The following article first appeared in the November 2008 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you canÆt find on our website, please send an e-mail to: [email protected]

Hedge funds may be remorselessly absolute-return driven, but fail to achieve their goals in a year where markets have been down, down, down. AsiaÆs weighting towards the long/short hedge-fund strategy has resulted in a challenging year.

Coming after the bull market in 2007, this year of mass destruction has provided an especially rude awakening. However as a rational excuse, æthe woeful marketsÆ has considerable limitations for explaining poor performance. This is because hedge funds say they can make money in both up and down markets, and they can swiftly bias the fund to the short side in most of the larger, liquid Asian markets.

At least, they could until September 2008, when shorting restrictions were slapped on by stock exchanges. Asia-Pacific exchanges for the most part did not blink, and with the exception of Australia and Taiwan, shorting here did continue, albeit in the truncated form and with the limitations characteristic of AsiaÆs markets.

The position we have now arrived at is one in which macro conditions, and market beta, is influencing everything. Any advertised ability to pick individual stocks is becoming moot as the macro tidal wave inundates every corner of the market. Even stocks publishing upbeat news find themselves dragged down on their good news day by broad-based falls across the general index. Going short would be the only moneymaker, even for companies with strong fundamentals. Liquidity is going down the plughole and the theory of economic decoupling has been comprehensively debunked.

ôThis is a quest for liquidity that easily exceeds the Asian financial crisis a decade ago. Financial markets are becoming more coupled, and even innocent Asia is not spared the axe,ö says John Lord, the managing director of Ginger Capital in Hong Kong.

He notes that given this background of margin calls and redemptions, shorts have been squeezed and longs have been sold off, in some instances in an indiscriminate fashion.

During disorderly retreats the natural self-preservation tendency is to run and hide, that is to say, for managers to adopt low exposures and retain as much cash as possible. ôThis is what I believe most managers have done,ö Lord says. ôIt is the foolish ones who stand and fight.ö

That said, he expects Asian markets to hit bottom in advance of local economies, which are going to require time to shake off the effect of recession in the West and the impact of mass de-leveraging.

Looking for re-entry

Hedge funds with a trading mentality appear to be faring better. Momentum approaches, even over very short time spans, are hard to accomplish, because markets reverse direction sharply on a day-to-day basis.

ôDuring the treacherous markets this year, we have performed relatively well, with September month to date at a positive 2.63% and year to date at negative 9.97,ö says Vikas Gattani, managing principal for Progress Capital in Singapore. ôThis is due to keeping the portfolio nimble and having a trading approach. In addition, the focus on large caps has helped. I believe that these directionless and choppy market conditions are likely to prevail over the next six-12 months at least. Having that nimble trading approach is essential in such markets.ö

In terms of investment, and going long, it is inevitable that there are going to be re-entry points, possibly a series of huge daily index rises dispersed throughout the near future. Every hedge fund is going to want to nail those entry points and trade around them. Staying out of the market waiting until the storms are clear is of no use to them.

ôOur directional models are very bearish on Asian markets, and macro economic data is worsening everywhere,ö says Robert Howe of the Akamai Pan Asia Fund. ôHowever, our Asian stock long book is filled as valuations are at their cheapest in history this month. To be very net short right now risks losing a lot of money into any rebound. We are consciously neutral rather than maximum short. We want to hold net asset value steady and not bet on continued meltdown at this point.ö

Asia has but a handful of dedicated short-side funds. Artradis runs one, as part of its triptych of Naga Funds. The Naga short fund is up 20% in 2008. Its long-side sister is down about 20%. Positions from both funds are replicated in the third member of that team, the Naga market-neutral fund, which is flat for the year.

No Chinese safe harbours

The region, while suffering intermittent down months, only became irredeemably bad in the months of September and October 2008. For funds operating in markets such as China that still offer no ability to short, and where the managerÆs only alternative is to go to cash, it has been a rotten year.

But most markets in the region have continued to allow covered short sales, including Hong Kong. Hedge funds trading H shares could therefore continue to take advantage of shorting opportunities. Those which have done so have been able to differentiate themselves û making the market turmoil a ôblessing in disguiseö for a minority of fund managers such as Sun Partners in Hong Kong.

Its CEO, Kevin Yip, says the fundÆs strategy has benefited from market turbulence, thanks to an active exposure management and an equal long/short bias, at a time when so many competitors are long-biased.

ôWe run a long/short book, so in some months like July we were net long. Then in June and August 2008 we were net short. In the year to date our net return is close to 10%,ö Yip explains.

China has endured hard times during all of 2008, thanks to a worse bear market than 2004-05. This bear market was so swift and powerful that it did not give many China-focused managers a lot of time to prepare. Those who had pre-empted found themselves in a better position.

ôWe had the foresight in mid-2007 to begin lowering our net exposure, first over concerns about the impact that the global credit crisis might have and second due to stretched valuations,ö says Alan Landau of the Marco Polo Fund in Hong Kong. ôBy the time we saw the first big drop in the start of 2008, we were already at a 40% net long exposure. Our conservative allocation served us well and allowed us to outperform. We have experienced a large drawdown, but much smaller compared to the overall market. Funds that have seen large redemptions have received an unequivocal statement from their investors. We are happy that our investors have stuck by us. Not only are we net subscriptions in 2008, but we have received only one partial-redemption from an institutional investor.ö

The Foundation China Opportunity Fund is down 15% in 2008, which is not bad in comparison to the 60% falls in ChinaÆs A-share market. That fund is watchful for government action emanating from the next Communist Party congress, being held as this story was going to press.

Michael Liang of Foundation in Hong Kong says timing markets on the back of expected government moves is difficult. He reckons any such action taken will not blunt the reality of a slowing Chinese economy over the next six-to-nine months. ôThe China market could bottom out in late 2008 or the beginning of 2009 at the very earliest, however a small year-end rally could be on the cards,ö he says.

That which does not kill me, makes me stronger

So all in all, it has been a tough year for equity long/short, and just at the point when you thought things could only get better, they got worse, with the unprecedented event of the bankruptcy of a prime broker Lehman Brothers, that has tied up its client hedge funds in legal action to retrieve their holdings. Exogenous events such as this liquidation, in tandem with poor performance, might be sufficient to drive numerous hedge funds out of business, particularly in AsiaÆs crowded long/short space.

September saw $31 billion of net drawdowns from the global hedge-funds industry, according to Hedge Fund Research, representing the biggest net capital redemption in the industryÆs history. Another wave of drawdowns can be expected for December. It is inevitable that this will sink many of hedge funds around the world. In Asia, the multitude of long-biased equity hedge strategies are the most vulnerable.

Long/short hedge funds will seek to hang on during the white-knuckle ride through the end of this year. Few hedge-fund managers want to go back to work in investment banking, and in any event, there are precious few jobs left there anyway. Those hedge funds that survive the latter months of this year and more importantly can generate positive annual returns for the period should become the chosen ones that attract capital in 2009 and build assets.

ôPerhaps the most persistent mistake you can encounter amongst investors is the habit of overpaying for the hope of growth,ö says Alain Barbezat, a portfolio manager at Rab Pi Asia. ôThat is something that the sell-side analysts are happy to fuel with over-optimistic earnings forecasts. Even though the evidence of a bubble exists, markets simply donÆt want to hear about any of the bad news and instead prefer to repeat the four most dangerous words in investing, those being either æthis time is differentÆ or æthe fundamentals are strongÆ. This never ends well because hope is not an investment strategy.ö

A violent shakeout is now in the making. Many long/short equity managers in Asia are going to lose their business. But those who survive û particularly the minority which thrives û will be set to dominate the industry.