000-2005 (year to date) rank Asian distressed debt funds as No. 1 with the best risk-return combination. This is followed by event-driven and long/short funds, respectively. The risk-adjusted ratio for distressed debt funds is the highest among all, at 3.08. This was brought about by the increase in global corporate activity, which fed through to the region, and created more opportunities for these funds in terms of merger and acquisition activity, as well as debt restructurings.

Trailing the pack were multi-strategy and macro funds with the worst risk-return combination and Sharpe ratios of less than one.

II. By investment region

In terms of performance by investment mandate, the Australia/New Zealand region ranks highest on the risk-adjusted list, indicating the best risk-return combination. However, looking at just performance in the Asia-Pacific region, Greater China has outperformed the rest of the region. This is not surprising as China's economy has been buoyant since 2000. The Greater China market has returned over 18% per annum since 2000. Korea is the next best market in the Asia Pacific space, with an annualised return of 15%.

Surprisingly, India-focused funds ranked at the bottom of the league in terms of risk-adjusted rankings although it has generated fairly high returns in the long/short sector. India long/short funds have produced an annual return of more than 23% since 2000. This is however dragged down by the lacklustre performance of multi-strategy funds. The negative Sharpe ratio for India is driven more by exceptionally high volatility than by low returns.

Also not faring too well on the risk-adjusted rankings are Taiwan-focused funds. Note that they represent less than 1% of the total Asia-Pacific funds, reflecting in some part the traditional reliance on the part of Taiwanese institutional investors to diversify into hedge funds, its reliance on a tech industry that is hard to call and an overall economic situation blighted by political uncertainty. The MSCI Taiwan equities index was marginally up by 1.48% till July 2005 since the December 2004 closing.

III. By size of assets under management

The large-cap Asian hedge funds (funds with more than US$250 million) have been lagging slightly behind their small- and mid-cap peers in the region, with an annualised return of 10.57% compared with 10.99% and 10.9%, respectively.

In the risk-adjusted rankings, mid-cap funds are the best bet in terms of superior risk-return combinations. The risk-adjusted ratio for mid-cap funds at 1.88 is significantly higher than the small- or large-cap funds at 1.64 and 1.66, respectively. Mid-cap funds being more risk averse, did not take as large a position as large-cap funds, which are more confident or in the case of small-cap funds, which have perhaps more to prove.

In terms of returns, however, large-cap funds have outperformed the rest in 2004 and are leading the tally in 2005.

Industry Analysis

I. By strategy

There remains a strong preference for long/short equity strategies among Asian hedge funds, with almost 66% of the universe falling under this category. Looking at new launches in 2004, it was not surprising that out of 100 Asian strategy funds launched, 61 of them were long/short funds. This reflects the earlier stages of the industry, when it was dominated by fundamentally driven, long-biased equity managers. Multi-strategy and distressed debt funds combined make up another 18% of the Asian universe.

Figure 5: Breakdown of Asian Hedge Funds by AUM

Source: Eurekahedge

The exponential growth of strategies like convertible arbitrage, CTA and relative value should not come as a surprise because all of them started from a low base since 2000. However, we should note that the strong Asian demand for commodities, especially in China and India, has been instrumental in the growth of CTA and commodity-only funds in Asia.

Figure 6: Annualised AUM Growth Rate since 2000

Source: Eurekahedge

This perhaps suggests that start-up funds are increasingly becoming less focused on a narrow range of investment strategies. The impressive performances of distressed debt and event-driven funds in the past five years suggest that these strategies are likely to be considered by new fund managers. There are also visible trends in convertible arbitrage funds morphing into multi-strategy hedge funds doing risk arbitrage, relative value, etc. Examples of such funds are Stark Asia Fund and Artradis Barracuda Fund.

Figure 7: Funds' Annualised Growth Rate since 2000

Source: Eurekahedge

The comparison of average assets relative to the risk-adjusted ratio for each strategy, however, put the performance of the strategies under a different light. The wide gap in terms of average assets for the various strategies with similar risk-adjusted ratios perhaps suggests where future asset flows into Asia will go. For example, long/short, fixed income and relative value funds have similar risk-adjusted ratios but the average assets for long/short funds far exceeds the other two strategies. There is also a wide gap between the risk-adjusted return and average assets for event-driven funds, perhaps suggesting much potential in this strategy.

Figure 8: Average Assets vs Risk-adjusted Ratio

Source: Eurekahedge

II. By investment regions

Of Asian hedge fund assets, 30% are focused purely on the Japanese market, the bulk of which comprise of equity long/short funds. This is followed by strategies focusing on Asia including Japan, Asia ex-Japan and Australia/New Zealand, which make up another 41% of the Asian hedge fund universe.

Figure 9: Breakdown of AUM by Investment Region

Source: Eurekahedge

At this point, it is very interesting to note the growth rate of assets focusing on different Asian markets. The explosive growth in China-focused assets is not a surprise, especially when it has been producing returns in excess of 18% per annum since 2000. This is the best performance across all the Asian markets.

Figure 10: Asset Growth since 2000

Source: Eurekahedge

Having said that, Australia/New Zealand, Korea and even India are potentially promising markets coming up in Asia Pacific.

III. By location

The US and UK are home to more than 50% of the Asian hedge funds by assets. This is not surprising as investors prefer to stay close to the source of capital. Within Asia, Australia, Hong Kong, Japan and Singapore house about 43% of Asia-focused hedge funds by assets.

With the continued stellar performances of Asian strategy funds, we feel that there would be more demand for Asian products among Asian investors and the Asian pie will get bigger in the coming few years.

Figure 11: Breakdown of Asian Assets by Head Office Location

Source: Eurekahedge

Singapore or Hong Kong?

For 2004, Singapore emerged as the top choice for Asian hedge fund start-ups in the region with 19 launches. This is while Australia has fallen from the top of the league with only 13 launches in 2004 as compared with 27 in the previous year. On the other hand, the UK retained its popularity for Asian start-ups (around 40 in 2004), reflecting the continuing importance of European institutional investors, and the close relation between investor proximity and capital introduction for many funds.

Asian hedge funds obtained close to 40% of their capital from Swiss investors in 2004. This was followed closely by the UK and US with 30% and 20%, respectively. Asia-Pacific investors continued to lag behind, being responsible for only one-tenth of flows, including those from Japan.

In terms of start-up and running costs, Singapore remains less expensive than Hong Kong. Cost of professional services (accounting, audit, tax, legal), marketing and human capital placement remain competitively lower than Hong Kong. Legal costs for a simple exemption application can be obtained at US$6,000-8,000, while a full-blown licensing application from Hong Kong would likely require experienced Hong Kong legal advice from US$15,000 and upwards.

In terms of localised presence, most of the experienced institutional Asian hedge fund professional expertise such as prime brokers and administrators has stronger operational bases in Hong Kong. However, there is a growing trend of human capital shifting into Singapore as well as strengthening local branch services. HSBC's alternative fund services, for example, have a strong and fully manned and serviced branch in Singapore, as do the Singapore offices of PricewaterhouseCoopers and Ernst & Young in relation to fund audit.

Nevertheless, Hong Kong is still generally viewed as being more active by the investment community, drawing more investors than Singapore or Australia. Hong Kong remains well ahead in terms of total AUM, at around US$9.3 billion to Singapore's US$3.8 billion, out of an Asia-Pacific total of US$70 billion.

Regulatory and Tax Overview

Singapore imposes tax on a semi-territorial basis. Income is taxed based on it being sourced or deemed as sourced in Singapore, and foreign-sourced income is taxed when remitted or used for the purposes of defraying Singapore-based expense. In the context of a hedge fund, the place of business will determine the source of the income, and a foreign hedge fund that has its discretionary management in Singapore would be regarded as carrying on business in Singapore. However, 'legitimate' fund managers may take advantage of statutory provisions that allow exemptions of tax of 'designated' income of foreign funds. There are criteria for this, such as, investors of the fund have to be non-citizens and non-residents where an individual beneficiary and a company's investors must not be residents in Singapore, or have more than 20% of their issued share capital beneficially owned directly or indirectly by residents in Singapore. Some qualifying managers may be able to obtain an Approved Fund Manager (AFM) tax incentive, which allows tax to be reduced to 10% from the normal corporate tax rate of 20%. This incentive requires a minimum of S$100 million under management as well as other conditions relating to the experience of the managers.

For Hong Kong, a 17.5% profit tax is payable by a person who carries on business in Hong Kong or derives profits which are sourced in Hong Kong. This includes an agent, who is a person based in Hong Kong on behalf of another, but with general authority to negotiate and conclude contracts. Investment managers or advisors based in Hong Kong generally operate within this role definition. However, investment advisors approved under the Securities and Futures Ordinance (SFO) will generally not be considered as an agent of a non-resident person for this purpose if the advisor is not an associate of the fund and acts in an independent capacity while receiving customary rate of compensation. Draft legislation on whether fund profits are taxable may not have fully and clearly addressed the matter. There are however specific exemptions within the current tax legislation that provides protection for collective investment schemes that are 'authorised' by the Securities and Futures Commission (SFC) (although not many such funds have been authorised, only about 10 or since 2004), or collective investment schemes (CIS) that are established outside Hong Kong where the Inland Revenue Department of Hong Kong is satisfied that it is 'bona fide widely held' and complies with the requirements of a supervisory authority within an acceptable regulatory regime.

Figure 12: Annualised Growth Rate of Asian Funds since 2000

Source: Eurekahedge

Overall, however, the biggest issue for many managers is that of registration and this has proved to work in Singapore's favour. In both Hong Kong and Singapore, managers are required to register as investment advisors before they are allowed to trade securities. However, there remains a startling discrepancy in processing time. While it takes a couple of weeks to register a start-up in Singapore; it can take several months in Hong Kong. This is a big issue for Japan-located hedge funds as they need to have their trading offshore, and more and more are having their trading set up in Singapore rather than in Hong Kong. This lag in processing times has also much to do with the arrival of big American funds opening branches in Asia such as Tudor, Everest, Moon Capital and most recently, the US-based US$2 billion fund, Tribeca, started by Citigroup, which chose Singapore to be its Asian headquarters.

The rise in Singapore's fortunes as a hub for Asian hedge fund managers is juxtaposed to the decline in Australia's share of the region's start-up market, which was almost halved from 22% of the market in 2003 to 13% in 2004 by number of funds. This reflects the difficulty funds face in raising new capital, given the continent's time difference and distance to key investors in Europe and the US. In addition, many of the hedge funds in Australia are still denominated in Australian dollars; only a few have offshore money.

Performance Comparison

The MSCI AC Pacific Equity Index outperformed the Eurekahedge Asian Long/Short Equity Hedge Fund Index during the bull market of 2003 and 2004, but hedge funds managed to remain in positive territory between 2001 and 2002 when the equity markets were falling. This is clear evidence of hedge fund managers putting forth their superior skills in exploiting market mispricing and inefficiencies to deliver alpha when it counts.

Since June 2000 the Asia-Pacific Equity markets have gone down by nearly 14% while the Eurekahedge Asian Hedge Fund Index has risen by 62%. The correlation of the returns for the Eurekahedge Long/Short Equity Asian Hedge Fund Index relative to the MSCI Asia Pacific Equity Index for 2000-2005 is as high as 0.85. This is not surprising since 65% of the Asian hedge funds assets are with equity long/short funds. However, it is interesting to note that although Asian hedge funds offer little diversification from the local equity indices during bull markets (which is good!), they are able to provide significant downside protection when the markets are falling.

The index returns chart (below) compares the performances of the various indices since 2000. The Asian equity markets witnessed a sharp drawdown in 2000 as they were still reeling from the effects of the Asian financial crisis. The MSCI Asian Equity Index lost 30% during the year. However Asian hedge fund managers held their nerve and did exceptionally well with a gain of 1.6%. And since 2001, Asian hedge fund managers have beaten their North American and European counterparts every year with sterling performance in 2003.

Figure 14: Index Returns Comparison

Source: Eurekahedge

Wrapping Up

The demand for hedge funds has remained healthy so far in 2005. Till June, Asia witnessed a launch of 54 new funds, almost identical over the same period in 2004, which saw around 50 new funds launched. Total assets under management of the new funds launched totalled more than US$2.3 billion. The new SEC registration ruling for hedge funds with at least 15 US-based investors so far has had no dampening effect on the demand for Asian hedge funds out of the US. Further, the entry of the Singapore government investment arm, Temasek Holdings, into the hedge fund market last November when it launched its US$300 million Fullerton Short Term Interest Rate Fund, is perhaps an indication of the increasingly mainstream flavour of the alternative investment route in Asia.

Footnote

¹ GDP data from www.adb.org

² Post 2000

³ Returns up to and including July 2005 NAVs