Features of Korean Hedge Funds and Their Implications

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1 Features of Korean Hedge Funds and Their Implications Kim, Jongmin* The analysis on Korean hedge fund returns for the recent 14 months using data from media reports found the following. First, the volatility of Korean hedge fund returns is lower than that of the overall Korean stock market, and the returns have improved since the second half of last year. Also, some well-performing hedge funds have built up their reputations, and Korea s hedge fund market is reshaping based on returns. If this trend continues this year, hedge funds will attract investments from institutional investors, who are still hesitant to invest in hedge funds. In conclusion, how Korean hedge funds perform this year will be a watershed for Korea s hedge fund market. However, the overall private placement fund regulations (that cover hedge fund regulations) should be fully reviewed so that the funds are managed more creatively and with more discretion. It has been 15 months since Korea officially introduced the hedge fund market as part of efforts to develop the capital markets. The hedge fund market was the first of its kind in Korea, and the media has a keen interest in the market s outcome. So far, however, the results fall short of expectations. As of January 2013, the market size reached KRW 1.08 trillion, a seven fold increase from the initial size of KRW 150 billion. But the growth is disappointing compared to the experiences of Europe and other Asian markets. 1) Nevertheless, some well-performing hedge funds have successfully built their reputations, All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, Fund & Pension Department, Tel: , jongminkim@kcmi.re.kr 1) The growth of Korea s hedge fund market is about half of European and Asian hedge fund markets, which grew rapidly since the early 2000s. 1

2 and the hedge fund industry has exerted efforts to devise investment strategies and secure fund managers with expertise. This breeds hope for a bright future for Korea s hedge fund market. Korean hedge funds were launched without sufficient management experience, professionals, infrastructure, and demand pools, and it is unrealistic to expect outstanding performances immediately. Rather, the first year was for trial and error, which will eventually help the market take root successfully. What is necessary now is objective evaluation of the achievements so far, and then addressing the challenges to future growth. This article first estimates Korean hedge fund returns using data released through media reports, and then discusses the implications and future challenges. Primary features of Korean hedge funds In this article, I compute the estimated returns of Korean hedge funds for 14 months from their launch to January 2013, based on the AUM and returns released through media reports. 2) The returns used here are from five time spots (May 8, 2012, July 10, 2012, October 30, 2012, December 5, 2012, and January 31, 2013). Then, all hedge funds were divided into four groups (quartile) according to the returns of each time spot, and I calculate the portfolio returns of each quartile as shown in Table 1 and Table 2. Table 1. Korean hedge fund returns Monthly average return Date 1 st quartile 2 nd quartile 3 rd quartile 4 th quartile Total KOSPI % -0.54% 0.07% 0.69% 0.04% 1.39% % -0.09% 0.21% 0.47% 0.11% -3.39% % -0.27% 0.57% 0.80% 0.47% 1.01% % -0.54% -0.08% 1.21% 0.61% 2.08% % 0.74% -0.05% 0.76% 0.31% 0.40% Cumulative return % -3.03% 2.74% 10.71% 3.55% 6.63% Note: 1) The monthly average return is the average 30-day return computed by using the return of each time spot. The cumulative return refers to the time-weighted rate of return for each quartile since the funds included in each quartile were established. 2) All the figures in this table are calculated by using the data from media reports. 2) The returns calculated in this article can be different from the actual time-weighted rate of returns because it is impossible to find out total net asset sizes and money flows. Nevertheless, it is safe to say that those figures reflect the overall trend of hedge funds performance. 2

3 Table 2. The percentage of AUM for funds in each quartile Date 1 st quartile 2 nd quartile 3 rd quartile 4 th quartile AUM (KRW 100 million) % 16.60% 18.36% 46.10% 5, % 10.72% 18.56% 46.97% 6, % 9.40% 24.84% 52.58% 9, % 7.67% 24.99% 54.73% 10, % 10.85% 25.90% 52.15% 10,798 Note: I use the data released through media reports to calculate the total AUM, and then the proportions that AUM of the funds in each quartile represents in the total are computed. Korean hedge fund monthly average returns and cumulative returns as of January 2013 are shown in Table 1. Also, Table 2 indicates the percentage that AUM of funds in each quartile represents in the total AUM. According to the data, Korean hedge funds recorded 3.55% of cumulative return, which is below the KOSPI return of 6.63% during the same period. As media reports pointed out so far, Korean hedge funds underperform the Korean stock market. But a close look at Table 1 and Table 2 reveals some intriguing facts. First, the monthly average return trend demonstrates that the volatility of Korean hedge funds returns is far lower than that of KOSPI. Furthermore, the overall return began to improve in the second half of Second, the gap between well-performing and worst-performing funds is widening. For instance, the top-performing funds included in the fourth quartile had 10.71% of cumulative return, which well exceeds KOSPI returns. On the other hand, the return of the worst-performing funds in the first quartile was -10.7%. Third, well-performing funds successfully built their reputations and accordingly seemed to attract investments. This is evidenced by the fact that the fourth quartile funds saw their AUM increase continuously and remain over 50% of the total AUM since October On the contrary, the proportion of worst-performing funds in the first quartile fell to 11% from 19%. 3) The percentage of funds with positive return also rose dramatically from 64% to 78%. 3) The correlation coefficient between AUM and cumulative return increased from 0.40 to 0.62, and that between the return at the end of the previous term and AUM also rose from 0.43 to This confirms the trend in which better-performing funds receive more investments. 3

4 Implications and future challenges The aforementioned analysis result implies that Korea s hedge fund market is reshaping based on returns. Moreover, as the entry barrier to the market was lowered at the end of 2012, new hedge funds with diverse investment strategies are expected to emerge. 4) Certainly, this will lead to more frequent entries and exits of market players and deepen the market concentration on best-performing funds. 5) Also important is that the overall hedge fund return is lower than the stock market, but so is their volatility. This opens the possibility that hedge funds will be well-received by investors seeking mid-risk, mid-returns if their returns increase slightly above the current level. In this regard, the upward trend in hedge fund returns since the second half of 2012 is worth noticing. This trend, if continues this year, will encourage hesitant institutional investors to invest in hedge funds. But the opposite is also possible: If the current upward trend reverses, Korean hedge funds will have difficulty attracting investments from institutional investors for a few more years. In short, the key determinant for the future success of hedge funds in Korea is higher returns. 6) In order for Korean hedge funds to take root successfully, persistent efforts should be made not only to increase returns, but also to improve rules and regulations. It is important to remember that hedge funds attracted institutional investments because they were viewed as a portfolio diversification tool. Also notable is that hedge funds, seeking absolute returns regardless of market conditions, must have differentiated investment strategies and reputations to attract investments. This strongly suggests that the first policy priority is creating a market environment where hedge funds with diversified investment strategies can emerge. 7) More specifically, some entry barriers should be lowered. For example, it is necessary to 4) According to the press release of the Financial Services Commission on December 6, 2012, about 23 companies (12 asset management firms, 5 securities firms, and 6 investment advisors) plan to enter the market. 5) From the investment strategy perspective, performances of long-short funds varied widely, indicating that their sub-strategies are significantly different. This also shows that the investment strategy is a key determinant for hedge fund performance. Also, it is presumed that more funds adopt multiple strategies. For example, a long-short hedge fund also uses the global macro or eventdriven strategy. If this trend continues, more funds will move away from the long-short-only strategy to multiple investment strategies in two to three years. 6) In the aftermath of the 2008 global financial crisis, not only Korean hedge funds, but global hedge funds underperformed the stock market. Therefore, many hedge fund managers and institutional investors see this years performance as a decisive factor to future growth (Preqin, 2013). 7) Since the global financial crisis, hedge funds regulations have been strengthened globally and investors have asked for higher transparency. Korea s hedge fund market is less prone to problems related to systemic risk or investor protection because it preemptively reflected the global hedge fund trend. But still, Korea needs to examine what improvements should be made in this aspect. 4

5 consider lowering the capital requirements and streamlining the authorization process. Indeed, Korea still has a weak demand base for hedge funds, and reputation counts most in this market segment. Therefore, lowering entry barriers is not likely to result in a crowded market. In a broader sense, the overall regulatory regime for privately placed funds including PEFs should be reviewed so that funds make full use of their discretion and creativity to perform better. 5