Asia's booming hedge fund industry will be tested in the coming year by heightened volatility that will catch out less talented managers who have coasted along on the multi-year bull run in regional stock markets.
Investors may be best off betting on the small but growing number of Asia-focused managers who use options and other trading tools to profit from heightened market turmoil, hedge fund executives said this month.
But given the limited number of players in this space compared with the more developed US and European markets, they may simply have to be more selective when investing in Asian hedge funds, most of which bet on stocks and tend to do best when prices rise.
"In theory, volatility is the hedge fund's friend as they can make money on either side. More volatility in the markets should actually give them more opportunities," said Scott Lothian, head of manager research for Asia ex-Japan at investment consultant Watson Wyatt World-wide.
"On the difference between a manager who does well and one who does badly, I think you'll start to see that gap widening. There are fewer places to hide," he added.
Asian markets rallied on September 19 following a bold half-percentage point interest rate cut by the US Federal Reserve aimed a shielding the US economy from a housing slump and the impact of global financial market turmoil.
But lurking in the background are a range of potential pitfalls for markets, including record oil prices, inflation pressures, the risk the latest cut won't revive US growth and potential for further bad news from financial institutions.
Hedge fund executives at a recent conference in Hong Kong said given the range of uncertainties, the best bet for the year ahead is likely managers who can be "long vol", using derivatives to profit if volatility remains high.
For example, a fund could buy options on a stock index that are out of the money, betting they would turn profitable if the index jumps or sinks by a large amount.
Lau, whose firm managed about $2.3 billion at the end of June, also thinks fixed-income arbitrage funds will provide attractive risk-adjusted returns, given the likelihood of a steepening yield curve in the region.
Among equity-focused hedge funds in Asia, the best risk/reward should be found among those geared to continued volatility, Daniel Wang, a portfolio manager with fund of hedge fund manager Vision Investment Management, told the event.
Data shows most Asian hedge fund managers pursue a relatively straightforward long/short equity strategy, in which they mainly buy stocks they hope will selling short others they think will fall.
Research firm Eurekahedge said of the 1,150 Asia-Pacific focused hedge funds managing $155 billion in its database at the end of July, about 58 percent of assets were managed using an equity long/short strategy, compared with 30 percent of US focused hedge fund assets.
And macro and fixed-income arbitrage strategies each count for just 3 percent of Asia-focused hedge fund assets, roughly half the level of hedge funds playing US markets.
Some industry analysts have complained that too many Asian long/short hedge funds are really long-only managers in disguise, offering little downside protection when markets sink.
They point to the poor performance of many Japanese managers last year funds last year, when a meltdown in small-cap stocks showed few had properly hedged their portfolios.
Hedging can be a major challenge for many Asia-focused managers because of the high cost of shorting stocks outside of Japan and Australia. Markets such as South Korea have imposed onerous and complicated rules on the practice, while China bans it outright.
The futures and options markets needed to place sophisticated bets that profit from volatility are also less developed than in London and New York.
But hedge fund executives said the challenges of finding a way to bet on further market turmoil in Asia and elsewhere are likely to be worthwhile.
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