What did we learn from the downdraft?

Richard Johnston of Albourne Partners Asia assesses the data to see how well Asian hedge funds coped with the equity slowdown in 2007

With the exception of Australia, the Asia Pacific region has become very dependent on foreign portfolio flows and liquidity generated by retail investors, as there are not many local investment institutions. Japan with substantial pension assets, has lost its appetite for domestic equity over the past 15 years. Any global liquidity crisis will be amplified in this region even though banks in Asia are underleveraged as are the majority of hedge funds.

The days leading to 17 August suggested that liquidity was being pulled. The region’s equity markets were down 11.99% including Japan and 14.75% excluding Japan. However, once the Fed cut the discount rate, Asian markets followed the euphoria of global markets, and then some, with many markets setting new records by the end of October.

August 2007 could have been disastrous for hedge funds if the month had ended in mid August. The V-shaped recovery brought the monthly August numbers back from panic levels for many funds and the drawdown was largely contained. Funds that did nothing during the sell down ended the month showing positive returns; the more trading-oriented funds that were quick to act by cutting positions fared worse. They were not able to participate in the recovery as it happened just too quickly. Every hedge fund portfolio is different, but if we have to generalise about typical returns of a global diversified portfolio, we would say that such an investor was down 1-2% in August, made it back in September and is up 8-10% year to date, with October returns looking good.

This is not to say that there was no pain. As a broad strategy, quantitative equity market neutral suffered the most. In hindsight, this can be pinpointed to the weight of invested capital and the leveraging of what were diminishing returns. Many of the more leveraged players had no choice but to stop out even though prices were at absurd levels; the less leveraged could hold on and enjoy the recovery. A similar phenomenon also affected CTA funds and other systematic strategies. On the other hand, credit strategies, which seemed to be in the eye of the storm, were not all bad. Obviously, vehicles created for distributing structured credit in a hedge fund format were the high-profile victims, but many credit managers were well prepared and well hedged. In many respects, most of the hedge fund world seems to have largely avoided the pitfalls that have caught out both the banks and investment banks.

If there is a lesson to be learned about global hedge funds in August, it would be about the risks of employing excessive leverage and the dire consequences of being a forced seller. Many such strategies were traditionally perceived as ‘low risk’, but it is clear that diversification is a more genuine way of attaining low risk in a hedge fund portfolio. Leverage is often a symptom of diminishing returns and increasing real risk. This may not be apparent in short-term price action.

Anecdotally, we are aware that many of the managers in the region had drawdowns close or into double digits. Two thirds of the region’s funds are long/short equities and many had increased their net long bias through the bull market. In hindsight, the best return came from doing nothing or even buying more. But is this what we expect hedge fund managers to do when down 10%?

It is hard to find good indices to define hedge fund performance during this period. Most of the larger funds do not report their data and there is a strong bias in indices to small high beta managers. To give more of an institutional investor’s views, I have summarised composite returns of significant funds for two groups of strategies: pan-Asian long/short and pan-Asian multi-strategy, the two largest.

Pan-Asian long/short managers

The overall average year-to-date return at the end of July was up 18.86% followed by an average loss of 3.67% in August, profit of 4.63% in September giving 19.76% YTD (see table 1). Behind the headline numbers there are some very different stories. Around 25%, and typically with the worst August results, were the funds that heavily stopped out. Around 29% made money or had minimal draw downs. However, there is no consistent pattern here. This includes:

those that intelligently positioned in advance; those whose normal book structure afforded a high level of protection; those that bought bravely (or even recklessly); and those that did nothing.

Each fund has its own story on how it handled the month. What is more important is whether the story is consistent as to how it presents its strategy - in terms of stop-loss policy, drawdown expectation and investment style. Consistency is in many ways more important that any one month’s return. There are distinct differences between the funds that handled the 2006 correction well versus that of August 2007.

Pan-Asian managers fall into two main groups: those that include Japan and those that don’t. The performance of underlying markets in the region would suggest funds that allocate to Japan show performance returns approximately half those that do not allocate to Japan, based on the beta. However, we do not see such a pattern in the returns of funds. In fact we see outperformance for funds that invest in Japan, especially over the sell-off and recovery periods. I do not want to over- extrapolate an experience over a few months but I would make a few broad observations:

A pan-Asian manager including Japan was not compelled to invest in a market that was struggling (Japan) when there were better opportunities around the region; Japan has often been used to provide more liquidity on the short side and many use it as a ‘funding market’ to provide shorts with less risk; and many never intended to weight it by market capitalisation.

By any measure of the performance of these funds against the underlying markets including Japan, performance has been impressive, beating the market upside even after giving back some alpha over the correction.

The pan-Asian ex Japan managers have a much tougher benchmark. They obtained 77% over the market upside before the correction, but this was eroded down to 44%. Given that the range of net market exposures would be from +30% to +80%, it looks like most of alpha previously generated was wiped out over this period. However, we understand that managers have generally participated aggressively in October’s rally, so the numbers may improve.

These observations would support the following conclusions. Long/short funds do not handle short-term liquidity corrections well and few provide a high degree of protection. In high momentum environments much more alpha comes from country and theme selections and pure stock selection alpha is difficult.

Pan-Asian multi-strategy managers

Within this group we have included more broad-based multi-strategy managers and not ones overly dominated by a single strategy such as convertible bonds or options. However, the majority of strategies in Asia still tend to be more equity related than their global peers. This group tends to produce more stable returns, averaging in the 15% range, through a broader range of market conditions. There is still often a long bias, but rarely over 30% and this is mainly due to the inherent long bias nature of many events. Use of options is much more extensive and most will have neutralised their long bias to potential market falls.

The first observation is a rather obvious one. Despite most being long put options to protect the downside in August, they did not make money. However, while a typical long/short fund had an extremely poor mid-month valuation, the multi-strategy funds tended to be in a much more controlled position. They also had a more rigid culture of de-risking the portfolios. Had markets not bounced, the differentiation over long/short funds would have been much more obvious.

As with long/short, the de-risking process did ultimately cost alpha. We suspect that the multi- strategy funds might not have de-risked quite as quickly as the cost of option protection has been high and remains so.

The other main strategies

Japan long/short - After losing money in a difficult 2006, funds had made small gains in 2007 but this was wiped out with around 3% losses in August 2007. The market seems to participate in all the downside but enjoy very little of the upside. When this is combined with perceived anti shareholder attitudes and a political logjam, most investors have just capitulated and redemptions have been very high.

Long volatility - The more pure option based strategies were generally the star performers of August 2007. Volatility was cheap going into the sell-off and has been high since, with few signs of coming down. Convertible bond strategies lagged in August because, being securities rather than derivatives, they are affected by asymmetric supply/demand profiles. However, they are generally having a good year due to higher volatility.

China long short - China funds almost broke even in August 2007, but this says very little about their risk management and more about the extraordinary behaviour of the China market. By mid-August drawdowns would have been close to 20% and very few stopped out. We need to remember most of the funds in this asset class have only thrived in the bull market and because they are heavily long biased. Many managers may be good stock pickers but this is clearly a market in need of a lesson in risk management.

India long/short - Many of the China points also apply to India but to a lesser extent. Again the Indian managers lost very little in August. More of the managers have benefited from the experience of a more challenging 2006. While the extent of hedging in the market is still quite limited, there is a much harder valuation support than in the case of China.

 The lessons

The lesson I fear the market takes from this is: “Once again it proves we are in a long-term bull market and the wrong thing to do is to stop out. Every correction is an opportunity to buy on dips.”

There is always a risk that the collective memories are only as good as the last correction, yet in truth each one is different.

The lesson I would like the market to take is: “By mid-August I felt like a “beached whale”. I was helpless but luckily bailed out by the market. I never want to rely on luck again.”

I personally think we should expect more for our two and 20 fees.