Speech by Deputy Managing Director, MAS, Mr Ong Chong Tee, at Fund of Funds World Asia 2005, "Broaden Your Alternatives", 25 May 2005, Grand Hyatt Singapore
Alternative Investments: Meeting the Challenges
1 Good morning. I am happy to be here, in the company of so many participants and experts from the asset management industry.
2 The hedge fund community has been in the spot light in recent periods, and generated considerable debate on a number of fronts. Simply from media reports, one would be led to believe that hedge funds are responsible for many things. The upheavals in the credit markets; the sharp backwardation in the crude oil market last year; contango in the crude oil market this year; the spike in the prices of base metals, the failure of Deutsche Borse's bid for LSE and most recently, Malcolm Glazer's takeover of Manchester United.
3 Underlying all these reports is perhaps tacit acknowledgement by regulators and investors alike that the hedge fund universe has grown too big, too fast and now warrant greater attention. Is that a reasonable view? Allow me to share some thoughts with you, coming from the perspectives of an investor as well as a central banker with interest in financial stability issues.
4 From the financial stability viewpoint, the basic question is whether hedge fund positions have grown so big that they can potentially threaten market stability. Today, assets managed by hedge funds are estimated to be around US$1 trillion - double the size in 2001. It is estimated that over 2,700 hedge funds manage some 7,000 to 8,000 single strategy funds. Of these, about 160 have at least U$1 billion in assets. Institutional investors are expected to pour in another US$250 billion over the next five years, with fund-of-funds expected to capture a sizeable share.
5 The US$1 trillion may not seem all that big compared to the U$12 trillion mutual fund industry. But because hedge funds tend to trade their portfolios more aggressively, they account for a disproportionately large share of trading volumes. For example, some observers have estimated that hedge funds account for some 40-50% of daily turnover on the New York and London stock exchanges, about a fifth of credit default swap volumes, and a third of US speculative grade bond turnover. In the fixed income universe, it is noteworthy that hedge funds and banks' proprietary desks sometimes account for the subscription of 20% or more of ultra-long bond holdings (30-50 year bonds) at primary issuance.
6 A large share of a market's trading volume in itself may not be destabilizing. Indeed, as noted by Fed Chairman Alan Greenspan, hedge funds often provide valuable liquidity to financial markets. In addition, the acts of arbitraging across markets and the use of complex instruments that take on risk characteristics of different asset classes have reduced anomalies in any one market. And because hedge funds generally have a higher risk tolerance than traditional investors, there is some expectation of their being net providers of liquidity in periods of stress.
7 These contributions to market efficiency and liquidity do not come without charge. Hedge funds can also pose risks to market stability. First, with the large numbers of new entrants entering the business every year, there will be a greater stretch in getting those higher expected returns. By their nature, hedge funds scour the globe for profit opportunities. As the number and amount of funds grow, there will be a larger and larger amount of money chasing ever scarcer opportunities. This raises the risk of herding - where large amounts of money enter and exit similar positions at the same time. Should the majority of players find themselves caught out on the same side, and head for the exit together, it will be volatility and not liquidity that is transmitted.
8 The second risk is that, as competition amongst hedge funds intensifies, managers have to rely on more complex methods to uncover market inefficiencies and to spot the profitable opportunities. This raises the risks of blind spots in the form of model errors, data inadequacies and unforeseen events. Everyone remembers the LTCM saga in the autumn of '98, but the story may be remembered while the lessons are forgotten.
9 A third risk to financial stability lies in hedge funds' susceptibility to abrupt withdrawals of capital should their returns prove disappointing. The more established hedge funds have been able to mitigate this somewhat by negotiating longer lock-up periods. But it is not apparent that the newer start-up funds enjoy the same leeway. Unfortunately, rapid and mass redemptions that may force some funds to liquidate assets quickly in anticipation of the withdrawals, tend almost always to occur in an unfavourable environment. Prime brokers and the general market would sense a hedge fund in difficulty, as speculations circulate like wild fire; and this in turn, can be destabilizing to markets if very large hedge fund positions are involved.
10 So central bankers and financial regulators see hedge funds as bringing both benefits and risks to financial markets. While the risks should and can be mitigated, different stakeholders will have respective roles to play. Central bankers and regulators recognise the need to step up to improve our market surveillance - detecting extreme herding effects early and take steps to normalize them. The transfer of risks beyond regulated entities like banks and insurance companies makes financial surveillance that much more challenging, and this has to be a global effort involving cross-border collaboration. To this end, finance and central bank groupings, such as the BIS, have started dialogue to foster exchanges of views and knowledge by official surveillance units. On their part, banks and prime brokers will need to be prudent in the credit extended to hedge funds. For example, the practice of permitting for contracted lags before hedge funds' margins are called, translates in essence to a form of operational leverage. Such arrangements should be carefully monitored especially in the context of further gearing elsewhere. Down the line, investors will need to be diligent in selecting managers - not merely on the basis of how good the story is but also in understanding their investment and risk management processes - and in the risk budgeted to the manager. And finally, the hedge fund managers themselves need to be careful not to over-extend themselves and to be mindful of unexpected events of risks.
11 Outside of financial markets, hedge funds have also attracted attention to their roles in board room decisions, as the case of Deutsche Borse. Participation in board debates is not something entirely new to large investment firms and plan sponsors. But a tension can arise when a presumption is made that the value-investor should also by definition be a long-term investor. This does not sit well with the perception of hedge funds as "fast money", reliant amongst other things, on nimbleness in the usage of risk capital to generate returns. This issue will not be easily resolved, not least because shareholders may feel necessary to push for corporate actions they believe to be in the company's best interest. Hedge fund managers as active independent investors can play a visible role in unlocking and maximizing value for shareholders. I suspect the eventual resolution will turn on how investment funds as an industry see, and communicate, their roles as corporate stakeholders.
12 Let me now change perspective to that of an investor. How should an investor view this rapid growth in hedge funds? Should the rapid growth of the industry add or subtract from hedge funds attractiveness? Before answering these questions, it is worth reminding ourselves about the unique characteristics of hedge funds in absolute return investing.
13 To begin with, hedge funds do not fall into traditional asset categories of fixed income, equities, private equity, property or even asset-backed derivatives. Some funds operate entirely within one category while others specialize in arbitrage plays across assets. Indeed, attempts to broadly pigeon-hole what each fund does have led to myriad descriptions such as "global macro, convertible arbitrage, long/short equity, event-driven, event-driven multi-strategy..." to name a few.
14 The common thread linking these name tags is this: Unlike long-only funds, the return of a hedge fund is wholly independent from the performance of assets. So when an investor puts money into an equity hedge fund, it is not the actual securities' performance but the strategies employed that determine the investor's returns. It is this skill-based, overlay approach that characterises hedge funds as an investment class.
15 This feature makes hedge funds an attractive addition to an investment portfolio in 2 ways. First, it allows the investor to pursue a positive return regardless of market conditions. This feature is gaining in importance, most notably as aging demographics in many parts of the world put a greater demand on wealth resources such as pension assets, to provide sustainable income streams. In this more demanding world, it is of poor comfort for investors to be informed that their funds have performed well against the relevant peer groups or benchmarks but still ended several percentage points negative for the period.
16 Second, because the returns of hedge funds are uncorrelated with that of traditional assets like bonds and equities, they can potentially provide good diversification. A number of institutional funds, such as the Yale endowment fund and the World Bank pension funds have added hedge funds to their portfolios with notable success.
17 Thus, it may not be entirely coincidental that reports indicate that pension, endowment and institutional funds comprise a substantial portion of the most recent inflows into the industry. Trustees of such monies would be keen to achieve diversification within their portfolios to gain stability in revenue streams and mitigate downside risks to capital.
18 So has the rapid growth of hedge funds make them more or less attractive? At the risk of coming across "hedged" in my own response to this question, I think the answer is both "yes" and "no". With a wider range of hedge funds, investors' ability to diversify manager risk improves. A Fund-of-Fund structure provides a convenient way to take advantage of this diversification. In other words, where new and flexible trading or investment strategies offer diversification benefits, it is a logical next step to seek greater diversification value by packaging together, strategies that themselves have limited correlation in a cost-effective one-shop structure.
19 But to individual hedge funds, the rapid growth of the industry is likely to exacerbate scarcity on two fronts - the availability of arbitrage and value opportunities, and the availability of managers (meaning people) that are able to consistently bring in good absolute returns. Talent in particular will invariably become a premium in the skill-driven business. Already, banks and fund managers complain of difficulty finding and retaining good market professionals. In some ways, this can well be the constraint to continued growth, considering that new talent is required beyond the managers who are already behind the strategies of today's 7,000-8,000 single strategy funds alone.
20 Let me now turn to the future growth of the hedge fund industry and this brings me to Asia. In my view, Asia offers new frontiers for hedge funds in both profit opportunities and talent. The hedge fund activity here is still relatively young, managing just US$60 billion or 6% of global hedge fund assets-under-management. So there is plenty of room to grow.
21 Talents abound because of the long history of risk-taking industries in financial hubs like Tokyo, Hong Kong and Singapore. Opportunities also manifest themselves as Asian financial markets de-regulate and develop. This will go beyond China and India, which have captured many investors' excitement, but also here in South-East Asia, which has emerged from the Asian currency crisis to be a more confident, vibrant region in terms of the economic growth prospects.
22 As an example of the new developments in Asian markets, we can look at the debt markets. Since the crisis, Asian authorities have made significant strides in developing their local debt markets as an alternative to the more traditional bank lending, for raising funds. Bond markets in Asia ex-Japan have more than doubled since 2000 to about US$1.5 trillion. Along the way, new instruments emerged - warrants, convertibles and securitized assets like CDOs and REITs. These present opportunities for fund managers. In addition, there are determined efforts to forge stronger links between Asian markets, reflected in ongoing work such as the Asian Bond Market Initiatives of the Asean+3 finance forum. Among the projects, are initiatives to harmonize conventions and rules between markets. These will present future prospects for inter-market investment opportunities.
23 Singapore is a good place to tap Asian opportunities and talents, and we have attracted considerable interest from the hedge fund community. Today, there are more than 80 managers in Singapore (from a handful just a few years ago) employing a mix of strategies. We continue to see more global names setting up dedicated Asian strategies teams and trading desks in Singapore, to cover the Asian time zone.
24 Why Singapore? Let me offer a few reasons. One, there is a sizeable pool of risk-taking talent, stemming from our position as the 4th largest FX trading centre in the world - and the largest in Asia outside of Japan. Two, Singapore's world class IT infrastructure and communications network, offers strong connectivity with the rest of the world. And third, Singapore is regarded as one of the most cosmopolitan city in Asia, providing a pro-business and efficient environment for businesses. And our urban planners take pride in making this city state a great place to work, live and play.
25 Singapore was a forerunner in Asia in recognizing the value of the asset management industry, and hedge funds as an integral part of it. I don't need to dwell on MAS' initiatives to encourage more global asset managers to set up here. We will remain proactive and responsive towards investor and business needs. We were one of the first to announce guidelines for retail investors in hedge funds. Our regulatory and tax regimes are clear and certain. Most recently, in March, we released details of the tax changes for start-up fund managers, to facilitate their growth. We have worked with the industry to foster a thriving financial community and have included the provision of financial grants to equip people with the right attitude, skills and knowledge. These measures, and others, will facilitate the continued growth and dynamism of the broader fund management industry including those in the alternative investment space.
26 To end, let me reiterate a point I made earlier. As the hedge fund industry grows, it will necessitate everyone - central banks, regulators, investors, and not least the hedge funds themselves - to quicken their pace of adaptation to and understanding of evolving market dynamics. For hedge funds, a key challenge will be on the one hand, individually seeking out new opportunities amidst a competition for talent and skills; and on the other hand, to work collectively toward a greater degree of transparency and disclosure, to give confidence to investors and all participants of a connected global financial system. On that note, I wish all of you a fruitful conference over the next few days.