Friday, 5 February 2010

Problems and Solutions in Investing with China-based Hedge Funds

This blog has been running for four months and this is the first posting to mention China. At the start of the year as strategists and economists gave outlooks for 2010 it was all about China. Anthony Bolton, after a career as a London-based fund manager at Fidelity dedicated to UK equities, has come out of retirement to run a Chinese equity fund and is to be based in Hong Kong. As a destination for investment, the popularity of China-focused funds is certainly on the rise. Sales of China-focused funds via Fidelity’s fund platform, FundsNetwork, increased by 59% in 2009, while sales into Fidelity’s China Focus Fund alone increased by 239%. That is how enticing China is as an investment destination. However, whilst  there has been a China theme to many investment portfolios, and the largest hedge fund companies have opened Hong Kong or mainland China offices, Chinese dedicated hedge funds have been something of a side show in the hedge fund industry. This reflects that China is much more developed as a manufacturing centre than a service and financial centre.

So China is recognised as  representing the largest global growth opportunity on a multi-year basis, but immature as far as the financial sector and capital markets are concerned. The Chinese equity markets represent a rich opportunity set, as do all frontier markets, but in this particular case, partly through cultural considerations, they can be difficult to access successfully and sustainably and with as much confidence in the execution as in the high concept. The practical difficulties were recently addressed by dedicated hedge fund site, using comments by GFIA as a springboard.

The rest of this post is in two parts: the article from Chinahedge, which has been re-written but not changed in shape or substance, and in part two a full, considered response from London-based Fund of Funds manager Caliburn Capital Partners, which targeted exposure to the China theme some years ago, and which has supported exposure in the region through a Singapore office.

Part One - The Problems

The investability of mainland China based managers has become an issue, as reflected in the decision by Singapore-based research firm GFIA to stop covering and investing in hedge funds based in mainland China. It has largely shifted its coverage to western-trained managers based in Hong Kong. As an example of the issues investors face it cites that on a number of occasions China-based hedge funds would not reveal the identity of fund backers or the background of portfolio managers.

Compliance issues

The majority of offshore Chinese hedge funds are run from Hong Kong and the mainland China cities of Shanghai and Shenzhen, with very few in Beijing. For those with a Hong Kong office, almost all of them are Hong Kong Securities and Futures Commission-registered.

"At the very beginning of the due diligence process for investors allocating to China hedge funds investors should check to see if the investment manager is regulated, if the fund they manage have independent directors, if the fund is administered independently by a well known firm, and if the firm is audited independently by a top grade auditor." Andy Mantel, founder and CIO of Pacific Sun Investment Management (HK) Ltd, told China Hedge by phone. Andy is one of few offshore Greater China hedge fund managers who is non-Chinese but is fluent in Mandarin having been in the Greater China Region for about 20 years. “Basically all mainland headquartered hedge fund managers fail this initial due diligence test.”

Based on the statistics of China Hedge Fund Managers (Onshore) Database complied by China Hedge, most of the mainland managers (about 200 managers) are only managing local Chinese hedge funds denominated in RMB which are not accessible by global investors. Around 10% of them are running offshore Greater China hedge funds as well. Some have HKSFC-registered operation. Only a few of them have no HKSFC-registered operations which may cause some compliance issues.

Transparency and disclosure issue

GFIA mentioned in its report that those mainland-based managers show "a lack fundamental transparency and openness." It is an issue with some mainland-based fund managers that they are not willing to disclose their real holdings, and they do not have a disciplined risk management either, according to Kaikai Hua, director of a Shanghai-based wealth management company. He said, “normally they have a bet on one or two stocks or PE investments, and cover up the big loss or a liquidity problem until the stocks stop trading, or the IPO fails.”

Before selecting China managers for their US-based institutional clients, Bill Hunnicutt strictly required the Chinese managers must be willing to accept complete portfolio transparency which is now mandatory post-Madoff. Bill is the President of Hunnicutt & Co., LLC which is a placement agency based in the US. Bill said this means showing a current portfolio upon request. “Some larger US institutions require daily transparency via a dedicated website, while others will accept transparency via 3rd party vendors who then provide a general summary of the portfolio to the client.”

Business and cultural differences

There are clear cultural differences between local managers and global investors. Most local managers come from mainland mutual funds and securities firms. They are accustomed to running funds to a local standard, not those expected by global investors. “If the local managers do not tell you the companies they hold because they do not want others copy the idea. Knowing something early than the market is an important way for them to make money", Kaikai said.

The cultural differences may be exacerbated by communication problems. Most local managers are not comfortable to talk and write in English, so, the email reporting and newsletter that foreign investors in hedge funds expect may not be produced on a timely basis, if at all. “They would rather not say anything than express something badly. It takes a while for investors to fully communicate with these managers.” Kaikai said.

So local Chinese managers have something to learn in terms of the normal global practices and standards of running a hedge fund, as recognised by international investors. It has been suggested that mainland Chinese managers of hedge funds would benefit from getting together on a regular basis to share some thoughts of running a hedge fund business – a draft practice for participants would follow. Some managers recognize that there is a trend of increasing allocation to China-based managers, and in response they have recruited Chinese partners who are Western-educated and/or have worked for Western companies so that they can acquire that necessary knowledge about the standards expected by global investors.

Changing regulated status

The current Chinese law has regulated Chinese mutual funds, but these regulations do not apply to onshore Chinese hedge funds. According to MarketWatch published by Citi Securities and Investment Services dated 17 December 2009, the mutual fund law review workgroup, set up by the China Securities Regulatory Commission, has reached an agreement to include privately-raised funds as regulated mutual funds in the revised Mutual Fund Law.

Li, Zhenning, Chairman of Shanghai Rising Fund Management and the member of the mutual fund law review workgroup suggested that the regulator release licenses on privately-raised funds (commonly called local hedge funds) in the future. Investors, thus, can expect better regulation of local hedge funds in areas such as transparency issue and information disclosure.

Comparative advantage of Chinese-speaking CIOs

”Some local CIOs are sound managers. They know what they are doing, and what risk they face. Despite the lack of transparency and absence of rigid risk control systems, mainland-based managers have a big advantage in that they know the market well. They are more alert to the growth engines in the market, as well as problems in the companies. They spend more time talking to people in the street, and ask what they think of a product. It’s much easier for them to get access to companies too,” Kaikai said.

To combine both HK and mainland managers

“Hong Kong is by far the best place to manage a China fund. Aside from the unparalleled infrastructure and regulatory environment, the free flow of instant, uncensored information is vital when making investment decisions.” Andy Mantel said. “Research activities on the mainland can only add value if it is a supplementary research and information gathering office in support of the manager's headquarters,” Mantel emphasized.”

Kaikai Hua states that Western-trained managers based in Hong Kong have a different strategy. Most of their holdings are big names and liquid stocks. They perform better in a bear market or when market is in a correction. And they have a better understanding of tools for hedging. “We see that one side are stock pickers, and the others are portfolio manager.” Hua suggests that clients combine both, so that they can enjoy the advantages each offer in accessing the growth of Chinese market.

Chinese hedge funds are growing

There is a strong case to be made that the Chinese hedge fund sector is becoming more significant within the global hedge fund industry. Many institutional investors have started to monitor and even allocate to Chinese hedge funds in their global portfolios. “We should not neglect the China market” is the common belief of most global investors.

The booming equity market has helped the growth of industry assets. The industry recorded encouraging growth figures last year. Chinese onshore hedge fund managers launched 242 products in 2009, according to a report by Chengdu, Sichuan-based Sinolink Securities Co Ltd. The average size for every fund was about 90 million yuan ($13.2m), the report said. The 151 non-structured hedge funds returned 54% on average in 2009. As the end of 2009, the local China hedge fund industry reached around RMB 50 billion ($7.4bn). Zhang Jianhui, Director of Fund Research with Sinolink Securities, said at the Sinolink Hedge Fund Forum last Saturday in Beijing that the hedge fund industry of China would manage about RMB 100 billion as at the end of 2010.

Part Two - The Solutions

Thank you for giving us the opportunity to respond to Peter Douglas’s comments. Whilst we acknowledge that Peter is well respected in the industry and has a long track record as a specialist on the Asian hedge fund industry as a whole, we would take issue with his view that mainland based managers are not transparent enough for investors to assess them properly from a qualitative perspective.

For the sake of clarity, what we mean by “mainland based managers” are those where the Portfolio Manager is generally based in China, may or may not have a Western background or speak very good English, but will have a Hong Kong office (or other location outside the mainland) and will be registered with the SFC in Hong Kong (or equivalent in other jurisdictions). This group includes some of the most well known and longest established Greater China hedge funds and all of our comments below are based on this group of managers. (There is a second group of mainland based managers who don’t have an investment management company outside of the mainland but who offer offshore products. Caliburn does not invest in this second group of managers because the law is not clear if mainland based funds offering offshore funds should be classified as Permanent Establishments, which would mean the fund and firm would be subject to tax. Currently we are seeing the market leaders in China’s mainland fund management industry, who are in the process of launching offshore products, all setting up offices outside of the mainland in Hong Kong.)

Bearing in mind the definition above, we have built an extensive peer group of mainland based managers who we monitor and from whom we receive regular updates. In our view, some of the strongest Chinese research teams from both a bottom up and top down perspective are mainland based. Their research edge comes from their ability to pay significantly more than the established, large local mutual funds so they can hire the best research analysts. We also find that in these teams there are more analysts with direct industry as well as buy or sell side research experience which provides an additional research edge.

These managers generally provide monthly reporting which is of a high standard with good portfolio level data, and they are happy to speak about the portfolio composition and their market views in some detail. If there is a problem it may be that some of the larger managers ($300m AUM or above) may be reluctant to offer transparency to other than significant investors. Equally, bottom up stock pickers may be reticent to elaborate on their rationale for individual and current stock picks. However both of these observations can be made of hedge funds in general and are not particular to China. In general we do not encounter these difficulties with the majority of funds. Clearly, full transparency is always available through a managed account with most mainland based managers. Of course, just as in the Western hedge fund industry investors will again need to meet a certain minimum investment size to take advantage of this option.

Of the three mainland based managers with whom we are currently invested, one provides us with probably the greatest transparency of any manager that we follow, including providing the full portfolio twice a month and an enormous depth of insight directly from the CEO and senior investment team. From the remaining two we receive monthly portfolio information with very good transparency such that we are able to establish and monitor all of the key risks and sources of return of the funds.

There is no question that communication is not always easy with mainland based managers. There are often cultural and language difficulties to overcome and few are polished presenters. It is therefore important to have Mandarin speaking analysts but it is not just about language. For Caliburn as a thematic investor, research does not start with the manager; we do a lot of work to understand the underlying market and investment opportunity. This includes attendance at industry and corporate conferences as well as independent meetings with regional thought leaders. The natural result of these activities is that our research team is armed with a good understanding of the Chinese macroeconomic situation, policy news and sector news together with a general knowledge of stocks in key sectors. With this as background it is possible to establish a better relationship with managers. Our thematic work supports very specific and focused questioning and with this approach we have been very pleased with the level of disclosure we have received to date.

In relation to getting comfort with the risk management processes at these firms, as with all peer groups there are funds where we trust the risk management and there are funds where we remain cautious or sceptical. Without question a significant commitment of resources and time is required to regularly communicate with the funds and ask the right risk related questions to form a view. From an operational point of view, the mainland based funds that we have approved for investment have top tier independent 3rd party service providers (administrator, custodian, prime broker, and auditor) and in this respect reflect the best practices of their non-Asian counterparts.

In terms of performance in stress periods, broadly speaking most of the China based managers are bottom up investors and they did not protect the downside in 2008 as much as we would have hoped, though poor performance over this period is a common failing from across the hedge fund industry regardless of geography. We were pleased to see a number of managers sticking to a disciplined valuation approach which meant they were already running low exposure levels before the crisis unfolded. In general terms our invested China managers fared better in the second half of 2008 than in the first half of 2008 and China managers as a group performed much better than their BRIC peers over 2008 as a whole. Importantly, a number of China managers who lost 20% or more in 2008 subsequently made significant improvements to their risk management and their adherence to risk disciplines and this has served them well in months such as January 2010, during which they cut exposure and balanced their portfolio much more effectively than during the difficult Chinese markets of early 2008.

In conclusion, overall the standard clichés apply: you get out what you put in. We commit significant time and resource to achieving a detailed understanding of each manager’s approach. We routinely make multiple trips to interview a manager in his / her office and follow up these on-site visits with a number of conference calls before deciding to bring a manager forward for discussion at our internal approval committee. There are barriers to entry and the investment opportunities may be less accessible as a consequence. However this can make the opportunities more interesting and the barriers can be overcome with a commitment of analytical time and a consistency of approach that reassures the manager that you are serious and there for the long term.

Richard Howard
Caliburn Capital Partners

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