Major market characteristics of the fund of funds market in Asia are:
- It has only been in existence for a couple of years and it is still very much in its infancy both in absolute terms and in comparison to the market in the US.
- The number of players in it and its overall size are set to increase dramatically.
- There are few barriers to entry.
- There are currently no dominant players.
- It is opaque.
Its opacity means that it is difficult to get hold of realistic and accurate numbers about the market; though we estimate that Asian investors (including Japan and Australia) have put about US$45 billion into alternatives. In terms of countries, that breaks down roughly into South Korea $1-2 billion, Taiwan $3-4 billion, Hong Kong $6 billion, Australia $2-3 billion with the balance coming from Japan.
The current investments and players in Asia:
In terms of the type of alternatives that are being bought perhaps as much as 85% is going into fund of funds products that have their underlying assets invested in US equities or comparable US dollar-denominated, US-focused investment strategies. This figure can be split into branded fund of funds products sold under the name of a US-based manager such as Grosvenor or Mesirow, and money which has been accumulated in Asia and given to a discretionary western-based manager or consultant to put into a fund of funds strategy on a bespoke basis.
Of the remaining 15% the vast majority will be investments in large US-based single-manager hedge funds with track records of greater than five years and a strategy that is based on US markets. The amount of money that has come from Asia into Asia-focused fund of funds or Asia-focused hedge funds is very small.
The buyers of alternatives in Asia have mainly been the large Japanese financial institutions such as Sumitomo and Orix. Other buyers are the big established family offices, private banks distributing to high-net-worth individuals who qualify as "accredited" or "professional" investors. Endowments in the form of organisations such as the Hong Kong Jockey Club and government 'quangos' responsible for reserves are also starting to consider alternative investment strategies.
In terms of distribution, some of the bigger names in the fund of funds world have set up their own marketing offices in Tokyo. Several of the long-only houses such as AXA and Schroders are going into marketing alternatives. The Man Group, which is more a hedge fund than a fund of funds, is said to have sold up to US$1.5bn of product in Asia so far.
How the money is sourced:
Most of the product is being sourced in the west and sold via the "accredited investor" route by a variety of intermediates. It is probably safe to say most of the intermediaries are western-owned private banks and the bulge bracket investment banks rather then Asia-based distributors. Many of these intermediaries are selling their own in-house products but that is not always the case. It will be interesting to see whether the move to "open architecture" will accelerate this trend.
There is also a growing group of specialist third-party marketers who independently represent one or more western fund and market by traveling the region without actually having an office or regulated presence in Asia. Asian investors have also given money to Swiss-based private banks to run alternatives strategies for them.
Asian investors look for western-based products:
There are several reasons why Asia-based investors have tended to buy western-based products.
- Diversification. If you have the majority of your assets in Asia it could be said to make sense to get your alternative exposure in the West.
- Size of the market. Even at its current size of US $18 billion the Asia-focused hedge fund industry is a fraction of the global industry. There just are not enough hedge fund investment opportunities in Asia with the size and track record that are required.
- Asian investors are new to hedge funds. Investment to date has been more dipping a toe into the market to test it out. Consequently there is preference for tried and tested low-risk strategies.
But the most pressing reason is that the fund of funds decision-makers have to be where the hedge fund decision-makers are. To invest in a hedge fund, fund of funds managers or discretionary managers have to do extensive due diligence on the managers, their systems, etc. Even if there was the expertise to evaluate hedge funds in Tokyo the team would have to spend only a small proportion of their time in Tokyo as the hedge funds that they were seeking to evaluate are in London or Mid-town Manhattan. As long as the demand in Asia is for global fund of funds, the product will be sourced and managed in the west and sold in the east.
Problems faced by western distributors:
Bear in mind that distributors of western-based financial products face several problems in Asia. There are the obvious issues - such as language problems and the lack of a single major dominant financial centre. Then there are the more difficult to appreciate issues - an example being the confusing array of regulatory guidelines (or in some cases the complete lack of them). The fact is, that in Asia a lot of financial service distribution focuses on the strength of personal relationships rather than the quality of the product. It's also true that some of the normal business practices used to incentivise deals might cause a few raised eyebrows in compliance departments in the west. But perhaps the biggest hurdle is the sheer lack of knowledge about how alternative investment works and the benefits thereof. In the west there is a realisation among the upper end of the investing community of the merits of diversifying into alternative absolute return-based products. This message is only just beginning to get through in Asia. Marketing alternatives in Asia is more educational then selling.
Going forward, the trends we see are:
At present alternatives in Asia is a bit of westerner's game. Gradually this will change. Already some financial institutions in Asia are setting up due diligence operations in New York so they do not have to pay for the expertise of western firms. At the family office level also families that want to get a meaningful exposure to alternatives are just setting-up branch offices in the west.
But the overall dilemma of alternatives in Asia is the western fund of funds looking at Asia saying that "we have the product but are not equipped or knowledgeable enough to market it effectively in Asia," and the Asia-based bank saying "we cannot create the product (track record, size) but we could market it."
It seems to us that one of the ways that this will resolve itself is white labelling and bespoke managed accounts, whereby a local bank agrees to market a western run fund of funds or bespoke discretionary portfolio, but markets it under its own brand name. This allows both sides of the transaction to focus on their strengths. We see huge potential for this strategy.
One major issue is the fragmentation of the alternatives industry. On the mutual fund side, the industry has consolidated to an extent that it is clear that 80% of the money is being managed and invested by less than 10 visible global players, starting with Capital and Fidelity. The long-only industry took a long time for consolidation to occur with it only really gathering pace from the mid-1990s onward. With alternatives, particularly in Asia, it is fair to predict that the number of players is going to increase - particularly as local financial institutions enter the fray. Consolidation is several years away from happening. In many ways alternatives are where the mutual fund industry was in the early 1980's.
The implications of this are interesting:
As the industry becomes characterised by a very large number of players with no dominant participants operating a variety of strategies from a variety of locations its opacity will continue. There will be no central register of information on performance and fees.
In such a market it is unlikely that fees will come under pressure. Indeed the high level of fees on alternatives versus long-only will attract more entrants into the field. The current demand for guaranteed products, which carry a very high margin, is a case in point. Marketing will be more word-of-mouth and road-show instead of brand name recognition and advertising.
In terms of the potential size of the alternatives market in the region; Japan has the largest pool of savings in the world, estimated at around US$20 trillion. Though a lot of that money is of a different kind than has gone into hedge funds and alternative strategies in the west (such as endowments and family offices), it is still a frightening large number. It is difficult to predict the speed at which Japan's savings will be funnelled into absolute value strategies. Near zero interest rates should prove a catalyst but capacity issues, the government's view on alternatives, and the learning curve will have an impact. Even so, from a five- or ten-year point of view this is still a market in its infancy.