Alternative Investment Management Association Representing the global hedge fund industry
Citi Global Markets Asia Ltd
A good property investor knows that the three most important factors when investing are location, location and location. This adage can just as appropriately be applied, in general, to the hedge fund industry and the Asian hedge fund space specifically. With the vast majority of hedge fund capital based in the US or Europe, the problem of location for Asia-based fund managers becomes much more critical than just the occasional case of jet lag or staying up late for a conference call, with time zone challenged New Yorkers. The distance problem becomes a race against time for the small manager to have enough assets to break even. For the large manager, it becomes a globalisation decision of when and how to base employees in those capital centres in order to raise capital.
In this article, we will discuss one of the most explosive areas of growth in the industry for hedge fund investing: Fund of Hedge Funds (FoHF).
Follow the money
Over 40 percent of Asian hedge fund managers are based in New York or London (see Figure 1). This may seem a surprising number for those outside the industry. To those inside, this speaks of inertia and being too close to the money, rather than being close to the action;
• inertia, because that is where the capital has been managed from for generations and is slow to change;
• close to the money, because it is easier to gain the trust of an investor if you speak the same language, are from the same culture and are located just down the street, in case something goes wrong.
The paradox of creating and managing a hedge fund near the money, rather than near the market, is that the fund will perform -5.28 percent worse. One study, by the Singapore Management University (Tseo), revealed that hedge funds with a physical presence in the market they trade outperform other hedge funds by 5.28 percent annually. This is a tremendous discount for funds headquartered in New York or London but it exists because having access to large amounts of capital at an early stage of corporate growth, will make or break a new hedge fund. With an estimated $1.4 trillion invested into hedge funds, over half of that is based in the US or UK. What this means for Asian funds managers is that to raise funds, you have to travel (see Figure 2).
Capital-raising target: 2,200-plus Funds of Hedge Funds (FoHF)
In order to maximise fund-raising efforts and minimise the time until funds are invested, hedge funds should concentrate their initial efforts on the Fund of Hedge Funds (FoHF) groups. With over 10,000 individual hedge funds in existence now, an entire industry has grown up around evaluating, dissecting and investing into them. There are over 2,200 FoHFs and they mirror the earlier distribution of investment capital by being heavily skewed to US- and UK-based groups. Out of the thousands of FoHFs, InvestHedge in 2007 listed the “billion dollar” group – those FoHFs with over $1 billion in assets – as a total of 147 companies. Out of these 147 heavyweights, only three are headquartered in Asia and only 27 percent have local representative offices. In order to gain investments from the FoHFs, you will have to convince the decision makers in New York and London. This means frequent flyer miles for both the Asian hedge fund and the American and European due-diligence teams.
While the investment committee might sit overseas for the large FoHFs, the trend is now to have a research outpost based in Asia. This might be a one-man band based in a serviced office, or a small team that interviews, tracks and finds new funds across the Australasian continent. The investment decision will still be made thousands of miles away but Asian funds can now get on the radar screen of investment houses, when they launch rather than when they travel. The direct repercussion of this is that the investment process is lengthened by the distance and time-zone lag.
Asian Fund of Hedge Funds (FoHF) entrants
Each market inefficiency leads to a business opportunity. This is true for the new market entrants in the Asian FoHF space. During 2006, we met with more than 15 newly established Asia-based FoHF companies. These ranged from small groups managing under $10 million to regional asset-management groups expanding their existing business model with hundreds of millions. The business opportunity for the FoHF is the same for locally based hedge funds; being closer to the market action gives a competitive advantage in finding, investing into and monitoring the Asian hedge fund space. These new Asian FoHFs are either targeting the emerging manager segment of new funds, or any Asia focused strategy, or both. In many cases, the individuals that are founding these groups come from the international FoHFs or local family offices that have been in this space for years. This means that while the FoHF companies may be new, the people behind them are usually well known within the industry.
How to find Fund of Hedge Funds (FoHF) Databases
How does a newly launched Asian hedge fund get in contact with over 2,200 FoHFs? A lifetime could be spent “Googling” to find company names or compilation of lists. In fact, if you type “Fund of Hedge Funds” into Google you will get 62 million responses. A good prime broker can assist you in getting you in the front door if you do not have a team of summer interns hacking Google. Another way to gain access to these FoHF companies is by understanding how they operate. Most FoHFs will utilise a database service that will amalgamate hedge fund returns on a global basis. This can be done through a technology provider that costs thousands of dollars or a direct subscription to the database, costing tens of thousands of dollars. For the hedge fund, submitting fund performance is free, simple and amounts to adding one more email address on the monthly newsletter distribution list. It is estimated that only 3-5 percent of hedge funds submit their monthly performance updates to the top five database companies; not to mention the other 25 global and regional databases.
Caveat emptor: The drawbacks of Fund of Hedge Funds investing
Whilst the FoHF industry has become one of the largest, if not THE largest, channels for institutional investors into global hedge funds, it does have its detractors among the hedge funds that receive the investment. The most pressing concern is the reputation, right or wrong, of FoHFs being “fast money”. One investment bank survey reveals that 75 percent of FoHFs will make an investment into a hedge fund within six months. That is great for the hedge fund looking to raise assets. The converse of this is also true, in that FoHFs have to act in the best interests of their investors and may pull the funds out just as quickly. Due to macroeconomic rebalancing, profit-taking or redemptions by their own investors, FoHFs must manage their monthly performance results much as an underlying hedge fund manager does. Too many down months, under-performance or style drift can cause the underlying investor to pull money out of a hedge fund or FoHF. The caveat of the FoHF is that this often has a domino effect on the underlying hedge funds causing redemptions.
Frequent flyer miles
FoHFs are one of the easiest sales channels for an Asian hedge fund manager to target. The simple reason is that you have a salesperson selling to a salesperson. The FoHFs wish to know about a hedge fund just as much as the hedge fund managers wish to be introduced to FoHFs. For the long term survival of a hedge fund business, the investor base must be diversified beyond just one sales channel. The healthiest hedge funds and the ones with the best chance of long term growth are the companies that have investors from across the channels. This allows investors with different time horizons, loss sensitivities and redemption requirements, to balance each other out. “Long-term” money from a pension or family office can be balanced by retail distribution through private banks or structured products. No matter how a hedge fund’s investor base is balanced, an Asian hedge fund manager cannot escape travelling to New York, London and Switzerland. The simple fact is that an Asian hedge fund manager will have to follow the money and travel – so sign up for a good frequent flyer programme and get marketing!