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Bringing you news, views and analysis since 2013
Hans Schlaikier, Hedgeweek

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Hedge funds and investors look forward to the China Exchange Link… Hedge funds surpass 2007 leverage…

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Hedge funds may drive initial demand for Shanghai-listed stocks through a linkage of the city’s bourse with that in Hong Kong, according to Goldman Sachs, reports Bloomberg.

The link will tap into pent-up demand from hedge funds to buy Yuan-denominated class-A shares traded in Shanghai, said Shane Bolton, head of Asia prime brokerage at the New York-based bank. Long-only managers may grapple with pre-trade requirements that are different from their usual practice at the beginning, he added.
 
Foreign investors so far can only buy Yuan shares listed in Asia’s second-largest stock market through the qualified foreign institutional investors, or QFII, and the Renminbi QFII programs. The link, set to start next month, will allow investors, with or without their own QFII licenses, to buy as much as 13 billion Yuan (USD2.1 billion) of Shanghai-traded Yuan stocks a day, according to a Sept. 4 statement posted on the Hong Kong stock exchange’s website.
 
Few hedge funds have been able to win their own QFII licenses, which are typically reserved for long-term investors such as mutual fund managers, endowments and sovereign wealth funds The initial hedge fund interest represents a combination of fundamental stock pickers and funds looking to exploit arbitrage opportunities presented by the different prices for stocks listed on both the Hong Kong and Shanghai exchanges. Investors are betting that the link will help narrow the price differential between the two exchanges.
 
Goldman, which is the largest prime broker in the Asia-Pacific region with an estimated USD27.4 billion of client assets, according to a regional trade journal, reportedly expects a boon in trading in both directions as a result of the link. Just as Western investors might now pour into the Shanghai exchange, Chinese domestic investors who were restricted from the Hong Kong market may be interested in investing in casino and technology shares they can't invest in on the Shanghai exchange.
 
Shanghai-listed stocks accessible to foreign investors through the link will account for about 90 per cent of the bourse’s total market value and 80 per cent of average daily turnover, according to a May presentation posted on the Hong Kong exchange’s website.
 
Investors have been betting the link will help narrow the pricing gap between the two exchanges.
 
Not everyone, however is equally excited about the prospect, Chinese investors have very muted enthusiasm for the Shanghai exchange. This has been attributed to a combination of government controls over which companies can list on the Shanghai exchange and the large losses suffered during the financial crisis. Although the Shanghai Composite Index has risen 12.5 per cent year to date, it is still down 60 per cent from its 2007 high. The other concern is that the interest the Through Train will attract to the Hong Kong and Shanghai markets may draw investment away from other markets in the region.
 
There are also unresolved issues over taxes. Foreign investors in mainland China’s stock markets are technically liable for paying capital gains taxes, but China has historically not taxed such investments under the existing quota scheme. It remains an open question whether that practice will change. Given these and other uncertainties, companies like MSCI — which compiles indexes that are tracked by funds with trillions of dollars invested in stocks around the world — have so far declined to include mainland Chinese shares in their indexes.
That could change as soon as next year, when MSCI is next scheduled to review Chinese shares.
 
“Even after the implementation of stock connect, there will still be demand from both long-only managers and hedge funds for QFII quota,” said Jignesh Patel, a Hong Kong-based managing director on Goldman Sachs’s prime brokerage team. “QFII allows them to trade other products, such as Shenzhen-listed stocks and convertible bonds, which stock connect presently doesn’t cover.”
 
In addition, for investors to trade through stock connect, both the Shanghai and Hong Kong exchanges need to be open on the day. QFII doesn’t have such restrictions, Patel added.
Hedge fund managers including Hong Kong-based SPQ Asia Capital Ltd. has been trying to exploit the pricing gap between Shanghai-listed Yuan shares and Hong Kong-quoted shares of Chinese companies ahead of the link’s official start. Because those two classes of shares are not interchangeable, their price differences will potentially shrink from the bourse link over time, instead of disappearing altogether, Patel said.
 
Hedge funds are further out on the same limb they occupied in 2007, right before the collapse.
 
According to Eurekahedge, a global hedge fund monitoring service, hedge funds’ gross assets hit 170 per cent of capital in January, which surpasses the previous peak of 168 per cent in 2007.
 
Leverage at many of the largest hedge funds is far higher.
 
For instance, in April, the New York Post noted that Citadel Investment Group, one of the 25 biggest US hedge funds, had implied leverage of about 8.8 times its total investment capital. The Post also noted that Citadel’s “leverage last came under scrutiny in 2008, when it had to unwind a leverage of 8.2 times as the financial crisis unfolded.”
 
The US Senate’s Permanent Subcommittee on Investigations confirms the imminence of a reversal
.
In July, Congress opened a major probe into the inner workings of the hedge fund industry. A report from one set of hearings is titled “Abuse of Structured Products: Misusing Basket Options to Avoid Taxes and Leverage Limits.” The subcommittee recommended that regulators “take steps to examine complex financial arrangements.”
 
It never fails. When a mania ends, the instruments of the uptrend are often subject to recrimination and “reform.”
 
In the early 1930s, there was the Pecora Commission, which led to the Glass-Steagall Banking Act of 1933. This is a bigger peak, so the politicians will extract more than just their average pound of flesh.

SAIF Partners Group is well on its way to raising the USD500 million it seeks for its new China-focused hedge fund.
The Hong Kong-based private-equity firm in December unveiled its first hedge fund, SPQ Asia Opportunities Fund, with USD40 million. Through August, the fund had more than tripled that number to USD130 million.
Most of the growth has come from investors, who have shown a growing appetite for Asian hedge funds. SPQ returned 1.6 per cent in its first month last year and is up 5.1 per cent this year, Bloomberg News reports.
 
Research shows that listed single manager hedge funds have beaten the S&P 500 and the HFRI Composite Index.
 
While hedge funds have been widely criticized – for failing to beat the S&P 500 and other broad equity indexes, data from alternatives investment bank Dexion Capital shows listed single-manager hedge fund quality shining through in the current cycle.
 
The S&P 500 closed at the end of August at 2,003, an all-time month-end high (the daily high reached 2,007 on September 5). The market has been ahead of its previous highs for a while, but the month-end peak in the last cycle was 1,549 at the end of October 2007. Between November 2007 and August 2014, peak-to-peak, the S&P 500 has generated total returns of 50.3 per cent, or 6.1 per cent a year.
 
Over the same period, average hedge fund performance as a whole has been lacklustre. The HFRI Fund Weighted Composite has returned 20.6 per cent, or 2.8 per cent a year. The HFRI Fund of Funds Composite index has returned just 1.3 per cent, or 0.2 per cent a year. Of the main sector groupings, HFRI Relative Value (5.5 per cent a year) performed strongest, followed by HFRI Event Driven (4.1 per cent a year). Despite the strong equity markets, HFRI Equity Hedge generated a modest 2.1 per cent a year, while HFRI Macro also returned 2.1 per cent a year.
 
But research by Dexion Capital, shows the quality of the listed single-manager hedge fund universe is above average, with only the best managers able to launch funds with requisite scale.
 
Net asset value (NAV) returns, peak-to-peak, support this view. Of the funds that have a track record starting at or before November 2007, including master funds or carve-outs prior to listing, only Pacific Alliance Asia, a small Alternative Investment Market-listed fund, failed to beat the S&P 500, while the best-performing funds have been Third Point (11.1 per cent a year), BlueCrest BlueTrend (8.9 per cent), BH Macro (8.8 per cent) and BlueCrest AllBlue (8.6 per cent). BH Credit Catalyst has a track record only from April 2008, but has returned 12.9 per cent a year since then.
 
Furthermore, according to Dexion, NAV volatility has been much lower than equity markets.
 
Credit Suisse Group AG, Asia’s second-largest prime broker by share of assets, hired Aditi Velakacharla to head a team linking potential investors with Asian hedge funds, said two people with knowledge of the matter.
 
Velakacharla, who resigned from Nomura Holdings recently, is expected to start in Hong Kong in November, the people said, asking not to be identified as the information is not yet public. She will replace Deborah Lee, the departing Asia capital services head on the Zurich-based bank’s prime brokerage team, they added.
 
Velakacharla’s Hong Kong Securities and Futures Commission license with Nomura expired on 13 August, according to data posted on the regulator’s website.
 
Credit Suisse is filling the job amid signs of renewing investor interest in Asian hedge funds, which have outperformed global peers since the beginning of 2012, according to Eurekahedge Investors added USD4.1 billion to the region’s funds in first eight months, with the USD1 billion August inflows eclipsing net new deposits into North American and European peers, the Singapore-based data provider said in a report earlier this month.

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