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 (before leverage)1.
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 in strategy.
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 illiquid.
- 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 managers?
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 tax revenues.
- 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 market.
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 sector.
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.
- 4th Quarter 2001 Hedge Fund Industry Estimates, Hedge Fund Research, Inc.
- Thomas Schneeweis, Dealing with the Myths of Hedge Fund Investment, Journal of Alternative Investments, Winter 1998, page 11.
- On the Performance of Hedge Funds, Bing Liang, Financial Analysts Journal, July/August 1999. (Bing Liang)
- For further detail, see Hedge funds, Regional Monitor issue no.29 March 2000.
- Highwaymen of the global economy, Mahathir, Asian Wall Street Journal, 23 September 1997.
- IMF 1993 Capital Markets Report, page 11.
- For the IMF's view on the 1998 Hong Kong financial crisis, see IMF 1999 Capital Market Report, page 173.
- Hedge Funds and the Asian Financial Crisis of 1997, Brown, Goetzmann and Park, January 1998.
- "On balance, concerns that the HLIs could pose a systemic risk to the international financial system are less than before." The Financial Stability Forum Recommendations and Concerns Raised by HLIs: An Assessment, 11 March 2002, paragraph 42.