Emerging markets pose regulatory obstacles and provide fewer trading options but offer the biggest opportunities.
When Lou Gerken first started investing in Asia in the mid-70s as an investment professional at London’s GT Capital, Sony was a small-cap stock and Japan was considered a risky, emerging market. Today, Gerken is chairman of San Francisco-based hedge fund Gerken Capital, a registered investment adviser with $1.4 billion under management in alternative assets, and Japan is now considered one of Asia’s mature markets, along with Australia, Singapore and Hong Kong, on par with the US and Europe,
“Hong Kong and Taiwan are completely G7-compatible,” says Gerken. “Administrative and operational infrastructure is in place and being rapidly developed.”
The pace is even faster than in the West because Asian companies typically buy the latest technologies, leapfrogging over entire generations of development. Three to four years ago the equity derivatives market in Taiwan did not exist. “Today, it’s the third-largest market in the world,” Gerken says. “In the blink of an eye, things are changing very quickly in these markets.”
In general, the developed Asian markets are open to foreign investors, make it easy for money to move in and out, offer open access to the exchanges, are well-regulated, and offer hedge funds a variety of options when it comes to trading technologies, such as algorithmic trading and analytics.
However, Asia’s emerging markets, chief among them India and China, pose regulatory obstacles, offer less transparency and fewer trading options, and otherwise make life difficult for hedge funds. But they also offer some of the biggest opportunities.
In China, by comparison, brokerage firms lag far behind their foreign counterparts in the tools they offer to institutional investors—and foreign firms are not yet allowed to enter the market, except for a couple of limited joint ventures.
Four regions—Australia, Hong Kong, Japan and Singapore—account for over 95 percent of hedge fund assets in Asia, according to Neil Katkov, group manager of Asia research for Boston-based consultancy Celent. The largest centers for hedge fund activity are Australia, with 30 percent of assets, and Hong Kong, with 35 percent. These four Asian markets are also among the top 10 global locations in terms of total assets and among the top six in terms of performance over the past three years, according to a report from the Alternative Investment Management Association. International hedge funds, such as Barclays Global, invest in Asia, and so do specialized emerging market funds. And Japan, Hong Kong, Singapore and Australia also have their own home-grown hedge funds.
But Katkov expects that Hong Kong will dominate, growing to 45 percent of Asian hedge fund assets by 2010, as a result of the growing market in China. The smaller hedge funds still tend to rely on their brokers for technology, using Bloomberg, Excel spreadsheets, broker-provided tools and telephones, Katkov says. However, according to websites like SoFi, larger hedge funds are investing in high-end trading technology, and hedge funds are driving the growth of algorithmic trading in Asia.
“It is difficult to predict the China situation due to the regulatory uncertainly there,” he said. “A likely scenario is that Hong Kong-based managers rather than China-based funds will account for most of the hedge fund investment in China.”
Japan has also been losing ground due to onerous tax laws and reporting requirements, he says, which have prompted many hedge funds to relocate to Singapore. Japan’s Financial Services Agency, the country’s stock market regulator, has extensive authority over a set of regulations that is considered opaque by international standards. As other countries continue to modernize, Japan becomes less attractive by comparison, Katkov says.
Barriers to Trade
While it’s relatively simple to connect in Europe and the United States to the big exchanges and electronic trading venues and figure out various regulatory regimes, that is not always the case in Asia, says Russ Rausch, EVP of global buy-side sales at Chicago-based Trading Technologies International, which develops high-performance derivatives trading software. “In Asia, you have to sort out all of those issues—what you can trade, what you can get electronic access to, through what brokers, what vendors connect to what, how good is the technology. It’s just a lot more complicated on all fronts.”
Trading Technologies, for example, connects directly to the Sydney Futures Exchange, and the Singapore Exchange, and will be linking to the Osaka Stock Exchange by the end of this year. Not all markets are as welcoming. The most common solution is to work with a broker, and the broker then sorts out the regulatory problems, gets access to the exchanges, and installs trading software from vendors like Trading Technologies, which claims 16 of the top 20 brokerage firms as clients.
Asian exchanges have long been geared to serving local needs. Even for electronic trading, which has been available in many Asian markets for years, the focus has been very regional, said Robbie McDonnell, Trading Technologies’ managing director for Asia-Pacific sales. This is starting to change, however. “Exchanges now recognize the importance of the global nature of the market and are working to expand and attract liquidity from other regions,” he says. “For example, 50 percent of the open interest on the 10-year bond contract on the Sydney Futures Exchange is now held by offshore customers.”
New York-based trading technology company Portware also recently opened a Hong Kong office to support a growing Asian client base. “We have seen a rapid growth in demand from both global and regionally based buy- and sell-side firms for multi-asset trading systems,” says Scott DePetris, global head of accounts.
In Asia today, hedge funds execute 9 percent of their Asian-share trading volume electronically, and that figure is expected to jump to nearly 30 percent by 2009, according to research firm Greenwich Associates, based in Connecticut. “Hedge funds are staffing up in Asia, and in many cases they are transplanting traders from New York or London to Hong Kong or Singapore,” says Karan Sampson, the firm’s hedge fund specialist. “Those who have been accustomed to trading electronically will naturally pull some electronic knowledge into the Asian marketplace.”
Today, Gerken has offices in Shanghai, Shenzhen, and Beijing, Hong Kong and Taiwan. The reason? To get close to the nascent opportunities in China. Like many others, Gerken must work through partners to get into China. The Polaris Group, a joint venture partner, handled the government approvals necessary to open an office in mainland China. And Gerken’s primary broker, Citicorp, obtained the quotas necessary to move money into China and invest on the domestic stock market.
Gerken says that his fund is also applying for government permission to invest in China directly through the Qualified Foreign Institutional Investor program. Currently, only about 50 firms are approved to bring money into China and invest it in domestic stocks, with significant limitations on the kinds of investments they are allowed to make. The approval process is long and by no means certain.
“Most investors are primarily investing in China-domiciled companies that have listed their companies on the Hong Kong market,” Gerken said. For those companies that get access to China, either on their own or through their broker, there are no local hedging instruments, no direct market access, no algorithmic trading. E-trading tools and back-office services are available in Hong Kong, Japan and Taiwan.
By comparison to China, India is blooming when it comes to hedge fund activity. “Foreign investors can move money in and out of India without any obstacles,” Gerken says. There are some regulations limiting what percentage of a company can be owned by foreigners, but for the most part these impediments are transparent and clear.
However, in other ways, India is much like China, in that it is still primarily an equity market. “The fixed income, derivatives and foreign exchange markets are developing quickly but are not as developed and accessible as the equity markets,” he says. As in China, most hedging of Indian investments has to take place offshore, though some hedges are available in the form of indexes, options, and futures, and exchange traded funds (ETFs). “The ability to directly short a stock in China or India is prohibited,” he says.
Gerken is setting up an Indian fund now and expects it to be active soon. He is working through a company based in Mauritius. “Most of the hedge funds that operate in India do so by way of an offshore entity,” he says.
The Securities and Exchange Board of India (SEBI) is currently considering asking hedge funds to formally register with the regulator. About 30 percent of all foreign institutional investment into India is from hedge funds, according to the agency. SEBI is expected to issue a ruling on hedge fund registration soon.
—Rachel Liu and Maria Trombly
Asia hedge funds AUM:
2005: $101 billion
2006: $132 billion
Growth rate: 30 percent
Japan, 2005: 29 billion
Japan, 2006: 31 billion
Emerging Asia, 2005: 72 billion
Emerging Asia, 2006: 132 billion
Total funds in Asia, 2005: 847
Total funds in Asia, 2006: 1,032
Japan, 2005: 217
Japan, 2006: 241
Emerging Asia, 2005: 630
Emerging Asia, 2006: 782