Research

Introduction

The 2006 edition of the Eurekahedge Asian Hedge Fund Directory¹ contains information on close to 950 hedge funds, investing and/or located in Asia, an investment space that stands at just over US$128 billion as of the end of July 2006. Although the pace of growth of the industry has lessened (we expect the industry to grow 25% by number and 40% by assets, in 2006) compared with the past two years (for instance, the number of hedge funds in Asia grew by 35% in 2004 and 30% in 2005), in absolute terms, the growth is still substantial, with more than US$30 billion in net assets estimated to flow into Asian hedge funds in 2006. On the performance front too, Asia continues to be appealing to hedge funds with the Eurekahedge Asian Hedge Fund Index rising 16% during 2005 and 4% for the first seven months of 2006 (despite severe market corrections during the last three of those seven). The figure below offers a more comprehensive snapshot of industry growth over the past decade.

Figure 1: Growth of the Asian Hedge Fund Universe over the Years

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Source: Eurekahedge

In this review, we seek to examine the current structure and some of the key trends shaping the industry, and analyse the performance of the Asian hedge fund universe over the past few years. The latter includes a taxonomy of performance by time period, strategy employed and fees charged, and a comparative analysis of performance vis-à-vis other modes of alternative investment. The data used in the analyses are based on the size, structure and related details of a sample of 952 funds, and the performance and asset growth details of 638 funds.

Broad Industry Trends

Deepening Market Segments

The brisk pace of growth and sustained investor interest in Asia has meant a broadening of the scope of investment activities in the region. One development in this regard is the growth of single-country focused hedge funds, as opposed to those that have a generic allocation to Asia. This also suggests investor confidence in the region’s long-term prospects insofar as fund managers perceive country risk as less of a threat in their pursuit of absolute returns. This trend is apparent from the figure in the following page, which compares the annual rates of growth in the number of funds against their respective geographic mandates in Asia. As is evident from the figure, India, Taiwan, and to a lesser extent, China, have accounted for the bulk of new funds launched in the region over the past three years.

Figure 2: Growth in Number of Funds since 2003 by Geographic Mandate in Asia

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Source: Eurekahedge

In Japan, start-up activity picked up in the first quarter of 2006 but is losing steam as the year progresses. Despite the Japanese markets entering an expansionary cycle in late-2005 on the back of a pro-active government, hedge funds struggled in an environment of weaker-than-expected earnings newsflow and a lack of clear guidance from macroeconomic data. Japan saw close to 50 new fund launches in 2005, taking the total number of funds operating there to over 200, but with only about 10 new launches in 2006 to date. This is reflected in the market shares by head office location, discussed elsewhere in this article. The current breakdown of assets by investment region is shown in Figure 3.

Figure 3: Current Share of Asian Hedge Fund Assets by Geographic Mandate

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* Others include Korea and Taiwan.
Source: Eurekahedge

Also of interest is the increasing regional presence of global multi-fund managers in place of the erstwhile smaller-cap, single-fund players. This is apparent from the disparate growth trends in the numbers of managers allocating to Asia and in the number of funds they manage, as depicted by Figure 4.

Figure 4: Annual Growth Comparison – Number of Funds vs Number of Managers

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Source: Eurekahedge

The United Kingdom is still the most preferred location for managers allocating to Asia, with 25% of the Asia-focused funds managed from there (Figure 5). After all, investors in the United Kingdom are an important source of capital for Asian hedge funds, which comprise about 25% of the assets parked therein. UK expatriates returning to London to launch funds after spending time in Asia, also contribute to this number.

Figure 5: Current Share of Number of Asian Hedge Funds by Head Office Location

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Source: Eurekahedge

However, there has been a reshuffle in the growing pie of Asian hedge funds since our last review. While managers located in the United States and the United Kingdom together accounted for close to 55% of the Asian funds previously, their combined share has now shrunk to under 45%. Singapore and Japan were the main beneficiaries of this shuffle, with the two countries catching up with the other two key regional hedge fund centres (Hong Kong and Australia) and boosting their market share slightly, from about 10% to over 15%. Figure 6 estimates the size of the assets managed from these four key locations in Asia viz. Australia, Japan, Hong Kong and Singapore, over the past five years.

Figure 6: Asset Growth (in US$m) by Country of Head Office Location in Asia

Year	Australia	Japan	Hong Kong	Singapore
2001	2,076	1,849	1,525	374
2002	2,567	2,102	2,889	443
2003	8,069	3,641	5,756	1,278
2004	13,420	6,314	9,553	2,516
2005	19,221	10,709	12,082	5,148
2006 (Current)	25,236	12,859	15,952	6,765

Source: Eurekahedge

Strategies

The dominant strategy among hedge funds allocating to Asia is still long/short equities, which accounts for close to 59% of funds and 60% of assets under management (AUM). Figure 7 shows the breakdown of Asian assets by strategy employed.

Figure 7: Current Share of Asian Hedge Fund Assets by Strategy Employed

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Source: Eurekahedge

However, as discussed earlier, the Asian investment environment is steadily broadening in scope. For instance, funds that saw the most asset growth in 2005 were those employing the relative value strategy (60% increase in assets). A detailed analysis of Asian hedge fund performance by strategy is included later in this article.

Key Performance Trends

This section aims to answer some key questions on the performance of Asian hedge funds² vis-à-vis how they fare against other alternative investment vehicles such as funds of funds or long-only absolute return funds. How do their returns match up against performance fees? Which are the better performing strategies the region and why? This is achieved in the first instance through a comparative analysis of fund percentile returns over the past five years, segmented into three time periods of five years (August 2001 to July 2006), three years (August 2003 to July 2006) and one year (August 2005 to July 2006). For each of these time periods, we also review other risk and return percentile statistics such as annualised volatility, maximum drawdown and percentage rise in NAV since inception.

Asian vs other hedge fund and alternative investment strategies

In order to see how Asian hedge fund returns match up to their peers in other investment regions as well as other investment modes, we compared them against regional returns in another emerging market (Latin America)–, and a developed market (North America). We also compared these returns against gains made during each of the periods in equities, absolute return funds and multi-manager funds of funds.

To start with, Figure 8 compares the correlation characteristics of these aforementioned types of funds, reaffirming some long-held observations about the hedge fund space: (1) that hedge funds exhibit a low correlation with traditional asset classes (in this instance, equities), thereby offering investors a very useful vehicle for asset diversification strategies; and (2) Asian hedge funds have traditionally shown a long bias in their hedging strategies and exhibit a higher correlation with equity indices. Also interesting to note is the relatively lower correlation between long-only absolute return funds and North American hedge funds, hinting at the fact that the focus of the former is usually rising and emerging equity markets.

Figure 8: Correlation between Index Price Movements
from Dec 1999 to Dec 2005

We then compared the last 12 months’ fund returns (by quartile and mean) of each of these fund types against the returns of the benchmark MSCI Asia-Pacific Equity Index, as shown in Figure 9. In Asia, for instance, we took all the returns of all the funds³ for the past 12 months (August 2005 to July2006) and ranked them in descending order. The bottom 25% (or the first quartile for Asia in the figure) returned less than 5% for the year. The median value was 10% (that is to say, half the funds in our sample returned less than 10% for 2005). The average (mean) return for our sample set, on the other hand, is higher at 15%. This is usually the case with hedge fund distributions, as can be observed from the mean-median differential of other hedge fund vehicles, which display positive skewness or ‘fat tails’ (ie. more funds in the upper segments of the return spectrum). Finally, the top 25% of the Asian funds (or the third quartile in the graph) returned in excess of 20%. 

Figure 9: Comparison of Mean and Quartile Returns among Various Investment Vehicles⁴

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Source: Eurekahedge

While Asian hedge funds have a slightly higher range of returns than Latin American funds, their mean and top quartile returns for the past 12 months have been slightly lower. This has to do with the sharp reversals in price movements in the past few months. North American hedge funds and global funds of funds, both exhibit significantly lower mean as well as median returns in comparison. The MSCI Asia Pacific Equity Index has prima facie grown more than the average Asian hedge fund over the year, but the former also has a higher volatility (15.4% annualised) to show for it. So, in effect, in the past 12 months, one could afford to have their money in a randomly selected Latin American hedge fund even without employing any due diligence process, and still stand a better chance at annual returns upwards of 10%, than investors looking at North American funds, who would have to be more discreet in their investment choices to reap similar returns.

Looking at the quartile distribution of long-only fund returns, one sees that their returns fall in a higher range bracket than returns in Asian or Latin American funds. Their mean returns are also significantly higher. However, the range between the first and third quartiles also suggests a greater volatility in returns for long-only funds, as the following comparison of quartile Sharpe ratios by fund-type confirms. Figure 10 shows that long-only funds have relatively lower quartile Sharpe ratios than their Asian or Latin American hedge fund peers, implying more stable risk-adjusted returns for the latter. Return and risk statistics have been similar among the three time periods studied.

Figure 10: Comparison of Quartile Sharpe Ratios of Hedge Funds,
Funds of Funds & Long-only Funds

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Source: Eurekahedge

Strategy Employed

Moving on to a comparison of performance by strategy employed, opportunistic funds such as distressed debt and event-driven players were clearly the best performers for the year, having the highest Sharpe ratios (close to 3.2 each) among all strategies and the least average maximum drawdown (-0.6% and -1.6% respectively). These funds clearly benefited from the heightened M&A activity during the year with several multi-billion dollar deals announced and/or closed, as also new issuance in the high yield markets. On the diametrically opposite end of the scale were macro funds, with one of the lowest Sharpe ratios among the strategies (0.9) and the highest maximum drawdown (-6.4%) among the strategies, hit by sluggish markets in the initial few months and intra-year market corrections. Figure 11 compares the Sharpe ratios of the various strategies employed by Asian hedge funds during the year.

Figure 11: Strategy-wise Comparison of Key Asian Hedge Fund Risk Statistics

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Source: Eurekahedge

Other key performers were long/short funds, and fixed income and arbitrage/ convertible arbitrage players, who benefited from rising equity markets and stable credit markets respectively.

Event-driven funds have in fact had a good run over the past few years. They were the best performers in a comparison of the risk-versus-return characteristics of the performance of Asian hedge fund strategies over the past five years. Convertible arbitrage funds, on the other hand, operate in a cyclical market, which was, in the main, sluggish over the past couple of years. This explains the low risk/low return nature of these funds in the past.

Figure 12: Risk vs Return Comparison of Asian Hedge Fund Strategies

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Source: Eurekahedge

Performance Fees

Nearly 90% of the hedge funds in the Eurekahedge Asian Hedge Fund Database charge a performance/incentive fee of 20%. A comparison of hedge fund performance over the past five years by fees charged, divided into three buckets (< 20%, 20% and > 20%), tossed up the following statistics:

Figure 13: Comparison of Asian Hedge Fund Performance by Fees Charged

Source: Eurekahedge

Interestingly enough, funds charging a performance fee of under 20% have generated better annual returns on average over the past five years (August 2001 to July 2006). These funds have also seen higher average growth in assets (percentage rise in NAV), and their respective Sharpe ratios are not appreciably different.

Funds charging a fee greater than 20%, on the other hand, have been able to justify the fee with superior returns (22.8% annualised, over the past five years), with only a slightly higher volatility than their counterparts in comparison.

A further comparison of these statistics by quartile between funds charging 20% and those charging under 20% (Figure 14) betrays greater volatility among the latter group. This is evident from the inter-quartile ranges (difference between the first and third quartiles) for the two groups. The volatility of the under-charging group is also much higher, at 10% volatility at the first quartile alone.

Figure 14: Comparison of Hedge Fund Performance Quartiles by Fees Charged

Source: Eurekahedge

While there has been a marginal increase in the number of funds charging 15% performance fees, it is negligible in comparison with overall industry growth. Moreover, the continued demand for hedge funds in Asia as well as the performance of these funds in the recent past are sustaining the higher performance fees.

Conclusion

The demand for Asian hedge funds has not only remained healthy and upbeat in 2005, but is also increasingly chasing single-country focused and other esoteric strategies. Launch activity has also been picking up with new launches in 2005 adding US$4.4 billion and those in 2006 to date adding another US$1.5 billion, to hedge fund assets parked in Asia. In fact, recent months have seen big players in the United States and the United Kingdom setting up shop in Asia, and we expect steady industry growth in Asia in the short to medium term.

On the performance front, managers in Asia have reaped stable and healthy returns over the past few years. Equity-based strategies such as long/short and merger arbitrage funds have benefited the most from bullish trends in 2005 and the first half of 2006. Barring short-term corrections intra-year (such as the ones seen in October 2005 and the spate of volatility in the three months up to July 2006), these trends are expected to continue well into 2006 given the fundamental soundness of many of the regional economies. For instance, in China, new policies easing foreign investment in the A share market, spell a boost to liquidity in its economy. China-focused hedge funds have managed to return solid returns of 9.2% on average, despite choppy and liquidity-strapped markets from May to July 2006.

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