The Asian hedge fund industry is coming of age, with funds having had a stellar year in 2003; the Asian hedge fund index was up by 27% and assets under management rose about 75%. From inception in the late 1980s, growth was relatively pedestrian for most of the first decade. The late 1990s saw a marked change with a rapid acceleration of growth in the number of funds and assets, albeit from a low base.

Source: Eurekahedge database

From the start of 2002 to-date, the number of funds and assets has more than doubled from 162 funds managing US$14 billion to 360 funds managing US$33 billion. In 2003, there were 79 funds launched.

And the rapid growth rate is set to continue. On our current watch-list are 100 funds/managers who will likely launch their products in 2004. If we assume that 30 existing funds become obsolete during the year (just under 10% of the total funds as at end December 2003), we expect the number of funds to grow to 430 by December 2004. For 2004, we expect assets to grow to US$43 billion through a combination of asset flows and performance. Notwithstanding, we believe these estimates may be conservative.

Source: Eurekahedge database

Suggestions of a bubble are, in our view, premature with the industry in Asia in essence just playing catch up with the rest of the world. The number of funds and assets deployed remain relatively small in the global context.

We believe that there is much room for the industry to expand. Asia Pacific markets represent 14% of the world's market capitalisation. The number of hedge funds that do not have Asian-exclusive strategies is around 5,600, with approximately US$650 billion under management. Thus, Asia-strategy hedge funds comprise less than 6% of the global hedge funds universe by number and value.

We are of the opinion that, for a number of reasons, that the disconnect between Asia's relative market capitalisation and representation in hedge funds will close in the next five years. First, it appears that short-selling rules are liberalising in Asia outside of Japan while tightening in Europe and the U.S. Regulators in markets like South Korea and Taiwan, where it was illegal for foreigners to short sell individual stocks two years ago, appear to be loosening these regulations. As well, the number of local capital allocators has increased over the past year and will likely rise dramatically over the coming five years. With the decision last year to allow funds of funds to register in Hong Kong and Singapore, we believe that there could potentially be a strong retail demand for Asian fund of funds products based in the region. As most allocators to Asian hedge funds are currently in Europe or the U.S., local institutional funds of funds could provide a further boost in capital.

Strategy Breakdown for Asian Hedge Funds

The assets allocated to Asian hedge funds are still principally going to long/short equity funds; this has been the case since the start of the industry in Asia in the late 1980s. However, the number of equity long/short funds is expected to decline as a percentage of the universe if a greater number of proprietary traders begin to launch macro funds, CTAs and multi-strategy arbitrage funds. As the risk/return balance between a proprietary trading career and launching a boutique hedge fund begins to shift to the latter, the number of these types of funds is likely to increase substantially over the coming years.

Source: Eurekahedge database

At the end, allocation comes down to performance. For example, the outstanding returns by distressed debt funds over the past 24 months have increased the number and value of those funds by 100%.

Latest Trends in Asset Flows to Asian Funds

Asset growth was slow in the first half of 2003 given a combination of SARs, which prevented allocators from visiting the region, and subdued equity markets. September this year saw a surge in assets flowing to Asian hedge funds as a result of the new Asian bull market and pent-up demand.

We estimate that, currently, in excess of US$1 billion is being allocated monthly to Asian managers. Fund flows are being derived principally from Europe with North America being much less significant. We expect to see this situation change in 2004 with American allocators increasing in importance.

The money is flowing principally to long/short equity funds, with inflows favouring a limited number of funds; 90% of the money is going to less than 10% of the fund population.

Source: Eurekahedge database

The Asian Hedge Fund Dilemma

Despite the surge in liquidity we have seen in the last four months of 2003, the biggest complaint among the majority of managers is still the lack of available capital. Over 40% of the funds in our universe have under US$25 million, the break-even point for most management companies. Those that are based in Asia outside of Japan will have a low cost base, but usually cannot survive for more than two years with less than US$25 million in total assets.

Source: Eurekahedge database

The frustration for most of the small boutique managers is that the inflows to Asian hedge funds are favouring a limited number of funds; 90% of the money is going to less than 30 funds, which are mainly from large institutions (JF Funds, Gartmore, GAM and Henderson) or hedge funds where the lead manager was previously employed at a large hedge fund (Soros, Tiger or Kingdon). On the latter, the manager can usually raise assets of a critical mass on day one.

The other problem is that to effectively raise money, the management team needs to be travelling constantly to see prospective investors; if there is only one manager for the firm, time away from trading is severely detrimental to the fund's performance. Ideally, a hedge fund boutique needs a secondary "manager" who will double as marketer or a highly-regarded, full-time marketer who understands the fund's trading strategy. Investors want to speak with someone who understands the fund's investment philosophy and how trades are placed, not a marketer whose expertise is outside of finance.

Lastly, being closer to the investor still counts: 90% of money dedicated to Asian hedge fund strategies is coming from North America and Europe. Our findings show that managers based in New York and London raise money faster and have more assets than their brethren in Hong Kong or Singapore. The exception is the relatively few managers based in Tokyo (26% of all Japan-only funds) who have on average raised US$215 million mainly because of good performance (the ABN Amro Eurekahedge Japan index is +45% since the end of 1999) and their strong connections within the investor universe from previous positions at Soros or Tiger.

* Include Argentina, Brazil, China, France, India, Luxembourg, Mauritius, New Zealand
Source: Eurekahedge database

Source: Eurekahedge database

Start-up Trends 2003

Success stories such as Ward Ferry in Hong Kong, Speedwell in Tokyo and EN Benton in London are, we believe, spurring increased start-up activity. As stated previously, the change of the risk/reward ratio between an investment banking career and running a boutique hedge fund has shifted towards the latter; this should add to the number of managers coming from proprietary desks and mutual funds to start their own hedge funds.

Institutional firms like Martin Currie and JF Funds, who successfully launched their first general Asian hedge fund product in 2002, are now beginning to launch their second and third hedge funds, this time country-specific. We are also seeing an increase in single-country hedge funds for South Korea, India and Greater China from new boutique firms. With the bull market in commodity prices, a number of CTAs based in Asia have emerged in the last two years. It appears more and more that commodities is an excellent way to play the China growth story.

On the surface, it appears that significant capacity is available for the investor; however, our analysis suggests an increasing lack of quality capacity. The managers with previous hedge fund experience, who launch their own fund, will raise around US$200 million at launch and immediately reject new investors. Managers who do not have the requisite hedge fund experience but show good performance over 12 months will receive capacity recommendations from initial investors that force an early soft closure. This has put greater pressure on allocators to make investment decisions earlier than they would previously had to have made them. We believe that the combination of the best relative returns from Asian hedge funds, a larger universe and the occurrence of pre-eminent funds closing earlier than before will force hedge fund allocators around the world to devote more resources to the Asian hedge fund universe.

There are currently 35 funds-a little under 10% of the universe-closed to investors. Of these our analysis suggest that 50% are still taking in cash from either existing or new "special case" investors month to month.