Comment: Sophisticated managers ready to shine in turbulent greater China markets

The Greater China markets, comprising Hong Kong, mainland China, and Taiwan, have had a tumultuous ride over the last few years, with generally strong performance in 2006 and 2007 followed by one of the sharpest corrections on record from November. Contrary to popular belief, however, stellar returns were not universal, and the recent correction dragged with it some areas of the market that never really benefited from the earlier liquidity frenzy.

The GEM index, for example, representing more than 190 small-cap companies on the Hong Kong exchange, rose by 9.7 per cent in 2007, and posted an annualised 3.3 per cent gain over the four years to the end of 2007. As of May 8, the year-to-date performance was down 32.9 per cent – erasing much more than the previous four years’ gains.

Taiwan’s TAIEX index, representing more than USD600bn of a total market capitalisation of some USD4.5trn within the Greater China region, rose by 8.7 per cent in 2007 and recorded a modest annualised 9.5 per cent gain during the four-year period, massively underperforming the Asia region as a whole, although performance this year has been relatively strong.

Mirroring the trajectory of the underlying markets, the universe of Greater China-focused hedge funds grew rapidly over the last few years to more than 100 funds, and performance partly reflected the dispersion in returns across the regional market. According to our internal database, an equal investment in the five worst performing funds in 2007 would have lost more than 2 per cent, whereas an investment in the five top performing funds would have gained upward of 133 per cent.

Funds braving the liquidity-driven rally on the mainland and in Hong Kong-listed China stocks were generally the best performers. Funds with relatively concentrated portfolios of Hong Kong-listed value names, or a distinct skew towards Taiwan, tended to perform poorly.

A few managers torpedoed healthy long-book returns through somewhat undisciplined execution of the short book. Importantly, though, a good number of managers achieved absolute returns well in excess of relevant equity benchmarks with minimal use of leverage. Indeed, many of these managers, although negatively impacted by the correction, managed significantly lower drawdowns than index benchmarks.

Unsurprisingly given the increase in global risk aversion, the Greater China space has suffered sizeable redemptions over the past three months. Fund closures have already started, and for some funds launched last year, wrong-footed by the whipsaw price action and now in negative territory since launch, survival is uncertain and retaining key personnel will be a challenge.

It is worth exploring a common pushback for Greater China, and indeed all Asian hedge funds – that they offer little more than beta exposure with negligible contribution to portfolio diversification. Thinking here is coloured by a widely held perception that Greater China markets remain underdeveloped and that shorting tools are illiquid and few in number. This perception had grounds a few years ago, but is probably a little harsh now.

Hong Kong’s market, the most developed in the Greater China region, had an average daily trading value of USD11.2bn in 2007 (compared with USD20.6bn for the London Stock Exchange 2007), up from USD1.9bn in 2004. The value of short selling transactions, involving more than 400 listed securities, reached USD166bn, while the trading value of derivative and equity warrants was USD602bn. In broad terms, the playing field for Greater China hedge funds does not preclude the successful execution of value-adding strategies.

In an academic study commissioned by Fullerton Fund Management last year, Professor Melvyn Teo of the Singapore Management University evaluated the performance of a universe of Greater China equity long/short funds between 2000 and 2006 relative to an asset-based factor model, finding that betas and correlations were similar to the historical market betas for hedge funds investing in the US. Teo also found that alpha generation for top Greater China hedge funds could not be explained by luck or sample variation alone.

Our own analysis leads us to similar conclusions. However, looking specifically at the implementation of short strategies, we believe some managers strayed too far from their core competence in long-only stock selection over the past couple of years. It has not been easy to make shorting a successful part of any portfolio over the last year, with frequent whipsaw price movements and concentrated index benchmarks catching many managers on the wrong side of the exposure scales, or just hedged poorly against a non-index long book.

Equally, escalating implied volatilities made many hedging tools expensive, and difficult to palate for those with a positive medium-term view on market direction. Anecdotally, one manager commented that after considerable pressure from marketers to justify hedge fund fees, he was running a consistently high hedge in 2006 and 2007 in spite of being bullish on the market.

Indeed, as funds focusing on the region multiplied, there has been increasing pressure to differentiate from the majority of long-bias long/short funds, which in some cases markedly compromised the expression of investment view within a portfolio to serve marketing aims.

In our view, however, the shorting element of a strategy is not the only justification for higher fees, and for strategies with limited total capacity and high risk-adjusted returns, hedge fund fees may be necessary to provide economic motivation to those capable of implementing them.

This year will be a challenging one for managers in the region, but it may also present an opportunity for some to differentiate and demonstrate genuine alpha. It was difficult to lose money in 2006 and 2007, but many funds are down significantly so far this year, with approximately a third down more than 20 per cent for the first quarter. We suspect some managers now shy from increasing exposures, driven more by an instinct toward business preservation (‘We cannot afford to be down another 10 per cent from here’) than an instinct to buy cheap assets and sell expensive ones.

But it isn’t all gloom. A handful of funds in the equity space managed to achieve positive returns both in the five-month period from the end of October and in the particularly difficult month of January. The few genuine Greater China market-neutral funds managed to navigate the downswing well, providing them with the first opportunity to differentiate positively in a couple of years.

Selecting the channels through which risk management was achieved in a portfolio of funds has been important in shaping returns and volatility. In addition to finding managers qualified to run a short-book, funds with inherently lower equity market exposure in strategies like distressed debt and hybrid credit, which were not available a few years ago, now provide useful tools to an investor looking for a broader-based, less volatile exposure to asset-pricing inefficiencies within the region.

And although we expect the long/short strategy to dominate for some time to come, a number of fund launches in other strategies over the past 18 months has helped to diversify the opportunity set. This positive trend is likely to continue, particularly after the effect of a severe multi-month correction on long/short funds in the space was experienced first-hand by investors.

With growing breadth and depth to the region’s capital markets, more sophisticated players are entering the fray, and the number of US and European hedge funds establishing offices in Singapore and Hong Kong bears testament to the expanding market opportunity.