Hedge fund prospects bright for next year

Asian hedge funds' 2007 performance shows how the industry will fare in 2008.
The Asian hedge fund space has been on an exponential growth curve over the last several years, with nearly six times as many funds managing ten times as much in assets, since 2000; the industry is currently estimated to be 1150 funds strong, and managing about $175 billion in assets. The underlying Asian financial markets were (and continue to be) a key driver of this growth, offering not only a broadening and deepening opportunity set but also returns not fully correlated with those from other emerging market allocations; the Eurekahedge Asian Hedge Fund Index has returned 170% since January-2000, with the first 10 months of 2007 seeing some of the best annual gains in the past five.

Funds investing in Greater China (60%), India (35%) or emerging Asia (23.4%) in general have seen the best performance for the year to date, largely owing to the rallying markets in these regions. Save market corrections and an associated up-tick in volatility in late-February (triggered by the Chinese governmentÆs attempt to rein in growth by making it more difficult to purchase equities on margin) and again in July/August (as distress in the US credit markets spilled over into other asset classes and regional markets), these markets were characterised by robust corporate earnings results, rallying equities, high levels of M&A activity, and resilience to market movements elsewhere. As a result, the best-performing funds also tended to be those employing opportunistic (22.8%) and equity long/short (23.4%) strategies, or a combination thereof (30.4%).

While the quality of returns is the highest among Latin American funds (a return-to-risk ratio of over four times), this is evidently not the case on a comparison in absolute terms. The broad conclusion is that returns from Asian hedge funds are significantly better than those from their peers in other regions û an Asian hedge fund picked at random generates over 15% in returns 50% of the time, while the probability of similar returns from a randomly selected European or Latin American fund is only about 25%. Furthermore, the said Asian fund would offer comparable risk-adjusted returns, on average.

Asian markets are, on average, conducive for superior hedge fund returns. Can better returns be sought from other modes of alternative investment in Asia? In other words, assuming ready investor access to all three modes of investment surveyed, is it the region or the how one allocates to the region that has a bearing on returns obtained? To this end, we carried out a comparative analysis of average past 10 monthsÆ returns similar to the one detailed in the previous section, among Asian hedge funds, (long-only) absolute-return funds, and funds of funds.

Evaluated purely on absolute performance, long-only funds are the investment vehicle of choice in Asia, with mean returns at an impressive 27%. But on a risk-adjusted basis and also in terms of bottom-quartile returns, Asian hedge funds prove to be marginally better. Furthermore, long-only funds benefited from largely bullish trends during the period under consideration.

Asian funds of funds too have their merits, offering a much tighter spread of returns than the other two, and indeed better bottom-quartile returns than Asian hedge funds û an investor allocating to a randomly selected Asian fund of funds is ensured returns of 8% or more 75% of the time, whereas the probability of similar returns with a similarly selected Asian hedge fund is lesser.

Of course, in reality, the choice of investment vehicle boils down to their accessibility (especially the better-performing ones) to investors.

As is evident from the discussion so far, the first ten months of 2007 have witnessed very impressive returns among Asian hedge fund allocations. The markets in November continued to be characterised by volatility, given that third-quarter earnings news have not yet been fully reported and that the extent of credit exposure among major investment banks and bond insurers remains uncertain. The Federal Reserve, on the other hand, has met market expectations in its meeting of October 31st by announcing a 25 basis point cut in its short term interest rate, while also identifying the risk of an economic slowdown on the one hand and inflationary pressures on the other (given surging oil prices, which breached $100 per barrel during early November).

We expect volatility to persist in the coming months, and believe this to be a positive trading environment from a hedge fundÆs perspective. Our outlook of the Asian markets for 2008 is optimistic, with India, China, Korea and a few ôemergingö emerging economies in the region continuing to display strong macroeconomic fundamentals. This set of factors promises opportunities on both the long and short side for equity-focused managers, as the market swings overshoot specific names in one direction. Clearly trending markets (India, China etc) and asset classes (energy, forex etc) both afford an expanded opportunity set to trend-following and opportunistic managers.

Allocations to Japan, on the other hand, did not fare as well for the year to date, with the region witnessing fund outflows to the tune of $8 billion, and the year to date returns of the Eurekahedge Japan Hedge Fund Index at -0.7%. This is, in the main, a case of an absence of confidence in the markets rather than of any fundamental deficiencies. We expect the resultant cheaper valuations to bring in at least spurts of activity in the coming year, as evidenced by the announcement of several multi-billion dollar deals in JapanÆs property markets slated for 2008.

Our outlook on the growth of the Asian hedge fund space in the coming year is, by extension, similarly positive. With Asian equities as a whole up over 30% for the year so far (going by the MSCI Asia index), while over 50% of the funds surveyed only returned under 15% each, many investors will re-evaluate their allocations. Funds with large global and emerging market mandates continue to set up offices in Asia and/or increase their allocations to Asia.
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