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Interview with Edward Mullen, Dynasty Asset Management Ltd
Eurekahedge

November 2004

Dynasty Asset Management Ltd was established by Steve Dai and Edward Mullen in 2000. The firm is one of the earliest alternative investment managers to set up operations in Shanghai. It manages two funds - the Dynasty Fund and the Dynasty China Opportunities Fund. The former has generated average annual returns of 38.5% since inception (February 2001) and -4.72% year-to-date, while the latter was launched this year and has generated returns of -2.72% since January.

  1. There are now around 25 Greater China focused hedge funds; that is up from five funds two years ago. Do you believe that the space is becoming too crowded and that returns for all funds will suffer?

    The number of hedge funds specialising in China-related securities has grown multi-fold over the past few years as you correctly point out, particularly after a strong 2003 for the markets, many new "experts" have emerged. This is true of China-dedicated funds, Asia long/short funds, as well as large macro funds and traders from other global strategies who see the opportunities in China, and are trying to capitalise on them. For Dynasty, we view this as a positive development for our markets and our firm. Liquidity in the markets has grown substantially, investor awareness for the region has also grown, and we believe that the more education that exists about the opportunities and pitfalls of the market, the better it is for everyone. Ultimately, more opportunities will be explored, rather than the space becoming too crowded.

  2. Has the ability to short borrow individual names in the Hong Kong H share and Taiwanese markets improved this year?

    Yes, and conditions continue to improve overall. In fact, total turnover increased 64% in the Hong Kong market in the past year. While shorting stocks is still more challenging in Asia than in other markets, like the US for example, continued increases in liquidity have made it easier.

  3. Do you envision that going forward (and, of course, depending on market conditions) hedge fund managers running Greater China funds will actively short individual names instead of using index futures as a hedge?

    Not as extensively as in the more developed markets. Shorting stocks takes great research and diligence, and many firms do not have the abilities or resources to effectively place shorts and monitor them. Due to these as well as because of liquidity constraints, using index futures is also an efficient method to hedge market risks. While there remain extraordinary opportunities on the long side, there are some companies doing business in China or trying to do business in China that will fail. There are also several names that exist now and will emerge in the coming years that will be overbought by overzealous China-philes, which will subsequently come tumbling down. As a long/short manager based in China and actively trading the markets for the past nearly four years, this plays to our strength. I expect that going forward both methods will still be very active for hedge funds.

  4. Do you think that property in China, specifically in Shanghai, will have a correction over the next 12 months? If this correction occurs, how will it play out in the equity markets?

    I do expect the property price in China to experience a correction over the next 12 months. The China property bubble is driven largely by foreign fund investment and speculation, rather than by the true demand of local residents. A few factors will likely bring pricing back into line:

    First - an interest rate hike. This has reinforced the market's expectation of easing measures, which increases speculation on property. However, I expect the Chinese government to maintain tightening measures, including an interest rate hike. A significant increase in interest rates will not only affect residential affordability, but also affect capital outflow, both being negative to the property sector.

    Second - demand cannot keep up with supply. The property supply is overwhelming the demand for property. The supply of new properties is rising at 20-30% per annum, while the Chinese household income is not increasing nearly as fast. The RMB deposit growth rate has been slowing down since the beginning of this year, which indicates that there will be less money for mortgage loans for property development. In this case, continuous property supply will lead to a drop in property prices.

    As for the impact on the equity markets, a fall in property prices could dampen stock investors' confidence in the markets, which has the potential to cap the upside of the equity markets.


  5. In September at the Communist Party of China's 16th Central Committee Meetings, Jiang Zemin resigned as chairman of the Central Military Commission and was replaced by Hu Jintao, President and General Secretary of China's Communist Party. President Hu now controls all three of China's most powerful offices. Many in the media see this as a "push-out" of Jiang Zemin and the old guard and a solidification of power for Hu Jintao and the "reformers." What are your views on the political events in September and how they will affect economic and political reforms?

    Since Steve and I started Dynasty, I have always told investors that the greatest risk to the long portion of our portfolios is significant political instability in China. That said, I then share with investors that over the years, the political situation in China has gotten far better and more stable than ever before. The "power transfer" in September, I believe, has improved the political landscape in China and strengthens the central government control, which can help the Chinese economy maintain stability. It is one of many very good signs about the future of China's markets and economy, particularly for foreign investment.

  6. There appears to be a massive amount of IPOs (estimated around US $20 billion) slated to be issued from Chinese companies next year; the three mega banks being the largest. Intuitively, this increase in supply and especially concerns over its quality should have a negative impact on the market. Are you concerned; and if not, what opportunities do you see for next year?

    In 2005, it is estimated that the dollar value of Chinese companies going through an IPO in the Hong Kong market will amount to US$20.3 billion. I am certainly concerned about the quality of some of these companies. This liquidity and financing opportunity for Chinese companies will be very important for them to maintain competitiveness in an increasingly competitive market. It will also, however, allow companies that do not merit existence to stick around with the help of the market momentum and frenzy for Chinese IPO shares. Comprehensive fundamental analysis using a top-down approach is one of the key means by which Dynasty tries to sort the high quality from the poor quality companies. We invest significant resources in research within mainland China to understand company fundamentals and consumer demands and desires. Some of the likely IPO companies are expected to be in up-stream industries in China, such as in the coal, port and power sectors, which we favour for both the short and long run.

  7. There has been much talk since April of China navigating between "soft" and "hard" landings; but we have rarely seen an explanation of what constitutes a "soft landing" in the context of China's economy. What is your definition of "soft landing," and has it been achieved?

    In my view, a "soft landing" should lead the Chinese economy to tone down its growth rate modestly, i.e., the growth rate of GDP will slow down, but stay above 7.5%. It is too early to say if China has achieved a hard landing or soft landing because some uncertainties still exist for the outlook of the Chinese economy. This depends on two factors. One is the property market in China. The uncontrollable nature of the property bubble increases the risk of a hard landing. Second is the pace at which the Chinese central bank (PBOC) and US Fed will raise interest rates. In this case, there are two scenarios: The worst-case scenario is the Fed goes on to raise interest rates, while China does not. This will result in massive cash outflows from China and make a hard landing more likely. The best-case scenario is the Chinese government raises interest rates following the Fed, which we believe will increase the chance of a soft landing.

  8. What is your 12-month view on Chinese interest rates and any possible re-evaluation of the Chinese Renminbi? Can the Chinese Central Bank raise interest rates while maintaining the currency peg? How would a rise in rates affect Chinese equities?

    I think China will need to raise interest rates given current US rates. The PBOC needs to squeeze out excessive and inefficient investment capacity via an interest rate hike. If this does not occur, it will not only result in more financial losses to the banking sector, but will likely also result in a mass exodus of capital outflow like we witnessed during 1998-2000.

    It is very possible that we will see a revaluation of the Chinese RMB. The Chinese government's failure to revalue would put further pressure on the cost of importing oil. Recently at least two Chinese officials have gone on public record stating that appreciation of the RMB will not negatively impact the Chinese economy or employment. I view this statement as a sign that RMB revaluation is likely, and believe that the actual result will be a widening of the foreign exchange floating range.

    A currency revaluation would likely boost market liquidity, especially for Hong Kong listed equities. Dynasty monitors this closely, and we are very ready to take advantage of this investment opportunity.


  9. You mentioned in your September monthly newsletter the managers increased the funds' exposure to the commodity, oil, power and sea transportation sectors. Has this re-allocation been successful and what are your sector views going forward?

    Yes, it has been successful. The portfolio return of Dynasty Fund was +2.17% and Dynasty China Opportunities Fund was +2.87%.

    Going forward, we favour oil & petrochemical, retail, insurance, toll road, power and port industries.


My personal comments

In my view, to understand the current Chinese economy one needs to understand what caused the investment boom. I think the two most important factors are exports and capital inflow. Chinese exports are driven by global consumption, especially consumption coming from European countries and the US. The capital inflow into China is caused by the low interest rates in the US. Therefore, the level of US consumption and level of the Fed interest rate will both be instrumental in determining the extent of the Chinese investment boom, and in turn, the Chinese economy.

Nowadays, the Chinese financial/banking sectors are not able to accurately price investment risks. In order to avoid an investment bubble, China needs to reform its financial system and make it more market-based. This is likely to happen as three of the major banks are floated and additional joint ventures with western financial institutions occur.

Looking on the bright side, the industrialisation and modernisation of China will continue for a long time. In the near future, the economy may suffer some pain. But the economic cycle is and will always be comprised of ups and downs. The best way to play China is to accumulate cash on the peaks and invest at the troughs. Dynasty has been profiting from this investment strategy for nearly four years, and we intend to do so for many, many years to come.

Contact Details
Edward Mullen
Dynasty Asset Management Ltd
+86 21 6340 4400
emullen@dynastyfund.com
www.dynastyfund.com


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