In the third quarter of 2002, it is expected that Hong Kong
retail investors will be permitted to buy hedge funds. Recognising
increasing retail interest in alternative investment, Hong
Kong's Securities and Futures Commission (SFC) has released
guidelines for authorisation of retail hedge funds. This marks
a recognition by the Hong Kong authorities of growing worldwide
interest in the sector.
The development of the hedge fund sector can be traced back
to 1949. In the 1980s and 1990s it boomed. The sector experienced
difficulties in the wake of the collapse of LTCM in September
1998, but it recovered, driven partly by the desire of US
investors to find alternatives to the US stock market. And
as markets worldwide performed poorly in 2001, investors saw
the value of an absolute return mandate. Traditional fund
houses developed their own hedge fund arms. There are now
an estimated 4,000 hedge funds with US$500 billion of capital
If hedge funds are good for investors, what about their effect
on markets? This article looks at the contribution hedge funds
make to securities markets, and the contribution hedge fund
managers make to a financial centre like Hong Kong.
The Nature of Hedge Funds
First, what are hedge funds, and how do they operate?
Hedge funds have been defined as loosely-regulated private
pooled investment vehicles that can invest in both cash and
derivatives markets on a leveraged basis for the benefits
of their investors2 . The term "hedge fund" is a
loose one that is used to cover a range of funds with very
diverse characteristics. However, hedge funds differ from
traditional mutual funds on a number of key criteria.
Traditional investment funds tend to be long-only ie holding
long rather than short positions, to be restricted in the
strategies that they may undertake, ie the use of futures
and options or leverage or short selling is limited or not
permitted at all, and to aim at relative returns, ie returns
relative to some benchmark index. The greater part of the
traditional fund's return will therefore derive from the market
itself, while the fund manager's skill (or lack of it) may
add (or subtract) a few percentage points. In contrast, hedge
funds aim at an absolute return, ie a return of say 15 per
cent per year every year, regardless of the market movement.
To achieve this return the hedge fund may adopt a much broader
range of strategies, including going short or taking out futures
and options positions. The return earned by the hedge fund
therefore tends to reflect the manager's skill rather than
the movement of the underlying markets.
Another point of difference between traditional funds and
hedge funds is the incentive/remuneration mechanism. A typical
long-only fund may charge a management fee of 1% per annum.
There may also be a charge for entry or exit from the fund.
However, a hedge fund, in addition to a 1% management fee,
will typically charge performance fee of, say, 20% of the
gains achieved. Many funds charge in accordance with a "high
water mark" mechanism whereby in case of losses the fund
first has to make good the losses before the performance fee
can be charged again. There is evidence that funds with the
high water mark mechanism perform better than other hedge
funds3 . While traditional funds tend to require their managers
to be independent of the fund's operations, the hedge fund
manager makes a virtue of his involvement. By investing his
own capital in the fund he demonstrates commitment and helps
ensure alignment of his objectives with those of his investors.
It may be said that while a traditional fund has high market
risk but low manager risk, a hedge fund has low market but
high manager risk. Thus it makes sense for the investor to
diversify his holdings of hedge funds.
A more detailed comparison between traditional mutual funds
and hedge funds is set out below.
Hedge funds adopt widely varying investment strategies, and
tend to be characterised according to the strategies they
adopt, for example, as fundamental long-short funds, quantitative
long-short funds, arbitrage/relative value funds, and macro
funds4 . A fund of funds invests in a portfolio of underlying
hedge funds, thereby providing the benefit of diversification
Impact on Securities Markets
What will be the effect on securities markets of hedge funds
operating in the above manner?
In principle, the following effects could be expected.
- Liquidity. Hedge funds are active traders. While
a traditional mutual fund might turn over its portfolio
50% in a year, a hedge fund with its active strategies and,
possibly, leverage, might turn over five or seven times.
Some hedge funds focus on sectors such as small caps, distressed
securities, and emerging markets that would otherwise be
- Price formation. Traditional long-only funds can
buy securities and can sell securities that they have already
bought, but are usually restricted in selling securities
they do not already own, ie short selling. This means that
their influence on prices tends to be one way, ie pushing
prices upwards. In good times this can lead to liquidity-driven
rallies and inflated prices. In bad times, liquidity can
dry up and prices fall dramatically. Long-only investment
may thus lead to an overshooting of prices. Hedge funds,
especially long-short funds which always have short positions,
can help bring prices back into equilibrium.
- Market quality. Relating to the above, hedge funds
have a broader role in contributing to market quality. They
tend to be market-neutral or even contrarian, and so bring
liquidity even in down markets. Unlike mutual funds, hedge
funds require their investors to give significant notice
of their intention to withdraw money - as much as three
months or a year in some cases - and so can afford to invest
patiently. They actively search out arbitrage opportunities,
whether between cash and derivatives markets, or between
related instruments in the same market, and by capturing
these opportunities they help eliminate market inefficiencies.
If the above are the benefits of hedge fund participation
in a market, what are the disbenefits?
Regulators and policy makers have concerned themselves with
the potential for hedge funds, especially large global macro
funds, to disrupt financial markets and destabilize monetary
systems. Since most hedge funds are private investment vehicles,
often domiciled in tax haven jurisdictions, they are not obliged
to report their positions and activities publicly. Regulators
face the nightmare of large HLIs prowling unseen round the
periphery of global markets, waiting to pounce. Malaysian
Prime Minister Mahathir denounced such funds as the "highwaymen
of the global economy"5 . In April 1999, global regulators
formed a Financial Stability Forum to monitor systemic difficulties
in financial markets.
Evidence that hedge funds have played a destabilizing role
is not easy to find. The IMF and other institutions have examined
a number of financial crises during the 1990s for evidence
of hedge fund involvement. These incidents included the 1992
ERM crisis6, the 1994 bond market turbulence, the 1994/95
Mexican crisis and the 1997/98 Asian financial crisis. However,
the IMF found evidence of hedge fund involvement only in the
1992 ERM crisis - and even this finding appears to rest partly
on the oral claims of one hedge fund manager which may not
be wholly reliable. In the other crises, the available evidence
points to other players, often the local corporates and institutions,
as playing the major role7 . Academic research tends to support
the IMF's findings8 .
Absence of evidence is of course not positive proof of innocence.
However, to some extent the world has now moved on. Concerns
about systemic stability have lessened9 , and regulators are
paying more attention to the basic rationality of the hedge
fund value proposition, and to the rising tide of investor
demand for hedge funds.
Is it beneficial for an economy to be a base for hedge fund
Hedge funds originated in the US, and today the majority
of hedge fund managers are located there, although London
is a growing and major centre. Relatively fewer hedge fund
managers are located in Asia. Although many hedge funds operate
in the Japanese markets, most of the managers of these funds
are based in London or the US. The reason is that managers
want to be close to the investors from whom they raise their
money. They can deal with the markets remotely.
Nonetheless, it is beneficial for a financial centre such
as Hong Kong to be a base for hedge fund management.
- Talent. Hedge fund management, because of its high
remuneration and independence compared with traditional
fund houses, tends to attract the best and brightest of
the profession. The transfer of knowledge from these practitioners
promotes the general development of the financial market
in which they are based.
- Revenues. Because of the high fees they earn, and
their active trading, hedge funds generate fee income for
their suppliers. It may be said that hedge fund managers
are "at the top of the food chain" in the fund
management industry. Their activities boost GDP and ultimately
- Employment. Although hedge funds tend to be small
boutique operations, they stimulate quality employment in
firms from which they purchase services, such as prime brokers,
custodians and accountants and lawyers.
- Capital. Locally-based hedge fund managers are well-positioned
to explore opportunities in the local economy, such as distressed
and illiquid securities, thus providing capital to local
firms that need it.
How is Hong Kong positioned as a market for hedge funds to
operate in, and as a base for hedge fund managers?
In terms of hedge fund operation, Hong Kong is perhaps moderately
well-positioned and currently improving. Hong Kong is basically
quite an attractive market for hedge fund investment. It is
relatively large and liquid; it is completely open to foreign
investment, with no limits such as obtain in Korea and Taiwan;
and it is accessible, being well-served by international brokers.
And, according to practitioners, its markets provide plenty
of profit opportunities.
In September 1998 following the Financial Crisis, the Hong
Kong authorities introduced Thirty Measures clamping down
on perceived excesses in the securities and futures markets.
Ten of these measures related to short selling; others imposed
tighter settlement procedures, more reporting of derivatives
positions and higher margin requirements. The effect of these
measures was to restrict or deter the typical activities of
hedge funds. Currently a review of the Thirty Measures is
under way, and it is hoped that relaxations will be introduced.
This could lead to more hedge fund activity in the Hong Kong
As a base for hedge fund management, Hong Kong is basically
attractive, but needs to do more to cement its position. Hong
Kong is a well-established financial centre, with all the
supporting services, communications and information flow necessary
to support hedge fund managers as well as traditional fund
managers. In the wake of the Asian Financial Crisis, official
statements were perhaps not welcoming to hedge funds, but
the tone has since moderated.
A major problem currently affecting hedge fund managers based
in Hong Kong is taxation. Given Hong Kong's source basis for
profits tax, the position of cross-border operations such
as fund management will always be ambiguous until clarified
by the authorities. Such
clarification was provided in respect of funds authorized
by the SFC when these were exempted from profits tax. However,
unauthorized funds, ie most hedge funds, remained in limbo.
The Hong Kong Inland Revenue Department (IRD) formerly adopted
a passive attitude to such operations. However, recently the
IRD began issuing tax enquiry letters and demand notes to
hedge fund managers. Since such tax assessments can cover
back years, and include gains enjoyed by investors who have
long since left the fund, they can cause grave problems for
the fund manager.
Singapore has recognized the opportunity presented by these
difficult circumstances, and has been soliciting Hong Kong-based
fund managers to relocate to the island state. Singapore offers
a fixed rate of 10% tax on offshore profits, and adds other
incentives such as subsidies for staff training, and the prospect
of managing a tranche of government money. Moreover, the Singapore
authorities are supportive and actively trying to promote
The SFC's willingness to authorize the sale of hedge funds
to retail investors signals a recognition on the part of the
Hong Kong authorities of the value of hedge funds to investors.
This article has suggested that hedge funds also make a valuable
contribution to markets, and to a financial centre like Hong
Kong. However, if Hong Kong wishes to draw more benefits from
this leading edge development, it needs to further liberalise
its regulatory framework, and, especially, clarify the taxation
of fund management operations.