The US$2 trillion hedge-fund industry is facing a triple whammy of margin calls, redemptions and whipsaw prices in markets, as it battles to prove its worth in a financial crisis.
Investors pulled US$1.7 billion out of the asset class in the first two months of the year, according to database provider Eurekahedge. If that was not enough, governments are increasingly banning short selling, which drastically limits hedge funds' ability to profit from falling markets.
"March will be a true test of managers' skills. You can go from hero to zero in a day," said Ed Rogers, head of Tokyo-based Rogers Investment Advisors, which helps pension funds and other big-money managers put cash in hedge funds.
Hedge-fund managers are under pressure to prove that they can provide uncorrelated performance during a market crash, something that the asset class failed to do during the global financial crisis of 2007 to 2008.
A global index of hedge-fund managers' performance compiled by data provider HFR had dropped 110.01 points to 1,169.07 on March 23 from 1,279.08 on February 28, a bigger fall in monthly index value than in October 2008, when the index lost 109.86 points to 1,065.50.
In the decade that followed, hedge funds' fees dropped from a 2 per cent annual management fee and a performance charge of 20 per cent to around 1.5 per cent and 15 per cent, respectively. "2008 killed the 2 and 20 model. Maybe 2020 brings it back," Rogers said.
The average hedge fund in Asia had outperformed broader indices, but was still posting a loss for the year up until February 28, according to the latest available data. And while some investors see that as hedge funds doing their job, others do not want to lose money and are asking where is the hedge in hedge funds?
"This is a major stress test of managers. We'll see as the dust settles who has done their job on a risk-adjusted basis and who has not," said Donald Rice, who is head of fund investment specialists in Asia for Zurich-headquartered Bank Julius Baer.
HFR's Asia excluding Japan hedge-fund index was down 4.09 per cent between January 1 and February 28, outperforming the MSCI Asia-Pacific index, which dropped 8.8 per cent over the same period. About a third of Asian hedge funds have their offices in Hong Kong.
Average numbers hide a motley performance as hedge funds span a wide range of strategies, with some managers more nimble than others. Eurekahedge said performance ranged globally from up 5.29 per cent to down 4.39 per cent in February; investment managers said the dispersion of results has widened significantly in March. Rogers' Japan-only fund-of-hedge-funds was down 2.5 per cent in February. That included one dedicated short-seller up 15 per cent and activists, who are by definition long only, posting losses.
Bank Julius Baer's team of analysts closely monitor a variety of funds, including a US manager who has been doggedly bearish for the past 18 months and is up 12.6 per cent so far in March and up 17.9 per cent for the year up to March 26.
Rice has noticed others who have fared less well. "Merger arbitrage funds have been hurt, for example, as spreads have widened, as 90 per cent of M&A deals are on hold," said Rice, who is based in Singapore. Tough market conditions may force these funds to sell and realise their losses even if they believe that an M&A transaction will eventually go through.
The so-called tail risk funds, which were made famous by Mark Spitznagel's Universa fund, prepare for Black Swan events such as the Sars-CoV-2 virus, which causes the disease known as Covid-19 and has killed more than 23,000 people around the world.
Some investment advisers were sceptical that these funds were worth the wait. "It's very rare to see these funds successfully pull it off when you need them to. What you usually see is a gradual erosion of value in wildly out-of-the-money options over time," Rice said.
There are few such funds in Asia. About half of Asian hedge funds by assets under management are long-short equities funds. Most marketed themselves as a play on the Asian growth story during the 11-year bull market stretching from the end of the global financial crisis to March.
"Long-short funds tend to be more long than short. Being short or hedging usually cost investors in the previous rising market," said Allen Veryan, head of machine-learning investment at a family office in Tokyo.
Another drawback for hedge funds in Asia is the shortage of data in digital format across the region's patchwork of markets. Technology-driven funds that rely on data have been ramping up in Asia in recent years. New York-headquartered DE Shaw launched a systematic futures fund in September 2019, its first onshore investment product.
"Many hedge funds tend to use recent years' data but what has happened in the past decade? Markets have primarily gone up in those years," Veryan said. "There are a lot of similar algorithms trading the market, which could potentially aggravate market movement."
Even if hedge funds do manage to outperform, they still face challenges outside their control.
Hedge funds borrow from investment banks to juice their performance. During the global financial crisis banks tightened the amount of credit they were willing to offer, asking funds to deposit more capital in their accounts, forcing hedge funds to sell investments to make repayments. Hedge funds across Asia have been deep in conversation with their counterparties at investment banks to try and forestall such a repeat performance, said market sources.
So far, Lyn Ngooi at JPMorgan said, she has not seen any failures to meet margin calls. She put it down to a more robust banking system than in 2008 and hedge funds using less leverage. Quant funds, which select securities using advanced quantitative analysis, for example, often leveraged their capital 10 times before 2008 and are now around half of that.
"Funds learned from 2008 and have focused on securing stability of funding. Also while there will likely be an uptick in redemptions, many funds are on a quarterly " or even longer " redemption schedule," said Ngooi, who works in the Wall Street bank's Asia-Pacific hedge-fund solutions team based in Singapore.
Governments are also raising barriers for hedge funds. South Korea, India and Indonesia among others have curbed short selling in Asia.
When the market storm abates, hedge funds should be more profitable, particularly in areas such as distressed debt funds. The steady upwards grind between 2008 and this year becalmed many hedge funds and made bearish managers unpopular.
In the short term though, Ngooi said: "There's no place to hide."
This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2020 South China Morning Post Publishers Ltd. All rights reserved.
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