Summer 2013

ABSOLUTE RETURNS: Exploration of undefined territory

ChamelionIn uncertain markets, funds promising to deliver absolute returns continue to be popular with investors. But managers achieve this in a number of different ways. Muriel Oatham discusses the challenges within this sector. Funds in the Asian absolute return sector employ a wide range of investment strategies to succeed in this highly non-homogenous sector. Rajeev de Mello, head of Asian fixed income at Schroders and manager of its Asian Bond Absolute Return fund, describes his fund as “the grandfather of the sector”. The fund, launched in 1998, invests in government bonds, currencies, corporate bonds and convertibles across the whole of Asia. “No single view dominates the portfolio,” says de Mello. He runs a highly diversified strategy, and does not concentrate significant risk in any single currency or country. It is not a trading fund. De Mello says the overall investment philosophy is to take a medium to long-term view in all classes. But he says absolute return does necessitate moving quickly to defend the portfolio when the market moves down. “The key is to have many different types of strategies in order to cushion the fund. When yields are low, achieving [our targeted returns of] 6-8% is challenging. We have achieved these over the past 24 months but now yields have fallen, we are more actively looking for sources of income.”   The majority of funds within this sector are equity funds. Stewart Paterson, a partner at Tiburon Partners, is the manager of the Tiburon Taurus fund, which he took over at the beginning of this year. Tiburon Taurus is an Asia Pacific ex Japan equity long/short fund, targeting absolute return in all market environments. It can be either net long or net short, and is currently slightly net short. He says his investment policy is very macro-driven and describes his fund as “expressing macro views through Asian equities”. FACTORY OF THE WORLD
He says there are two factors which mean Asia is rich in opportunities for this type of strategy. “First, a lot of the cyclicality of developed economies is outsourced through trade. Asia is the factory of the world. Every spike of global growth is magnified in Asia. “Second, Asia Pacific monetary policy tends to be targeted on the dollar. Central banks pay a disproportionate amount of attention to the exchange rate. They inherit monetary olicy from the rest of the world. If it is appropriate, it is only by accident.” These factors cause Asian equities to oscillate hugely, says Paterson. So his fund plays these ratings and re-ratings of Asia through the equity markets. Rob Brewis is co-founder at and co-manager of two Asian equity funds at BDT Invest: BDT Asian Focus, which includes Japan, and BDT Oriental Focus, which excludes it. These funds are long-only and unconstrained, not absolute return, but they aim to deliver positive returns each year. Brewis says that being unconstrained is key. “We do not care about benchmarks. Instead, we look to invest in businesses that will grow over time.” He uses this freedom to invest in areas that may differ from other Asian equity funds. At the moment, he says, there is a lot of potential in Southeast Asia, particularly Thailand and the Philippines, which is his current favourite market. There are a number of factors behind this, explains Brewis. “The lack of a domestic manufacturing sector meant people went overseas: they are now sending back more than $20 million per year. And the IT business process outsourcing industry has taken off. Alongside this, the current administration is the most competent for several years: basics such as infrastructure investment are now being addressed.”     Brewis says this a result of following an unconstrained investment policy. “If we were following an index, we would have 1% of our fund invested in the Philippines. Instead, Oriental Focus has 10-12% and Asian Focus 8-10%.” The BDT funds do have the ability to hold cash, usually as a temporary position. Brewis says they are committed to being at least two-thirds invested, but are rarely less than 90%. The current position is closer to 95% on Asian Focus and slightly higher for Oriental Focus. Theodore Shou, international chief investment officer at Skybound Capital, looks at many funds within the Asian absolute return/long-only unconstrained sectors. His China Red fund is a fund of hedge funds, and he is consistently trying to introduce new managers and strategies to diversify the fund further. Shou says investment within the sector is evolving as managers move away from traditional equity and long-bias strategies. ZERO NET EXPOSURE
The relatively less advanced nature of fixed income strategies in Asia means the majority of funds are equity-heavy, regardless of their name. But this is gradually changing. In 2012, new issues of corporate bonds in China increased five-fold compared with 2011. Shou expects this trend to be sustained and the growing fixed income market will create opportunities for absolute return managers to diversify their investment strategy further. But Shou says managers still face a number of technical issues when running absolute return strategies within Asia. “Shorting/hedging capability in Asia is much less sophisticated: because of both the nature of markets and the constraints within them. For example, in 2011, Korea and Taiwan both banned shorting for a year.” “This means you do not find many strategies running at a zero net exposure within Asia. Funds will inherently have a long bias.” Paterson says the high cost of borrowing makes shorting more difficult. “You can short whatever you like synthetically, but costs are higher in Asia than in developed markets.” He says a more significant issue is size, and that the recent trend of big funds getting bigger and bigger could impede their performance. “Running multiple billions of dollars in the region is almost impossible if you need to go short. And you cannot give investors liquidity. There is an optimal amount of money to run. “As we aim to maintain a portfolio which is highly liquid, it restricts size.” Absolute return tableAnother challenge posed by running an Asian strategy is dealing with a very diverse group of countries. De Mello separates the region into three groups and uses them within the portfolio accordingly. He says the developed countries: Singapore, Hong Kong, Korea and Taiwan serve as the defensive part of the region.  Then the emerging markets:  India, Indonesia and the Philippines, generate risk and yield. Thailand, Malaysia and China are somewhere in between, and they provide a combination of defense and return. Paterson says Asia’s widely differing economic structures offer an opportunity. He says the contrast between commodity-intensive Australia and Indonesia and commodity-deficient India, the global city states of Singapore and Hong Kong and the manufacturers Korea, Taiwan and China, creates inherent diversity within his investment portfolio. The range of countries, economies and languages within Asia poses a challenge for fund managers. De Mello says he makes use of Schroders’s large Asian team to ensure he has the resources to cover every country properly. He has a team of 15 working on the fund’s strategy, based in different countries across Asia.   He says language skills are imperative. “If the Bank of Korea makes a statement it will be in Korean. To react to that, without having to wait for it to be translated, you need native speakers.” Conversely, Brewis focuses on individual companies. He says the diversity of Asia does not make this any more difficult than elsewhere. His funds take a long-term view, tending to hold stocks for three to five years, with turnover of around 20%. He gets to know individual companies well. “We have held some companies for over ten years, such as Taiping Insurance in China. We have held ITC in India over five years.” De Mello says the key to managing a portfolio made up of different countries is to recognise the times when they all move together, and the times when they are different. “After the financial crisis, you could treat Asian currencies as a whole. But over the past six months, you need to select countries and select credit risks.” TOP-DOWN VIEW
He says managers must be able to manage two quite different ways of investing, and the challenge is to be able to identify when the top-down view is more important than the bottom-up view. “It leads to very different portfolio construction.” Having run fixed income strategies in Europe from 1999 to 2005, de Mello is unsure which region poses a bigger challenge. “Asia used to be more difficult but now that Europe is more diverse, I’m not sure any more. Asian markets are probably more homogenous than European ones right now.” Managers remain optimistic about the prospects for the sector. Shou says investor demand for absolute return strategies will continue to grow. “Retail investors are becoming more sophisticated. They no longer merely look for growth.”   He says hedge funds in particular will benefit from growth in domestic institutional investment. The Asian markets have historically been dominated by American institutional investors. But now local institutions such as insurance companies and pension funds, looking for long-term steady growth and capital, are turning to hedge funds and absolute return-type strategies. De Mello says absolute return strategies suit uncertain markets. “Investors are willing to give up some of the upside to have someone decide when it is time to get out.” And he says the diversity of Asia drives investors to want managers to take investment decisions, such as which countries to be in, for them. Paterson says investor demand for this type of strategy should exist. He says the long-run returns for investing in Asia Pacific do not really compensate investors for the risk that they take, unless they have a fortuitous entry point. He adds that the trend for investors to buy into Asia when it is popular has long been a recipe for very poor risk-adjusted returns. “The key is to buy these markets when the exchange rates are cheap. When exchanges rates look expensive, as they do now, that usually indicates poor profitability.” Paterson says commodity market price falls, and what that implies about the outlook for China growth, means there appears to be a complete disconnect with Asean share prices. But he says this presents a challenge for absolute return managers. “There is a tremendous opportunity to make money in Asean markets for people who are prepared to be short.” ©2013 funds global asia

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