After an underwhelming start, South Korea’s nascent onshore hedge fund sector has seen steady growth in AUM and returns, with domestic pensions making allocations to the asset class.

The industry has about 24 onshore hedge funds run by 12 domestic asset management companies, says Scott Yoo, head of synthetic prime brokerage at Woori Investment and Securities in Seoul.

“Performance last year was good, with 70-80% [of funds] generating positive returns," he notes.

Total sector assets are estimated to stand at about $2 billion, according to various data sources, with 80-90% of capital run by four firms: Brain Asset Management, Samsung Asset Management, Daishin Asset Management and Truston Asset Management.

Shinhan Investment Corporation research forecasts that industry AUM could more than double to $5 billion by end-2015.

The small size of the market is the result of a gradual and measured opening of the sector by the Financial Services Commission over the past three years.

In December 2011, regulatory changes enabled funds to leverage up to 400% of total assets – up from 300% – and removed a stipulation that required each fund invest at least 40% of assets in companies targeted for restructuring.

However, asset management firms were required to have at least W10 trillion ($9.3 billion) in AUM to qualify for an onshore hedge fund management licence, handing a head-start to the largest domestic long-only players in the market.  

While the initial high threshold helped ensure that the funds would be well-capitalised, they were run by teams with mainly long-only portfolio experience. As a result, some of the first funds to launch in the market posted poor returns and withdrew from the market.

They were replaced by new market players, as securities companies and investment advisory firms became eligible to enter the market in November 2012,  so long as they had AUM of at W1 trillion and W250 billion, respectively.

The exit of weaker funds, combined with a wider and more experienced pool of managers, has resulted in outperformance among a number of strategies.

Brain Asset Management’s Baekdu equity long/short strategy returned 23.4% in 2013, while an Asia ex-Japan equity long-short fund run by Shinhan BNP Paribas Asset Management gained 20.6% during the year, indicates fund data compiled by Shinhan Investment.

By comparison, the benchmark Kospi index returned 0.73% in 2013. 

Inflows to onshore funds are largely from domestic sources. When the sector first opened up in 2011, the first investors were local seeding funds, Korean prime brokers and affiliates of the asset managers running the hedge funds, accounting for about 90% of inflows, says Yoo.

Since late 2012, however, there has been a rise in allocations from domestic high-net-worth individuals and local institutional investors such as pensions and insurance firms, he adds.

“Because of the good performance last year, more [high-net-worth] individuals and institutional investors are showing interest in the Korean hedge fund market,” says Yoo.

Domestic pensions Public Officials’ Benefit Association and Korean Teachers’ Credit Union made their first investments in onshore hedge funds last year, says Miji Son, analyst at Shinhan Investment.

For the industry to gain critical mass in the long term, however, overseas capital will be needed, says Son. At the moment, onshore hedge funds are in a league of their own.

While industry executives say there is little evidence of foreign capital being managed in onshore strategies at the moment, this could change in the near term. One local asset manager, said to be planning the launch of a global strategy by mid-year, is understood to be in talks with overseas investors. 

Ray Nolte, chief investment officer at SkyBridge Capital, a $9.8 billion US-based fund of hedge funds firm, points out that a foreign investor would need to travel to the country to perform due diligence work and get acquainted with the domestic hedge fund market.

SkyBridge has a strategic partnership with Woori Investment and Securities that enables it to distribute its products to the local market. However, it is not running an onshore fund structure.

“It's early days, both from the angle of Korean entities investing capital in hedge funds, as well as [overseas] investment managers running capital in Korea,” says Nolte.  “It’s a fairly nascent market at this juncture, but I do think that is changing.”

*A full version of this article will appear in the April print edition of AsianInvestor magazine.