Eastern Promise

Judging by the number of conferences and other events focused on them in recent months, the emerging market hot spots for hedge fund investment are China and India.

They seem like logical plays - two enormous countries, each with more than a billion people, rapid growth and a fast-rising upper and middle class.

There should be, and indeed are, a wealth of opportunities to be taken in these growing economic powers - both in terms of investment opportunities and potential new hedge fund investors. But there are also a number of barriers to jump and risks to assess before doing so. This has become particularly evident this week, as the Indian exchange fell 4.2% on Monday1 amid a worldwide downturn.


There is a large array of opportunities in both countries for hedge funds that can access them, according to Gary Kreps, portfolio manager of the Marathon Emerging Markets Fund. In China there are potential opportunities in companies producing “every manufacturing product known to man,” he adds.

Large oil and gas companies as well as Internet firms are performing well, property is a booming sector and local technology firms are becoming increasingly strong players, he says.

In India there are also “opportunities across the board,” according to Amitabh Dubey, an analyst at Eurasia Group, a global risk assessment firm, but it is very much a stock picker’s market. Real estate is strong in India, although companies operating in this sector could be vulnerable to corruption, he notes.

The Indian stock market is deeper than that of China, adds Kreps, and currently hot sectors include software and pharmaceutical manufacturers. However, it is also a significantly more expensive market than China, a fact that is turning some investors elsewhere. “Indonesia is a better story than India right now,” says Kreps. “It offers two thirds the valuation with earnings per share growing as quickly as India.”

On the whole China is the stronger manufacturing power and India is ahead in the service sector, according to Kreps. This is in part because China’s lower labour costs make it difficult for India to compete. However, in each there are many exceptions to this rule.

Spending power

With huge populations and growing wealth, both countries are becoming increasingly good consumer plays. “There is no question there is a growing middle class in both,” says Kreps. And they are looking to spend their new-found wealth, he adds.

China’s growth is more export-driven than India’s, which makes it more susceptible to economic slumps elsewhere in the world, but both countries are the “leading growth sectors in Asia, and this is certainly expected to continue,” says Dubey.

While there are many opportunities, there are also significant barriers to entry. In China, smaller players are only able to enter the market via B shares from Hong Kong. This presents a much smaller market than mainland China, where both A shares (local) and B shares (foreign) are open for investment.

According to Tom Schneeweis, director of the Center for International Securities and Derivatives and Markets (CISDM) at the University of Massachusetts, Amherst, due to the difficulties “hedge funds invested in mainland China have tended to be more in the private equity direct investment end of the business”.

In India too there are barriers. Foreign funds are not allowed to invest directly in India, so hedge funds must adhere to the country’s Foreign Institutional Investor (FII) rules that state they can invest in Indian equities by creating a sub-fund domiciled in jurisdictions such as Luxembourg or Mauritius, which avoids double taxation. The sub-fund must be registered with the Securities and Exchange Board of India and use a local intermediary to access India’s capital markets.

There are strict rules governing registration, covering areas such as manager track record, that make it difficult for less-established managers.

For this reason many hedge funds investing in India do so through a participatory note (PN), according to Dubey. “Possibly up to half of investment in India comes through this route,” he says.

The Indian government is concerned about PNs, because it has no idea who is investing, and set up a committee last year with the view to regulating them. India’s Reserve Bank wanted to put a complete stop to PNs, due to concern over the anonymity of investors, which has drawn some political heat. “If they restrict PNs there would be an exodus from the market, so it is very unlikely they will,” according to Dubey.

Overall India is an easier market to enter and operate in than China, says Schneeweis. “India, which has a more transparent trading system and a more established legal system, is easier to work with than China, but regardless you have got to have people on the ground who understand the legal and cultural issues.”

Political instability

Emerging markets are notorious for political instability, and China and India both have their share, which is often overlooked by investors in the region.

Enthusiasm for China’s growth has blinkered many to potentially huge problems there that could wipe out investments completely.

According to Ian Bremmer, president of Eurasia Group: “If you compare China to India, the downside potential in China is much greater. There are lots of American multinationals investing massively in China and nothing in India. They shouldn’t be putting all their eggs in one basket. You can actually lose everything in China.”

Avian flu, geopolitical problems and growing social instability all pose a threat to investors in China.

“With regard to avian flu, we have no idea what will happen. Nobody does,” says Bremmer. “We don’t know when and if we are going to see a pandemic. No one has any understanding of the likelihood.”

What is known, however, is the Chinese government’s track record on covering up the SARS epidemic and its lack of co-operation with the international community so far over bird flu.

“They are not co-operating with the World Health Organisation or providing full data to the international community,” says Bremmer. “There have also been incidents of harassment of scientists where they have given interviews. The Chinese government is more likely to hide an outbreak than others - that is the danger.”

But the biggest geopolitical problem that could affect investors in China is the country’s ongoing territorial dispute with Japan. China continues to drill for gas in a disputed territory and has been ramping up military patrols. The dispute has led to anti-Japanese demonstrations in China.

The most likely candidate to take over from Japan’s prime minister, Junichiro Koizumi, when he steps down next September is Shinzo Abe. An October cabinet reshuffle that saw him appointed as chief cabinet secretary - a position often referred to as ‘the prime minister’s wife’ in Japan - is probably a sign Koizumi wants him as his successor. Abe holds hawkish views on many areas of foreign policy and is an ally of US president George Bush.

“The likelihood that Japan will drill for gas if he comes in is high, and that could lead to possible conflict,” says Bremmer.

China is also beset by increasing social instability, according to Bremmer, a problem underlined by the 75,000 known demonstrations there last year, a number that continues to rise.

“China has the advantage that if the government wants to build a road it does it regardless of who lives in its path,” says Bremmer. “The downside to this is that villagers do not like it when you uproot them from a certain part of the countryside, or move a river, or cause massive environmental damage, and if they demonstrate the central government cracks down.

“That does not get anywhere near the attention the lack of infrastructure gets in India, and this creates market imbalances. There is no question China is the most exciting bull market story in the world but I think economists look at what they know but don’t look at political risk. China has political problems that aren’t understood well on Wall Street.”

By contrast to China, India’s problems are less political and more economic, including a lack of roads, a poor electricity grid, and inadequate ports. In terms of infrastructure, India cannot compete with China, says Bremmer.

China’s authoritarian state and India’s democracy pose their own problems for companies in each country.

“If you have a good relationship with the government in China you can do whatever you like. In India you need to spend more time on the ground,” says Bremmer. “There is more likelihood in China you will lose your business, but more likelihood in India of a strike disrupting business.”

India also faces educational problems, according to Bremmer. “The top 3% to 5% are highly educated, but beyond that education is very poor. India is not competing well with China in this area. In part this is because local governments control schools and they aren’t efficient at it.” The lack of educated labour means labour costs are higher for skilled jobs, which makes India less competitive.

There are more potential risks for investors in India, but those risks are likely to be less devastating than the potential risks to investors in China, says Bremmer.

Local investors

While there are opportunities to invest in India and China, albeit with caution, there is also a growing pool of potential hedge fund investors in both countries.

In China there are around 300,000 families with US$1 million or more in investible assets, according to John Benevides of the Family Office Exchange, a firm that advises 350 of the world’s wealthiest families in 18 countries. The top 10 families in China have around US$12 billion in investible assets.

There is a vast array of wealth and it is very opaque. “People do not want to let on what they have in case the government comes and takes it,” says Benevides.

The government is liable to step in under currency control regulations if it thinks a wealthy family is going to invest outside the country. It is a challenge for hedge funds to get their products into the Chinese market, but there are many wealthy Chinese nationals living in Hong Kong, Singapore and Malaysia who are more accessible, he says.

Traditionally, wealth and the entrepreneurial spirit among Chinese nationals have flourished outside the mainland, where Communism suppressed it.

“Now those on the mainland are finding a more accepting environment for wealth too,” says Benevides.

Chinese investors tend to be more prepared to take risks than Indian investors, but they like structures with principal guarantees, he adds.

The trend for longer lock-in periods in the US and Europe may not find much support in China, according to Benevides. “Lock-in periods are being tested now,” he says. “In the US they are being extended, but in Asia it is still early stages.”

Wealth in India is far more transparent. The 10 wealthiest Indian families have a net worth of US$68 billion.

The challenge for hedge funds trying to attract wealthy Indian investors is luring them away from the fast-rising Indian stock market. “A lot of the Indian buying community likes to keep money in India and the tax structure helps this. There is very moderate income tax,” Benevides adds. Indian investors also prefer to invest in assets such as real estate, he says. However, some investors may be attracted to hedge funds simply for the “cachet” of being invested in them.

Investment curve

If hedge fund investment in the US is at the end of the investment curve, in China and India it is at the beginning. But it is too early to say what type of strategy investors in Asia want. There are pockets of investors in Hong Kong, Korea and Singapore that are sophisticated, but most are not.

“If they believe they have found a good manager who is going to give really good returns they are happy,” says Benevides. “They are more focused on returns than on strategy. They don’t really care about strategy.”

Investing in the region

While Chinese and Indian investors are discovering hedge funds, investors from other regions are discovering alternative investment managers focused on those countries.

The principal investors in China and India in the past were from Europe and the US, but now Asian and Middle Eastern investors are also discovering the region. According to Dubey, “The Japanese are less familiar with the Indian market, but now they are becoming more comfortable.

“The Middle East is awash with funds because of the oil crisis and India and China are among the opportunities.”

All observers agree on one thing - that growth in China and India should continue to be strong (albeit with an occasional hiccup or two). Opportunities for hedge funds in each country are at an early stage as are potential investors, and because of this the quantity and quality of each is likely to grow into a rich seam for hedge funds. But they should do so with caution and with their eyes wide open to the potential risks.

This article first appeared in Issue 34 of HFMWeek.


1 15 May 2006.