A risk too far

South China Morning Post  |  Oct 9, 2008

By Sin-ming Shaw

yline: As in the US, Hong Kong's mostly incompetent hedge-fund 'experts' threw caution to the wind, writes Sin-ming Shaw

The collapse of Wall Street as we knew it has revealed a fundamental flaw: the lack of competent oversight by the relevant authorities in the United States, particularly the Securities and Exchange Commission whose Republican chairman, Christopher Cox, has now admitted his shortcomings.

In Hong Kong, over the past 15 years or so, "hedge funds" focusing on the Greater China markets have appeared like the proverbial bamboo trees in the spring.

Their prospectuses touted their expertise and "experience" in Asia, their knowledge of the China market and their "long/short" strategies seeking absolute returns while managing risks prudently. Some even flaunted their "personal connections" to high-up government officials in China as part of their credentials as fund managers.

For that guanxi and other "hedging" services, they charge their clients a hefty fee (1.5 per cent to 2 per cent of assets) and 20 per cent of profits. Ordinary mutual funds do not share in profits and charge not more than 1 per cent. Many charge less.

Investors were willing to pay for their expertise and seeking "absolute returns" - meaning profits - because managing a well-run hedge fund requires skills most mortals do not have.

The old-fashioned way of managing money - known as "long-only" funds - was to buy good companies and hold them over long periods of time, come hell or high water. In the most pessimistic business environment, conservative fund managers simply sold stocks and sat on cash, lots of it, waiting for better times to re-enter the market.

But hedge fund managers claim they can benefit from bear markets by going "short". They do so by borrowing stocks they don't own, selling them and buying them back at a lower level, thereby making a profit.

At the minimum, hedge fund managers could hedge their portfolios by "neutralising" market downturns. They could do this by buying "put options" - contracts giving the owner the right, but not the obligation, to sell a security at a specified price within a certain time - on stocks or market indices. In this way, when these stocks go down, or the entire market goes down, these put options would increase in value, thereby making up for the losses in the portfolio.

This year, Hong Kong's managers of "absolute returns" specialising in the Greater China markets have proved to be mostly incapable of running a hedge fund.

With a handful of rare exceptions, all have lost money, based on figures at the end of August. Some 99 per cent of funds lost between 15 per cent and 40 per cent; some losses reached 60 per cent. The one that was boastful of its China guanxi lost over 30 per cent. Something is not right.

Did they not say they would "hedge" their portfolio of stocks if they didn't want to take a view of whether the markets would go up or down?

A hedge fund in its classical definition is a fund where no market risks would be taken and that, for each dollar of a better quality stock A bought, another dollar of a lesser quality stock B would be sold, so that, even in a bear market, stocks of better companies would go down less than the poorer-quality ones. And, in that process, money would be made.

A well-run hedge fund should not be losing money at the magnitudes seen in Hong Kong, unless they are essentially undisciplined speculative funds that are run incompetently.

Global financier George Soros has always been explicit: he is a speculator and he states that in his prospectus. Anyone who puts money with him knows that.

In Hong Kong, "hedge funds" are mostly leveraged speculative funds with a bullish bias. They are "directional" bets on rising markets. There is nothing wrong with such funds if the managers, like Mr Soros, have full disclosure at the outset instead of falsely claiming that they could manage risks while obtaining positive returns.

A good lawyer could easily build a case against quite a few of these managers.

The SEC in the US has belatedly admitted it had been asleep at the wheel. Hong Kong's Securities and Futures Commission should be proactive.

Taking away the licences of one or two particularly incompetent "hedge fund" managers who falsely advertised their expertise would be far more effective in protecting investors than following the advice of Secretary for Financial Services and the Treasury Chan Ka-keung. He said investors should read consumer reports regarding the risks of hedge funds.

Sin-ming Shaw is a former professional fund manager in Hong Kong

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