Like the weather and the economy, the financial world moves in cycles. From hot to cold, from boom to bust, from stability to chaos, financial markets seem to gyrate back and forth. But like in the movie “The Day After Tomorrow”, it’s possible for systems like this to permanently switch regimes after it reaches a tipping point. It may still be too early to pronounce a new “normal” in the world of hedge funds, but at least according to one respected commentator, Singapore’s GFIA, has come to the conclusion that the financial crisis has led to a new and “different world” for Asian hedge funds.
In a comprehensive research paper published this week (available with brief registration here at its website), the firm writes that the financial crisis was “the first time the Asian hedge fund industry was put to the test in a major crisis since attaining critical mass in 2003.” The report contains nearly 30 charts and tables that describe this different world and is worth a read, even if you’re not an Asian hedge fund manager.
The report chronicles an upward shift in the volatilities and benchmark correlations of nearly all Asian hedge fund strategies. But some strategies stood out on both counts. To highlight those strategies that had the biggest jump in volatility in the post-October 2007 time frame, we created the chart below using data contained on page 13 of the report. We plotted the pre-October 2007 annual standard deviations of each strategy index on the horizontal axis and the post-October 2007 strategy on the vertical axis. We also added a thick blue line to show where both “pre-crisis” and post-crisis” volatilities were equal and a couple of thin blue lines to show where the post crisis volatility was 50% greater and 33% less than equal.
As you can see, all but “multi-strategy” have a higher volatility in the “different world”. In fact, some strategies like Asian fixed income and Asian equity (including Japan) have a dramatically higher volatility than they did in the old world.
GFIA notes that individual hedge funds that had the highest or lowest standard deviations pre-crisis tended to have the best likelihood of remaining a high or low volatility fund. Still, even funds with mid-range volatility rankings showed a higher propensity to keep their relative ranking after the crisis. The chances of jumping or dropping over 50% (more than two quartiles) in the volatility rankings was very small – suggesting fund can’t totally change their stripes.
Similarly,there’s a lot more beta embedded in returns now that we’re in a different world. The chart below was constructed using data from page 17 in a similar fashion (with light blue lines showing +100% and -50% in this case).
Three strategies actually have a lower correlation to their benchmarks in the different world: Korean Equity, Macro, and Arbitrage. But Distressed/Event Driven and Asian Fixed Income saw a massive relative jump in their benchmark correlations.
Despite these higher betas, intra-strategy fund correlations remained roughly similar to the old world. As in the old world, equity long/short strategies remained high – although the correlation between ASEAN and Korean Equity funds actually fell in the post crisis period. The intra-strategy correlation of non-equity long/short funds remained lower with the intra-strategy correlation of Macro funds actually falling from “moderate to “low”.
Inter-strategy correlations jumped markedly after October 2007 though. As the chart below created with data on page 15 shows the absolute increase in the average correlations with other strategies increased after October 2007. Macro and Chinese Equity saw a better-than-0.45 increase in average correlation with other strategies while Arbitrage saw a very small increase. Note above that this strategy also had a lower benchmark correlation and a similar volatility as it did prior to the crisis.
GFIA found that net exposure of long/short equity funds (which dominate in the region) fluctuated pretty considerably in 2010 despite gross exposure remaining relatively stable. If you’re a long/short manager, you know this can only be achieved if you drop short positions to make room for more longs. As a result, the ratio of longs to shorts is also going to increase. Had gross exposure risen substantially along with the rise in net exposure, this ratio could have stayed roughly the same.
Alas, it did not, prompting the firm to conclude that:
The continued muted gross exposure, combined with a return to historical levels of net exposure, suggest that managers have become more cautious about shorting since the GFC [Global Financial Crisis].
Those who think that falling rates of new fund launches is a sure sign of crisis in the hedge fund industry might want to check out the rate of new launches in Asia. As the industry matures, the rate of new launches necessarily falls. According the GFIA, this has been the case since 2005 and has continued in both booms and busts for the sector.
When you think about it, this makes perfect sense. Any new industry is going to see a flurry of start-up activity in its early years. As successful players become entrenched, it gets harder to shake them loose and barriers to entry rise. So although fund closures peaked during the financial crisis, the launch rate doesn’t seem to have been as greatly impacted.
Since any current analysis of Asian hedge funds is, by definition, an analysis of Asian hedge funds that survived the financial crisis, this study is a study of the strongest funds in the sector. In this way, the culling that occurred in Asia and around the world during the crisis may have accelerated the natural maturation of the industry. As GFIA concludes:
There has been a measurable change in the characteristics of the industry. It’s growing more slowly, is riskier, more correlated, and parts of the industry more directional.