Prologue: The Beginning of
the Year for Asia
Back in January 2002, the consensus view on Asian markets
was remarkably positive - the military action against the
Taliban in Afghanistan was efficiently coming to a close,
the U.S. consumer was leading the general economy out of the
2001 recession, Korean exporters and domestic consumption
were steamrolling ahead and Asian equities were still trading
at historically low p/e ratios even after the market bounce
in the 4Q of 2001.
Asian markets began the year in much the same fashion as
they ended 2001; rising substantially on the back of a major
liquidity injection by central banks across the globe after
September 11th. The South Korean economy, and its peoples'
new love affair with the consumer credit card, was the most
salient investment story coming into 2002. Unfortunately,
the Korean peninsula would turn out to be the biggest story
in the closing weeks of the year also. But first we will look
The Story of Japan
During the first month of 2002 the Japanese stock markets
continued to lag behind the rest of Asia and the world's developed
markets. It appeared that foreign investors had become increasingly
skeptical of the ruling class' ability to initiate meaningful
economic reforms. People had become complacent with the view
that Japan had slumped into a "jellyfish economy",
i.e. one that floats with the economic cycles of the rest
of the world.
There were numerous reports that local investors were purchasing
large amounts of gold; the safe haven of last resort. (This
incidentally helped Australian mining companies, a sector
popular throughout 2001 and early 2002 among Asian hedge fund
managers). The most telling anecdote of negative investment
sentiment in Japan was that in January the number of investors
purchasing stock on margin was less than those short-selling
on margin for the first time in the market's history. With
the fall of the Japanese Prime Minister Koizumi's popularity
after the poorly handled firing of his Foreign Minister, it
even appeared that this "last hope" (Koizumi) for
change would be forced from his leadership position like so
many of his predecessors.
Then, like it seems to occur every year, the market began
a serious rally in the five weeks before the fiscal year end
on March 31. As always, managers began to cover their shorts
before the third week of March on their callable shares; however,
the rush to close both callable and non-callable lent shares
was spurred on by the government's "anti-deflationary"
plan at the end of February; this caused one of the biggest
short squeezes in three years. This fiasco was initiated by
Prime Minister Koizumi's much anticipated anti-deflation plan
announced at the end of February.
Much was riding on this anti-deflation plan, but it was not
surprising that in the end the only "deflation"
that it was meant to tackle was falling stock prices. Rather
than produce a substantive program to deal with the country's
economic problems, the government again propped up the markets
so the banking system could remain solvent for the March year-end
regulatory books. Thus, during the last week of February the
Financial Services Agency (FSA), the Japanese banking industry
watchdog and market regulatory agency, announced a number
of rule changes for shorting stock on margin. The most significant
of these was that hedge fund managers using foreign margin
would no longer be able to initiate a short on the "down-tic"
(the same rule applies in the United Kingdom and the United
States). There were also unconfirmed reports that the FSA
was forcing insurance companies, the largest lender of stock,
to recall their outstanding lent shares.
These actions combined with newly released data that Japanese
industrial production numbers appeared to have bottomed while
most companies had extremely low inventories caused an allocation
rush from global mutual fund managers into Japan (whose exposure
had been underweight the country since early 2000). On the
whole, Japan hedge fund managers were able to manage this
short squeeze particularly well; the ABN Amro Eurekahedge
Japan index was +1.1% while the TOPIX was +4.6% for March
This artificially induced upturn in the Japanese markets
would hold through May; the ABN Amro Eurekahedge Japan index
was +5.4% year-to-date at the end of May. Managers on the
whole were well aware of the seasonality of the Japanese markets
- they perform well during the first half of the year only
to whither out come summer and then fall sharply through Christmas.
However, most managers thought 2002 was going to be different.
Even though the banking crisis had yet to be resolved, most
Japan hedge fund managers believed that the rise in the previously
mentioned industrial production figures, record low inventories
for many companies, the perceived abatement of deflation and
the flood of share buy-backs would support the market until
the U.S. and European economies fully recovered.
May 24th was the yearly high for the TOPIX (1139). Over the
next two months TOPIX fell by 14.34%, marking one of the worst
2 months for the Japanese markets since the bubble burst in
early 1990. For the reasons discussed above, most managers
came into Japan with historically high net exposures (average
of between 60-65%); the market falls in June were broad-based,
with every sector falling except for the paper industry. There
was absolutely no place to hide on the long side. With hedge
fund managers coming into June so positive, it was no surprise
that the ABN Amro Eurekahedge Japan index fell 2% for the
With the leading indicators and fundamentals all positive,
what caused the markets to decline so much over the summer?
WorldCom's June 25th announcement of improperly booked capital
expenses and the subsequent falls in US markets dragged all
major markets lower. But the de-coupling from foreign markets
that Japan hedge fund managers were expecting (or at least
hoping) never materialized; suddenly the deteriorating outlook
for the U.S. created too much selling pressure for even fundamentally
inexpensive stocks to hold their p/e ratios. The sale orders
in June were futures-led, with macro and global mutual funds
leading the way (the later likely to have been facing redemptions
from the U.S.).
The widespread paranoia of accounting scandals in the U.S.
spread to Japan during July; when erroneous reports by sell-side
analysts on perceived accounting irregularities of fundamentally
sound companies caused shares to tumble limit down over successive
trading days. This investor paranoia reeked havoc on fundamentally
biased managers who were "whipsawed" out of long
Market volatility continued throughout August and for the
first time the market declines were not blamed on falling
U.S. markets; it became apparent that Japan's nascent domestic
led economic recovery that started earlier in the year had
begun to retract. Then in September came an unprecedented
announcement from the Bank of Japan (BoJ)- it would begin
to buy stock directly from the banks' proprietary portfolios.
This caused a sharp rise across the market in the middle part
of the month. The result of this action by the BoJ was not
believed to have any major effect on the available stock borrower
pool. But yet again, direct government intervention caused
havoc for managers trying to short sell what they believe
were inept companies.
Then only a few weeks after the BoJ's stock buying scheme
was announced, Prime Minister Koizumi appointed Professor
Heizo Takenaka as the head of the FSA. Mr. Takenaka, a highly
regarded economist and proponent of cleaning up Japan's non-performing
loan problem, replaced the ineffective Hakuo Yanagisawa. The
announcement was interpreted as a political shift away from
the old guard of the LDP (who were unable to rectify Japan's
economic problems) to a new set of advisors who understood
that the bad debt problem must be solved for the Japanese
economy to grow.
However, neither the BoJ stock purchasing plan nor the Takenaka
announcement had much traction in producing a market rally.
Managers realized that a short squeeze would not occur, and
the old guard of the LDP successfully stonewalled Mr. Takenaka
from making bold proposals in dealing with the banking crises.
When a new economic proposal was announced on October 30th,
it lacked any specific measures to improve the strength of
the banking system.
It appeared that the Japanese government had for the time
being lost the ability to generate market rallies; the next
upswing would have to be generated from the bottom-up. This
is exactly what happened in November when a number of blue-chip
companies announced surprisingly strong quarterly earnings
numbers. Japanese small-caps underperformed the index and
Japan-only managers running "long micro/short large cap"
books showed negative month-on-month returns for November.
Market volatility began to decrease.
This would be a false rally as the TOPIX fell 5.5% in December,
negating all gains during the previous month. Japan hedge
fund managers lowered both their net and gross exposures and
went on vacation; though selective technology names and REITs
helped some fund's performance. The news of the North Korean
government reactivating its nuclear program, though disconcerting,
had no serious effect on the Japanese markets; which actually
rose in the final week of the year. The ABN Amro Eurekahedge
Japan index was down a marginal 0.60% for December.
Managers waited to hear the government's likely announcement
early in 2003 of a decrease in the dividend tax and the replacement
of Masaru Hayami (the most hated man among hedge fund managers)
to head the Bank of Japan - will he be a "reformer"
or from the old guard of the LDP; or does it mater?
The Story of Asia
As spring came, most of the Asian regional indices reached
their highs for the year, topped by the KOSPI which hit 937
points on April 18th. The domestic consumption story and general
belief during March that the U.S. economy was rebounding at
a brisk path led both domestic and exporter stocks in South
With the statistical evidence of rising consumer demand across
the region coupled with accelerating earnings momentum, increasing
international fund flows to Asia and improving levels of business
confidence, many Asian hedge fund managers raised their net
exposure levels by April 2002 to the highest level they had
been at for over a year. This renewed confidence turned out
to be a trap.
During the second part of April on through the summer months,
concerns over the US economy and equity markets combined with
the economic and political turmoil in Argentina resulted in
sharp pullbacks in several Asian markets, most notably Korea,
India and Taiwan. The Korean "domestic consumption"
story that many Asia including Japan hedge fund managers latched
onto dissipated when the KOSPI fell 11% off its high during
the last two weeks of April. The increase in tensions between
Pakistan and India also hurt those managers heavily weighted
in Indian software companies. During this time the one bright
spot was mainland China, which continued to suck in direct
investments from the United States and Europe while its domestic
consumer spending rapidly grew.
During the summer months, Asian markets continued to fall
and the previous expectation that the U.S. economy (led by
the U.S. consumer) would lead Asia out of its doldrums switched
to the belief that the U.S. and subsequently Asia were headed
towards another recession by the year-end. The disappointing
2Q earnings announcement (and prediction that 3Q sales would
fall) by Taiwanese semiconductor TSMC in late July blindsided
investors and caused technology names to plunge further. Managers
who did not aggressively lower their gross and net long exposures
were hurt accordingly. The biggest draw-downs of the year
for Asia including Japan managers occurred in June and July.
The ABN Amro Eurekahedge Asia index fell 2.3% for those two
As managers came back from summer holidays, Asian markets
fell further during August and September. The general sense
of a strong U.S. consumer market and thus an Asian export-led
recovery had largely dissipated and renewed fears of U.S.
deflation continued the declines in the technology sectors.
The Korean consumption story had finally reversed and the
Bank of Korea persuaded local banks and financial firms to
limit credit to consumers in order to prevent what officials
believed was a growing credit bubble. Hong Kong continued
to suffer from an overvalued currency and a falling property
market; even the China stocks listed on the Hong Kong Exchange
fell due to profit taking.
Managers began to realize that unlike 2001 when they saw
similar market falls, there was no place to hide during the
summer and fall of 2002. Even companies with solid growth
and no debt were heavily sold off; and at valuations frequently
below book value, it was difficult to find interesting short
ideas outside of Japan. Managers continued to cut their gross
exposures aggressively and actively searched for stocks with
high dividend yields. Thus, there was a major shift out of
technology names (which usually don't pay any dividends) and
into domestic names with 5-7% dividend yields.
Markets generally quieted down during October, but terrorism
came to the forefront in Asia during a month that saw the
bombings of the Sari and Paddy's night clubs on the Indonesian
island of Bali. Groups affiliated with Al Qaeda were later
proved to be involved. The Jakarta Composite Index initially
fell 11.6%, but the markets rallied after the surprising effectiveness
of the Indonesian military in arresting genuine suspects and
monitoring believed terrorist groups in the country. Indonesia
had long become a forgotten market for most Asian hedge funds
and its tribulations over October and November had no major
effect on most funds.
November saw a reverse in the free-fall that Asian markets
experienced through the second and third quarters; technology
did well in Taiwan and South Korea with the stabilization
of DRAM prices and reports of late, surging technology orders
from the U.S. Generally, Asia including Japan managers traded
behind the markets- managers who increased their short positions
in early October were whipsawed when the markets in Korea,
Hong Kong and Taiwan bounced in late October through November
on better than expected earnings reports.
The naming of a new set of rulers in mid November for the
Communist Party in China, including the nomination of Hu Jintao
to replace Jiang Zemin as the nominal head of the Party and
State was long expected and the markets took the peaceful
handover favorably. This new "Fourth Generation"
of leaders in China (to be formerly "elected" in
March 2003) are seen as capable technocrats who will continue
to lead China through market reforms.
After 11 months of continual market surprises, the biggest
surprise of all would come during the last week of the year
and be initiated by political developments. In South Korea,
the somewhat surprising election of the liberal Roh Moo-hyun
of the incumbent Millennium Democratic Party did not have
a negative effect on the Korean markets. However, the confirmation
from the North Korean leader Kim Jong-il's representatives
to the U.S. Assistant Secretary of State James Kelley that
the North Korean government had restarted its nuclear weapons
program and the resulting "crisis" shocked investors.
The KOSPI fell 11.5% in the last trading week of December,
pulling down most Asian hedge funds with it.
Overview of the Asian Hedge Fund Industry
The overall Asian hedge fund universe performed reasonably
well in 2002, with performance being in a tight range of between
-5% to +10% for the year. The ABN Amro Eurekahedge index (including
all strategies and regions) was +3.6%. The ABN Amro Eurekahedge
Japan only index was +1.0% and the Asia ex Japan index was
The strategy that continued to have the best performance
were Asia ex Japan distressed debt funds; which on average
were up 17% for the year. Credit spreads tightened throughout
Asian countries and distressed debt managers were able to
find local buyers.
2002 was not a stellar year for equity long/short managers.
Only the "long small cap/short blue chip technology"
Japan hedge funds performed extraordinarily well. As stated
above, "Jones model" equity long/short managers
were caught with high net exposures during the market falls
beginning in June and subsequently were unable to find interesting
short ideas based on valuation metrics; unlike 2001 when finding
expensive stocks to short was easy throughout the year. For
the first time since 1998, stocks outside of Japan were collapsing
not for fundamental reasons but because of external events.
Many uncertainties still linger today: Japan remains the
only major economy without a plan of action to tackle its
economic woes, war with Iraq is still looming and nuclear
rumblings in North Korea need to be addressed. Though the
performance of Asian markets and economies will ultimately
depend on the health of the American economy, Asia is still
widely believed to offer the most attractive long term opportunities
for equity investors.
Lastly, there is a general belief among managers that a potential
U.S. led invasion of Iraq (most believe it will occur in the
coming 6 weeks) will be quick and a serious rally throughout
global markets will follow. Thus, high Beta names in Asia,
which are relatively inexpensive compared to their U.S. and
European peers, should be where the greatest upside occurs.
However, a cursory reading of military history will show that
wars rarely proceed as forecasted; predicting where the world's
economies and markets are headed today still remains an unpredictable
game. Until the fog of war clears, Asian markets should continue
on their flighty path.