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Eurekahedge Global Alternatives
Caution: sharp hedges

Byline : John Berthelsen
Date : 25-09-04
Source : The Standard - internal reference only.

With Hong Kong's smog-saturated summer drawing to a close, the financial world's migratory birds are starting to fly in for their annual visits.

For glitz, it will probably be hard to beat CLSA's 11th annual Investors' Forum two weeks ago, which featured a concert by Elton John, or this week's Forbes CEO forum, which featured Stephen Roach, Morgan Stanley's notoriously pessimistic chief economist.

But, sandwiched among them was the 7th annual Hedge Funds World Asia Conference, whose delegate count zoomed to 535 this year compared with 400 in 2003.

That is emblematic of the sudden steep rise in activity in Asia-based hedge funds, which at the start of the year covered US$34.5 billion (HK$269.1 billion) in assets. That figure is expected to jump 59 per cent to US$55 billion by the end of this year.

Market capitalisation of the funds, which use a variety of strategies in an attempt to offset market risk, has risen 40 per cent to US$49 billion in the year to date, both through asset flows and performance.

That is about 7 per cent of hedge fund assets across the globe, with around US$800 billion now under management.

Some 97 new Asian funds were launched in 2003 and another 21 so far in 2004, according to Eurekahedge, the Singapore-based hedge fund consulting group, bringing the total number of Asian funds to 415.

That US$55 billion in market cap is admittedly tiny when compared with the total market cap for equities in Asia, which is about US$1 trillion. But ever since the market crash of 2000, the conventional mutual fund industry has been under attack for its minuscule yields.

Where in the past US stocks, for instance, had an average real return of 7 per cent annually, today that has fallen to 4.3 per cent by income, or just 1.1 per cent real growth after inflation, according to Research Affiliates.

In addition, given the cumulative loss to the mutual fund industry's reputation prior to the crash, many analysts are concerned that the industry's business model is under threat. Certainly, these flat returns have driven investors to new places to put their money _ of which there are few. Bank saving rates are so low that fees eat up whatever is earned. Bonds are not priced to offer real returns above about 3 per cent.

Money market funds are equally flat. Currency trading is hazardous _ ask the hedge fund managers who bet against the US dollar versus the euro earlier this year.

Thus, after relatively lacklustre growth from their inception in Asia in 1989, the Asian Financial Crisis of 1997-1998 caused growing increases in the number of funds coming to the market _ from fewer than 10 a year in 1996 to nearly 100 last year.

They have have been increasingly attractive to investors, and they are finding new ways to lure the retail investor. These funds until very recently have been the investment vehicles of the very rich. Typical is the FTSEhx PC fund, a Cayman Islands fund launched on May 31, which requires a US$500,000 initial investment with a minimum of US$100,000 in any class. It requires another US$100,000 for any additional investment. But as hedge funds have started to go after retail investors, instruments like the London-based Man Hedge Diversified Ltd ``fund of funds'' have come into being.

Funds of funds are an increasingly popular investment vehicle that invest only in other open-end funds and are aimed at investors who have a relatively paltry US$20,000 to spend and are willing to lock it up for five years.

The fund is targeting growth of 15 to 17 per cent a year. This new access to hedge fund vehicles is fuelling an increasing rush by small investors. But beware. That 15 to 17 per cent performancethat Man Diversified is targeting is actually fairly far from actual performance by hedge funds across the board, which is probably closer to 3 to 5 per cent.

Many of the funds are under water. According to Eurekahedge, ``50 per cent of hedge funds are currently non-economically viable business entities''. Five per cent of funds were at least 20 per cent below their high water mark at the end of 2003. Of Asia's 415-odd funds, fully 40 per cent are estimated to have assets less than US$25 million. As Eurekahedge pointed out in its latest study of the Asian hedge fund industry, ``those that are based in Asia outside Japan will have a low cost base, but usually they cannot survive for more than two years with less than US$25 million in total assets''.

Some 85 per cent of the money going into Asia hedge funds goes to fewer than 40 funds, the most successful of which are Lloyd George, Boyer Allen and Sloan Robinson, large institutions like JF Funds, Gartmore, GAM, Man or Henderson, or hedge funds where the lead manager came from such funds as Soros or Tiger.

More typically, the hedge fund operator is likely to be a former investment banking analyst or salesman who racked up hefty bonusesthrough the unspeakably rich _ and aberrational _ 1990s for investment banks and found himself either unemployed or downsized into a less-rewarding job after the 2000-2001 market collapse. He or she took the hefty cash reserve built up during the fat years.

Armed with intimate knowledge of a particular sector and a particular geographical area, the new hedge fund operator set up the Joe Plotz Long/Short Equity Hedge Fund and started looking for 25 investors with US$1 million each to invest.

Long/short funds are probably the least complicated of hedge strategies. They are the most ubiquitous, comprising 64 per cent of Asian hedge funds by assets, according to Eurekahedge. They take their name from the way managers make investments, seeking to keep their portfolios buffered against market volatility. Against their typical ``long'' positions _ buying some equities in conventional trades _ they take short positions as well, selling securities they do not own yet, gambling that they will be able to buy the stock at a lower price than the one at which they sold short.

The trouble, according to Man Investments regional manager Matthew Dillon, is that "just because someone is good at being long, it doesn't mean they have the skillset to go short''.

Going long has limited downside because a share price cannot go below zero. But if the shorted share's price skyrockets before the day the buyer has to clear his position, the capacity for disaster is virtually unlimited.

The hedge fund manager with limited resources who starts to go into the hole will begin to discover it takes a lot longer to get out than to get in.

"They might know that's not going to happen for two years,'' Dillon says. "Is it economically viable to stay in business? It might be wiser to close down and start up again. For these small players, you really have to view them as a business risk.''

It pays to remember that that hedge fund manager is the same guy who persistently got it wrong as an equities research analyst or salesman. "You might make 40 per cent in one year, but if you can't survive in a drawdown, you're out of business,'' Dillon said.

"To effectively raise money, the management team needs to be travelling constantly to see prospective investors,'' according to Eurekahedge's analysis of the industry. "If there is only one manager, time away from trading is severely detrimental to the fund's performance.'' Accordingly, a boutique fund needs at least one secondary manager to double as a marketer or someone who understands the fund's investment philosophy. Another well-publicised problem for Hong Kong is that of Asia's 415 hedge funds, only 13 are registered with the Securities and Futures Commission.

"It is an industry that is less well-regulated because it is targeted at those deemed able to look out for themselves,'' one private investor said. "But it is increasingly being entered by retail investors who are used to being able to place much more reliance on the regulators.'' In addition, he and other investors say, is that some hedge funds have very wide briefs and can do anything they want as to asset classes.

Thus a bewildering stew of funds is coming to the market. These other funds are into such esoteric fields as convertible arbitrage, which involves buying convertible securities and shorting the corresponding stock. The conversion is intended to offset the short position, and reaping profit if the convertible is priced incorrectly relative to the stock itself.

Buying distressed debt, using multiple strategies, going for "event-driven'' strategies, commodity futures, options and foreign exchange are other strategies. As the funds grow more esoteric, they can involve increasingly high degrees of leverage that can either result in substantial gains or even more spectacular losses.

You have the possibility for a spectacular collapse if something goes wrong,'' says another private investor. Nor, against all odds, are small operators alone. The investing world seems to have learned few lessons from the near collapse in the late 1990s of Long Term Credit Management, at the time the world's biggest hedge fund, which lost massively by leveraging bets on exotic derivatives trades. Federal Reserve Chairman Alan Greenspan and then-Secretary of the Treasury Robert Rubin were forced to organise an unprecedented bail-out by 16 banks to the tune of US$3.2 billion against the threat of the destruction of the world's entire financial system.

Likewise, Tiger Management, one of the world's largest funds, with more than US$20 billion in management, lost as much as US$2 billion in a single day in the late 1990s by borrowing yen and investing proceeds in dollars. When the yen strengthened against all predictions, Tigerlost heavily and investors began pulling out. In nine months in 1999, Tiger lost 23 per cent of its capital.

Retail investors are also at risk _ or possibly in for bigger returns in the form of institutional investors such as pension funds, universities, banks and others. They have been increasingly returning to the hedge fund market.

A study by Greenwich Associates, a US consulting firm, found that 23 per cent of US pension funds are now investing in hedge funds, compared with just 12 per cent in 2000. The proportion of Japanese institutions investing in hedge funds is even higher, doubling to 39 per cent in just the last year.

So is there a bubble coming?

Eurekahedge calls the suggestion ``premature'', saying that the industry in Asia is catching up with the rest of the world. Institutional firms such as JF Funds are now beginning to launch their third- and fourth-generation funds.

Man's Dillon says his fund of funds, due to close in October, is raising US$1 million a day. He fully expects to meet his US$20 million target well in advance of the closing date.

But it pays to read the fine print. For instance, one commodity, futures, options and forex fund contains this chilling language:

"The risk of trading is substantial. The high degree of leverage associated with commodity futures, options and forex can work against you. This high degree of leverage can result in substantial losses as well as gains. You should carefully consider whether commodity futures, options and forex is suitable for you in light of your financial condition. If you are unsure, you should seek professional advice. Past performance does not guarantee future success.'' Indeed.

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