While the year in 2004 saw respectable gains for many managers, it was not the stellar year which we saw in 2003. The ABN Eurekahedge Asian Hedge Fund Index gained almost 9% through the year, falling short of the 27% gains in the previous year. In contrast, the MSCI AC Asia Pacific Free Index and the MSCI AC Asia Pac. Free Index ex Japan rose by 16% and 19% respectively over the year.
|Asian indices||2004 return||2003 return||Annualised return||Sharpe ratio||Annualised SD|
|Eurekahedge Asian Hedge Fund Index||8.79||26.57||11.02||1.89||5.84|
|Eurekahedge Japan Hedge Fund Index||9.02||18.67||9.42||1.50||6.29|
|Eurekahedge Asia ex Japan Hedge Fund Index||9.18||34.18||11.84||1.32||8.96|
Most managers in the hedge fund industry found 2004 to be a difficult year, especially in comparison to 2003's impressive gains, and cited decreased volatility and conservative net positioning due to a climate of uncertainty as the main causes. Traditionally, returns of hedge funds focusing on Asia tend to have greater market correlation than their counterparts based in European or American markets. This is due to the strong presence of long/short equity funds in Asia, most which tend to hold net long positions.
What also made the year difficult for hedge funds was that markets moved only modestly in the first half of the year. Notably, performances took a dive in May and June amidst concerns of a hard landing in China and interest rates rising faster than expected in the US. Markets turned around and began to move more dramatically when oil prices jumped and the dollar went into a range-breaking decline. Many funds, particularly directional macro strategies, made a good profit in November. However, December proved to be unexpectedly rough, as the dollar rallied and crude prices sagged, catching many managers off guard.
In terms of investment mandates, Taiwan-only funds reported a 9% return, and is one of three regional mandates (the other two being Australia/New Zealand and Korea) to record a positive gain over the preceding year. Nevertheless, it is worth noting that Taiwan does not attract many funds as a sole focus of investment. Taiwan-focused funds make up less than 1% of the total Asia Pacific-focused funds, reflecting in some part the traditional reluctance on the part of Taiwanese institutional investors to diversify into hedge funds, its reliance on a tech industry that is hard to call and an overall economic situation blighted by political uncertainty.
|Investment mandate||2004 return||2003 return||Annualised return||Sharpe ratio||Annualised SD|
|Asia incl Japan||9.49||29.28||15.03||1.30||12.24|
|Australia / New Zealand||16.13||15.94||17.03||1.74||7.61|
India continued to be a lucrative region for hedge fund managers, reporting the highest annualised returns since inception for the universe of India-only strategies at 59.25%. In spite of the higher level of volatility in these markets, in comparison to the rest of the universe, the Sharpe ratio for the region was the highest as well at 3.14, largely because of these exceptional returns. This was due in large part to the impressive rally which Indian stock markets had seen over the period.
The Greater China region saw a 1.88% return in 2004, in a steep decline from 2003's 36.39% gains, as investors remained wary of government measures to slow down the Chinese economy, as well as on corporate governance issues.
Strategy-wise, event-driven funds saw the highest annualised return since inception, recording a 20.71% return, closely followed by distressed debt strategies, which recorded a 19.6% annualised return. This was brought about by the increase in global corporate activity, which fed through to the region, and created more opportunities for these funds in terms of merger and acquisition activity, as well as debt restructurings.
|Strategy||2004 return||2003 return||Annualised return||Sharpe ratio||Annualised SD|
|Long / Short Equities||9.82||28.76||16.81||1.35||12.65|
Fixed income strategies saw a reasonable performance in 2004, with 9.74% returns though this was much lower than the 16.29% recorded in 2003. The Sharpe ratio for fixed income strategies is the highest among all strategies at 4.27, driven more by exceptionally low volatility than returns.
CTAs posted a bad year in 2004, averaging -1.37% returns over the period. Reasons for the poor performance across the CTA universe vary. Some funds had benefited from the strong Chinese demand for metals while others suffered, and a similar scenario was played out in the oil and rates markets, depending on the CTA model. In addition whipsawing markets in April/May/June hurt directional, long-term traders while short-term traders were hurt by the low volatility.
It is worth noting that the Asian large-cap funds (funds with more than US$250 million AUM) seem to lag their small- and mid-cap peers in the region, recording the lowest annualised returns at 9.89%, in comparison to 11.29% and 10.49% respectively. However looking at the returns generated in 2003 and 2004, it seems to suggest that the mid-cap funds were the laggards in the universe instead. Mid-caps funds, being more risk averse, did not take as large a position in the bull market to ensure greater returns, as did large-cap funds which are more confident, and small-cap funds which have more to prove.
|Asian indices||2004 return||2003 return||Annualised return||Sharpe ratio||Annualised SD|
|Eurekahedge Asian Small Cap Hedge Fund Index||9.10||28.21||11.29||1.71||6.59|
|Eurekahedge Asian Mid Cap Hedge Fund Index||7.27||22.04||10.49||2.01||5.21|
|Eurekahedge Asian Large Cap Hedge Fund Index||11.25||28.13||9.89||1.67||5.92|
The outperformance of large-cap funds over their smaller peers in the last two years goes some way to dispel the commonly-held misconception that (a) smaller funds outperform larger funds and (b) there is a lack of capacity in the markets for larger funds.
Nonetheless, hedge funds did still remain popular in 2004, drawing investors not just from traditional clients like funds of funds, but also from new clients like pension funds, eager to make up for losses suffered from traditional investments following the dot-com meltdown in the late 1990s.
Going forward, it is expected that demand for hedge funds should remain healthy in 2005, as US-based investors begin to increase their allocation to the region, though the new SEC registration rules for hedge funds with at least 15 US-based investors may dampen the desire for Asian hedge funds to accept many US-based allocators. Observers point to the entry of the Singapore government investment firm, Temasek Holdings, into the hedge fund market last November when it launched its US$300 million Fullerton Short Term Interest Rate Fund, as an example of the increasingly mainstream flavour of the alternative investment route in Asia. Investors in the fund include government-linked companies under the Temasek umbrella, as well Temasek itself, which generates US$1.4 billion a year in dividends. At the end of January this year, the state investment giant also revealed further plans to launch a fund of hedge funds, focusing on investment in Asia-Pacific markets.
Asia Pacific markets make up 15% of the world's market capitalisation, but Asia-strategy hedge funds represent only 5% of the world's hedge funds by assets. The robust growth seen over the past three years is a definite indicator that this disconnect is continuing to close. Asia's core attraction to global asset allocators is that it possesses some world class managers who are close to the ground, with the real-time flexibility and insight that intuitively entails, and who typically still have capacity, unlike in more developed markets.
Growth of the Asian industry was fairly flat from inception in the late 1980s. The last decade, however, saw a steady rise in the number of funds and assets with rapid acceleration in the last four years from 2001 to 2004 and no signs of abating in the early part of 2005. Figures from the Asian hedge fund industry continue to indicate strong growth, with 100 new funds launched in 2004. The number of Asian funds is expected to rise, by our estimates, to at least 600 by the end of 2005.
This growth in creation of new funds is aided by the liberalisation of short-selling rules in certain markets in the region, improved liquidity and the entry of more diverse players and strategies. Proactive governments such as Singapore, have further eased the start-up process for many funds. One such move as announced in the 2005 Budget, is the introduction by the Monetary Authority of Singapore of a 12-month window period for approved start-up fund managers to meet the general rules relating to tax exemption of offshore domiciled funds. Details on this are due to be released by end of March 2005. In Hong Kong, while full licenses are still required for fund management and the general period of application advised by the SFC is 15 weeks, there have been moves towards reducing this process, as well as recent reminders that temporary licenses can still be processed allowing an early foothold.
Asset growth figures also paint an encouraging picture, surging by 51% in the year. For 2005, we expect assets to grow to US$85 billion through a combination of asset flows and performance, up 42% from 2004's total assets of US$60 billion. Notwithstanding, we believe these estimates may be conservative.
|Year||Size of industry (US$m)||Increase|
In addition, there has been a shift in the location which these assets are managed from, as assets managed from outside the region fell steadily to 38% of the total, compared with 50% two years ago. This has led to a dramatic increase in the number of Asia-based funds from 150 in at the end of 2002 to almost 300 as at December 2004. These figures reflect the growing importance of the Asian investor, as well as increasingly crowded markets in the US and Europe, which is prompting some managers to seek superior performance elsewhere.
Fears of a bubble in the industry however, are unfounded from an Asian perspective as the region is essentially catching up with the rest of the world. The number of funds and assets deployed also remain relatively small in the global context of more than 7,000 distinct funds worldwide and assets of more than US$1 trillion under management from single-fund managers alone. While the rate of growth of the industry has slowed from the explosive 50% increase in numbers we saw in 2003, to around 25% growth in 2004, we believe that this is indicative of a rapidly maturing industry, and that there remains scope for further development in the Asian industry.
Changes in location primacy
Singapore has emerged as the top choice for Asian hedge fund start-ups in the region with 19 launches in 2004. This is while Australia has fallen from the top of the league with only 13 launches in 2004 as compared to 27 in the previous year. On the other hand, UK retained its popularity for start-ups, reflecting the continuing importance of European institutional investors, and the close relation between investor proximity and capital introduction for many funds. Asian hedge funds gained close to 40% of their capital from Swiss investors in 2004. This was followed closely by the UK and US with 30% and 20% respectively, but Asia-Pacific investors continued to lag behind in race of capital flow into the region's hedge funds, being responsible for one tenth of flows, including those from Japan.
|Location||2003 launches||2004 launches||% change||Total number of funds|
Hong Kong's attractiveness versus Singapore as a location for start-up funds in Asia has steadily eroded, as evidenced from the 13 funds launched there in 2004 in comparison to 19 in the city state, up 27% rise from the previous year. Singapore accounted for 20% of the new launches in the Asia-Pacific region in 2004, as opposed to 13% for Hong Kong. However, in terms of total AUM, Hong Kong remains well ahead of Singapore, at around US$9.3 billion to Singapore's US$2.8 billion, out of an Asia-Pacific total of US$60 billion.
The doubling of Singapore's share of the region's start-ups from 12% in 2003 to 20% in 2004 has much to do with active measures that the Monetary Authority of Singapore has put in place to woo prime brokers and other builders of market infrastructure. For instance, since 2002, the Securities and Futures Act and the Financial Advisers Act have introduced significant changes to the operations of the financial system. This included opening up the distribution market for offshore funds, allowing direct access to the retail public in Singapore; as well as the lowering of investment limits for retail hedge funds so as to introduce an alternative investment vehicle for retail investors. In addition, Singapore has further clarified its equities clearing laws (to the benefit of long/short equity funds) and has simplified its tax exemption laws for hedge fund managers.
In contrast, Hong Kong's continued uncertainty over its offshore funds taxation policy has served to deter potential managers from setting up operations in the SAR. In a bid to retain Hong Kong's position as an international financial centre for the region, the Financial Services and Treasury Bureau issued its second consultation paper on the exemption of profit tax for non-Hong Kong residents, on gains made from offshore funds at the end of last year. Hong Kong has also introduced a temporary hedge fund license for existing hedge fund managers based outside of Hong Kong.
That said, it is not an entirely smooth ride for managers trying to start out in Singapore, and there remain two issues for fund managers debating the merits of setting up in the Republic - that of the tax structure and regulations. Foreign funds need to have at least 80% of their investments from overseas in order to qualify for tax exemption, and this is a difficult requirement for many start-up managers to meet. Some managers also feel that a 10% tax rate on fund management fees may be too high and are looking to have it halved to 5% instead, to attract more onshore fund managers.
Overall, however, the biggest issue for many managers is that of registration and this has proved to work in Singapore's favour. In both Hong Kong and Singapore, managers are required to register as investment advisors before they are allowed to trade securities. However, there remains a startling discrepancy in processing time, particularly given Hong Kong's consistently high ranking as the world's most competitive economy. While it takes a couple of weeks to register a start-up in Singapore; it takes several months in Hong Kong. This is a big issue for Japan-located hedge funds as they need to have their trading offshore and more and more are having their trading set up in Singapore than in Hong Kong. This lag in processing times has also much to do with the recent arrival of big American funds such as Tudor, Everest and more recently, Moon Capital in Singapore, instead of in Hong Kong.
The rise in Singapore's fortunes as a hub for Asian hedge fund managers was mirrored in reverse by the decline in Australia's share of the region's start-up market, which almost halved from 22% of the market in 2003 to 13% in 2004. This reflects the difficulty funds have in raising new capital, given the continent's time difference to key investors in Europe and the US. Many investors find the trip down under taxing in terms of resources. The ease of operating from competing hubs like Singapore and Hong Kong, in terms of both lifestyle and logistics, has thus made Australia less attractive as a start-up location. In addition, many of the hedge funds in Australia are still denominated in Australian dollars; only a few have offshore money.
There remains a strong predilection among Asian hedge funds for long/short equity strategies, with almost 60% of the universe falling under this category in 2004. This reflects the earlier stages of the industry, when it was dominated by fundamentally driven, long-biased equity managers, who aggressively sought high returns from equity implementation of macro-type thematic bets.
|Strategy||2003||2004||% change||% of total universe|
|Long / Short Equities||75||61||-18.7||59.5|
Looking at new launches, it was surprising that not as many directional macro funds were launched considering the exceptional returns of this strategy in 2003. The number of multi-strategy funds launched in 2004 was also lower than that launched in 2003. Predominantly the domain of ex-prop desk traders, this perhaps suggests that less of these traders left their investment banking jobs after 2003 to launch multi-strategy Asian hedge funds; presumably because of the fruits enjoyed in the buoyant Asian markets in 2003.
At only 2% of the universe, the number of convertible bond arbitrage hedge funds remains small in Asia. This is as opposed to Europe where these comprise almost 7% of European hedge funds due to a much larger number of convertible bond issues in this region.
Recent market information suggests that start-up funds are becoming increasingly less focused on a narrow range of investment strategies. Traditionally, Japanese and pan Asian long/short funds have accounted for the bulk of start-ups. However, it is expected that the domination of long/short strategies will diminish as the number of proprietary traders launching macro funds, commodity trading pools and multi-strategy arbitrage funds increases.
|Strategy||2003||2004||Average size (US$m)|
|Long / Short Equities||62%||59%||147|
In terms of average size of the respective strategies, distressed debt funds lead the pack averaging US$235m, attributable mainly to four large funds with successful track records dating back to the late 1990s.
The impressive performance of distressed debt and event-driven strategies in the last two years means these approaches are also likely to be considered for new Asian hedge funds.
The decline in new launches in the hedge fund universe across most categories, except that of distressed debt, should not distract from the fact that the Asian industry has grown almost 4,400% since ten years ago, and is now reaching a maturing pace of growth.
Regional mandate, asset flows and average asset size
The number of new launches focusing on Asia including Japan, saw a 57% increase from 14 to 22 in 2004. This was while the Japan-only strategies saw a sharp decrease in interest from start-ups, experiencing a decline of almost 50% through the year from 38 to 20 new launches, perhaps reflecting investors' growing preference for more aggressive emerging markets strategies.
|Regional mandate||2003||2004||% change||% of total universe|
|Asia incl Japan||14||22||57.1||18.6|
|Australia / New Zealand||13||5||-61.5||6.7|
This was in contrast to asset flows, which saw the strongest flows to Japanese funds, at 41% of all flows to the region, totalling almost US$8.2 billion. Asia including Japan funds saw more than a quarter of the flows in 2004, while Asia excluding Japan funds saw a fifth of total flows. While there has been a slowdown in the growth of the absolute number of Japan-focused funds, from 50% in 2003 to 17% in 2004, total assets have increased by almost 82% from the previous year.
|Investment region||2003||2004||Average size (US$m)|
|Asia incl Japan||19%||26%||168|
|Australia / New Zealand||4%||7%||86|
There was also a 60% fall in the number of new launches of Australia/New Zealand-focused funds. This was while their share of the asset flows in the region rose from 4% to 7%.
Average asset size of funds located in Japan fell by 14% to US$145 million, while those of funds located in the UK rose by a good 60% to US$157 million, which shows that being close to dominant investor bases still counts in terms of attracting assets. The average size of funds based in Singapore remains the smallest in the universe at US$46 million, while those based in Hong Kong and Australia saw strong increases of 40% and 49% respectively. US-based funds saw a 6% decrease in average asset size.
Asset flows into Asian hedge funds in 2004 were largely derived from non-Asian investors, with 40% of investors from Switzerland, 25% each from the UK and US, and 5% each from Asia ex-Japan and Japan. However there is an increasing interest in Asian hedge funds from US investors, and Japanese institutions are stepping up allocations to single manager Asian strategies. There is also an increasing demand for emerging market hedge funds, particularly in Asia. The China and India growth stories are attracting a lot of investor attention from the US, and the rest of emerging Asia is firmly on the radar of European investors looking to diversify portfolios with quality managers.
Though the number of beneficiaries of the increased demand remains small - the bulk of the asset inflows in 2004 went to around 20% of the funds - the large boutique managers proved to be just as capable of attracting assets as institutional players.
Prime broker trends
Hedge funds are amongst a bank's best customers, generating commission revenue for the bank from the large number of trades they execute in comparison to traditional long-only managers. They also utilise a wide variety of services, from capital introductions to trade settlements and credit advances, not to mention a whole range of back-office services and trade ideas. The balance of power in the battle for prime brokerage fees has shifted steadily among the various investment banks over the last three years in the Asian industry. The market in Asia is dominated by four banks, covering 77% of the industry.
Outlook for Q1 2005 3
Managers are likely to remain cautious in the new year, seeking to hedge returns rather than leverage gains from large directional bets. This is due to decreased visibility and fears of continued low volatility in the markets for many managers. While sentiment and liquidity continue to look supportive, the overall equity market valuations are not cheap and speculative flows may leave abruptly should there be signs of a sustained dollar rally.
The Australian stock market should continue to see strong activity, as equity supply is limited by heavy share repurchases by corporates and significant takeover activity. The equity market ended 2004 strongly, aided by natural resource plays (which Asian hedge funds were heavily exposed to). It rose 3% in December and moved past 4,000 for the first time. It was the best performing market in the region for the year by a significant margin. Managers expect momentum for the market to continue positively, driven by continued upgrades to consensus earnings forecasts and ongoing strong liquidity. However, with the risk of a slowdown in domestic economic activity looming on the horizon, managers will be paying close attention to trading updates and outlook comments during the upcoming reporting period.
Overblown concerns about a Chinese "hard landing" by many investors have cheapened the stocks relative to valuation. Investors are now skittish with the benchmark Shanghai Composite Index having slid 15% in 2004 - Asia's worst performing in 2004. This is as Beijing launched a campaign to slow its overheating economy during the year. On the flip side, this trend looks likely to provide hedge fund managers with good long-side opportunities in China shares, with the likelihood of Renminbi appreciation further enhancing those potential returns.
In addition, rough studies of the output gap suggests over capacity in many industries like automobiles and steel. This could mean an upward pressure on prices of coal and iron ore but downward pressure on finished goods like steel.
Asian managers did well investing in Hong Kong property stocks during 2004; the Hang Seng Property Index was up 23% as compared to the 13% rise in the Hang Seng Index, though this was not necessarily always pure alpha gains as the Hang Seng Index is around 20% property. The other sector which performed well last year was the Hong Kong retail market, boosted by an increase in mainland tourists for the year. Retail bellwethers like ESpirit and Giordano were the main beneficiaries.
India was a top performer for the year in the hedge fund universe, returning annualised gains of 43.85% in 2004. Managers expect that the Indian market's recent sell off should give rise to further buying opportunities across a diversity of sectors. At the same time, there are greater opportunities for individual shorts in India, both factors serving to enhance prospects in the new year for equity long/short strategies.
In addition, India has not had an investment cycle since 1994-1996. Its industries consolidated during 1997-2002, and balance sheets are mostly unleveraged. The aggregate bank loan to deposit ratio is 60%, which notwithstanding excessive borrowing by the central government, leaves ample liquidity to supply further demand for credit.
Valuations today are also reasonable. A year ago, the Indian market traded 14x forward earnings whereas today it trades 12x forward. Using calculations from some funds, assuming that India can grow earnings by 10%, the market can rise almost 15% from here without stretching historical valuation bands. While India is no more than 5% of a non-Japan Asian benchmark today, it is expected that this number will be multiples higher in three years' time. As such, sentiments remain positive on the prospects for India in 2005.
On the other hand, Korea remains an ambivalent play for investors, given the economy's difficulties and political risks. Some investors find cheer in the Korean market's valuations, better capital management, as well as activist minority shareholders and private equity holders. They see solid opportunities over the next 12-18 months in companies which have global and regional businesses or in industries at home which have franchise value and profit-motivated shareholders.
Others however beg to differ, pointing to the high levels of consumer debt, with 16% of the working population still credit delinquents after the credit bubble of 2001-2. Levels of small enterprise debt also remain high, and these combined factors could damage financials by forcing debt write-offs as a means of alleviating the situation. In addition, slower China investment demand, potential Chinese competition in exports and a stronger Won, add to domestic vulnerability to external shocks, and opportunities for strong short selling.
Given the uncertain prospects, it thus seems likely some managers will avoid taking strong views in Korea for now. We expect to see active hedging in these markets at many funds in the coming months ahead.
Malaysia is likely to allow its currency to appreciate from the current peg, and managers are likely to try gaining exposure there. This appreciation is not expected to hurt Singapore, which should continue to offer one of the better risk/rewards in our region. Meanwhile, the recommendation to lift a long-standing ban on the practice of regulated short-selling and securities borrowing and lending will be positive for the market.
Taiwan underperformed most of last year, and some managers might be tempted to gain exposure to the depressed tech sector, given its current valuation. Potential improvement in cross-strait relations given the recent election triumph of the Pan-Blue coalition has also rekindled some interest in the market.
Topix rose modestly in local terms in 2004, not quite meeting bullish investor expectations for the year. Given that profit growth has been strong, 2005 looks set to be a year for cheaper stock-picking opportunities. Credit expansion remains the foundation for the Japanese economic recovery, which raises prospects for banks and financials. The long/short equity strategy should remain popular among Japan-focused funds, given its relatively successful track record to date in harnessing the inefficiencies of the Japanese stock market.
Japanese commodity stocks are expected to benefit from the continuing strength in construction. While there are concerns about a possible property bubble forming in the large cities, industry sources believe that continued mass-migration from rural to urban areas and growing availability of mortgage finance to the expanding middle class will ensure a healthy pace for residential construction spending in the coming year. Furthermore, efforts by the government to raise rural incomes and the ability of farmers to now take loans against their 30-year leasehold rights are likely to further boost construction spending in rural areas.
Strong consumption, aided by a weaker dollar and falling interest rates, has fuelled a good showing from Indonesia to date. With a new, respectable government in place, hopes are rising that a capital expenditure cycle will occur and move the market higher. Earnings growth remains strong and stocks look relatively cheap.
In the Philippines, there is evidence of credit growth and a rise in property sales after 5-6 years of dormancy. Antiquated mining laws, which have deterred foreign investment in the mining industry for decades, are also set to change. In December, the Supreme Court abolished the law restricting foreign ownership in mining companies to 40%. Given that the Philippines sits on one of the richest mineral belts in the world, this heralds an exciting new development for resource development in the country. There should be opportunities here worth watching for in the coming year.
It seems likely that the greenback will continue to weaken against undervalued Asian and commodity currencies until the structural problems in the US are resolved. Managers expect to continue tracking the path of the greenback carefully, in particular looking out for indications of the pace and sustainability of any decline or rally.
Concerns going forward
2004 was a year of extremes in financial and commodity markets, and stock market volatility fell on both an implied and realised basis, reaching a 14-year low. The same trends we saw in 2004 continue to play on expectations for returns in the new year. The consensus is that 2005 will be a year of low, but positive returns and continued low volatility in the equity markets. The biggest threats to investor sentiment appear to be a renewed rise in oil prices, a slowdown in consumer spending in the US and UK (and continued sluggishness in Europe), a hard landing for China, where the government is intervening to cool the economy, and the continued deflation in Japan.
Observers worry that the weakness of the dollar and historical low emerging market spreads to US Treasuries have made global investors oblivious to the risks associated with investing in emerging markets. There are warnings of imbalances appearing in the investment world, whereby global investors with very little experience with Asia hand over increasing amounts of cash to hedge funds.
1 Based on funds that report to Eurekahedge as at 31 December 2004 but not including funds in the pipeline and funds with multiple share classes/currency denominations.
2 Through a combination of asset flows and performance
3 At press time