China's summer of woe slams hedge funds

Hedge fund managers slow to cut back on their exposure to China face significant redemptions. Value Partners underperforms; Segantii gains ground.

Hedge fund managers bullish on China face hefty investor redemptions after failing to cut their exposure fast enough through the country’s summer market rout, according to industry sources.

China-focused hedge funds stacked up a cumulative loss of about 19% in June, July, and August – the biggest three-month losing streak since 2000, according to global data provider Eurekahedge.

Hedge funds profited greatly during the bull run earlier in the year after China made it easier for overseas investors to access to its capital markets. They were also active users of the new trading and clearing link called Shanghai-Hong Kong Stock Connect that was launched in November.

However, due to their relatively aggressive net-long bias, some of these hedge funds were hit hard as Chinese markets turned south in June and become more volatile, prompting a selective exodus by investors.

“Investors have taken a very close look at managers: who managed the volatility and who did not,” Tim Wannenmacher, head of prime brokerage for Asia-Pacific at UBS, told FinanceAsia.

China-focused hedge funds lost an average of 6.55% in August, extending July’s 8.5% fall, according to an estimate by Eurekahedge.

Four funds lost more than 15% in August and another six dropped more than 9% to 15% in value, according to one hedge fund industry source. “There were only a couple of positive performances in August, the rest was a bloodbath,” he said.

Another index compiler, Hedge Fund Research, said on Wednesday that its China Index fell 8.22% in August bringing the drawdown to 20.5% since June, and a small loss of 0.56% year-to-date.

Vive la difference

But some China-focused hedge fund managers handled the challenging market conditions better than others.

The dispersion in performance between different funds has become increasingly scattered in recent months. The inter-quartile range of Greater China-focused hedge funds performance, after excluding the bottom and top 25% of funds, rose to 6.32 in August from 2.52 in February, according to Eurekahedge.

China funds' dispersion Source: Eurekahedge

One notable underperformer was a Value Partners' High-Dividend Stock Fund, which lost 9.5% of its value in August, dragging its year-to-date performance down to -5% according to its website. The fund has a broader Asia ex-Japan mandate but a significant allocation to Greater China.

The poor performance of this particular fund is all the more notable because it almost doubled in size since mid 2014 to become one of the largest funds focused on Greater China, the second source said. Value Partners said its assets under management hit a record high of $17.8 billion in June.

One of the few outperformers was a fund managed by ChinaAMC and another managed by Segantii Capital Management, one of Asia's fastest-growing hedge funds, industry sources said.

“August hedge fund performance displayed a wide range of performance dispersion, including differentiation between strategies, sub-strategies, regions, high and low beta exposures, as well as between individual funds,” HFR’s president Kenneth Heinz said.

Most fund managers cut their net and gross exposure to China's stock markets in July and August, fund managers and prime brokerage bankers contacted by FinanceAsia said. 

“July was difficult and people that didn’t adjust their portfolios at that point – will have to face tough questions from investors,” one hedge fund manager based in Hong Kong said.

Asia ex-Japan funds saw assets fall by 2.48% in August, according to Eurekahedge.

Total capital invested in Asian hedge funds declined by $10 billion in July, after rising to a record $126.3 billion at the end of June, according to HFR.

Investors in Asian hedge funds anticipate a handful of closures among smaller funds in the coming months, where managers tried to invest their way out of sharp drawdowns.

“There will be probably be a subset of managers that have exceeded their risk parameters – they may have gone through drawdown limits and deviated from strategy by trying to invest their way out of a drawdown by being even more aggressive,” Roger Bacon, head of managed investments Asia Pacific at Citi Private Bank, told FinanceAsia.

As a result, they may be forced to close down after redemptions among the thousands of fund managers out there.

“In the medium term you may see some managers forced to reassess their risk-management protocols,” Bacon said, whilst adding that most of them are very clear with investors about their aggressive investment styles. 

To be sure, Greater China hedge funds have on average outperformed benchmark stock market indices in Asia and are still up about 2% for the year.

The Shanghai Stock Exchange Composite Index is flat on the year but that masks a bull run up until June 12, since then the index has lost 37% of its value. In August the index dropped 12%. 

Hedge funds also outperformed Greater China long-only funds, which lost about 11% of their value in August, Eurekahedge said.

Strategy and tactics matter

As many hedge fund investors anticipated, net-long biased equity managers lost more money than most.

“We’ve witnessed some brutal numbers from some of the China-focused managers in the markets, which is not surprising given many of them are directional and use a lot of leverage,” Citi's Bacon said in an interview. He said he hadn't allocated capital to such funds.

Some hedge funds took a big hit after investing in the capital raisings of Chinese companies, which hit a record level in the first six months of the year.

These hedge funds used capital borrowed from investment banks to participate in these initial public offerings, private placements, and block sales, and used the shares as collateral. When the shares tanked from mid-June and investment banks made margin calls, many hedge fund managers told the bank to sell the stock. 

“China became un-investible in a very short period of time. You could not hold a position,” said one head of equities trading across the Asia-Pacific region at one investment bank. “Clients just said 'no mas' and reduced their accounts dramatically.”

Some relative-value managers did try to hedge effectively by shorting ETFs such as the Hong Kong-traded ishares FTSE A50 China Index ETF 2823 but were hampered by costs and lack of availability.

"Arguably funds would have made more money if they had had access to more borrow - but it was limited in these ETFs and pricey, around 15%," said one prime broker.

JP Morgan stopped offering synthetic shorts on China shares recently because strong demand from hedge funds had used up their inventory and they could not offer naked shorts, according to a person familiar with the move. 

Some hedge funds redeployed capital to the large, liquid market of Japan and went short South Korea. However when Japan’s Nikkei 225 index also tumbled in late August these managers also took took another hit.

Outperformers included pan-Asian macro managers who thought China’s economy would continue to slow and bet that the yuan would depreciate relative to the US dollar or shorted H-shares on the Hong Kong stock exchange.

Multi-strategy, event-driven, and CTA/managed futures funds broadly outperformed too, although there is scant evidence as yet of funds that made a lot of money from China's summer market dislocation.

“We’ve been very happy with some of the macro managers and event managers who have held up well,” said Citi’s Bacon who who targets capital protection with predictable medium-term performances in rising and falling markets.

Event-driven funds are also now scouting beaten-down markets for bargains.

“There are opportunities that have arisen particularly for event-driven and activist strategies funds to build larger positions as prices fall,” Bacon said.

One M&A arbitrage hedge fund manager noted that spreads on buyouts of US-listed Asian companies have widened on worries the acquisitions are now less likely to proceed, which signals opportunity for investors who back the right deals.

Prime Brokerage desks remain relatively quiet for now with most hedge funds long cash. However most bankers are sanguine about the outlook for business in China.

"The recent volatility does not change the long term very positive impact of China opening up to the region but in the short term, investors are cautious," said UBS’s Wannenmacher, who reiterated the Swiss bank's plans to expand its prime brokerage presence in the region.

“We will continue to build the team,” he said.

In August, Lai Man Wong joined UBS’s prime brokerage sales team in Hong Kong from Deutsche Bank, according to an internal memo seen by FinanceAsia.

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