Rapidly growing economies with strong fiscal and fundamental underpinnings

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1 3rd Quarter 2013 PAAMCO Perspectives Portfolios of Asian Hedge Funds: The Way Forward By Misha Graboi, Portfolio Manager, Asia Pacific Since the global financial crisis, those of us investing in Asia have found the hedge fund sector to be particularly cruel holding out the promise of enormous potential, while delivering a mediocre-to-disappointing reality. Indeed, Asia possesses a number of characteristics that we normally associate with an attractive environment for hedge funds: Rapidly growing economies with strong fiscal and fundamental underpinnings Quickly evolving industries whose winners and losers become apparent more rapidly Less efficient markets (by some measures) Lower levels of competition in hedge fund strategies When placed against a backdrop of improving liquidity, this should be the golden age of hedge fund investing in the region. In reality, with the Eurekahedge Asian Hedge Fund Index (Symbol: EHFI38) up only about 11% in total for the past five calendar years (January 1, 2008 through December 31, 2012),* it is not surprising that the capitalraising environment for most Asian hedge funds has been extremely challenging. The promise remains, but most hedge funds have simply not delivered. Lately, dispersion has risen and the opportunity set has improved, (with the Eurekahedge Asian Hedge Fund Index up about 7%YTD through June 30, 2013*) but it remains challenging to fully extract the returns we feel the fundamental opportunity set in the region offers. Since the financial crisis, we have come to realize that traditional methods of multifund management that we and others investing in the region employ leave a significant We see a chance to re-cast the nature of the relationship between fund managers and allocators in order to address some of the fundamental challenges of investing in Asia. *Source: Eurekahedge, Bloomberg

2 Page 2 PAAMCO In our experience, the mandates of many Asian commingled funds are often relatively poorly designed, even those created by people whom we consider to be very talented investors. One solution to these mandate design issues is using separate accounts to construct customized exposure profiles. amount of value on the table in Asia. After much study and evaluation, we believe there is a more effective way forward. We see a chance to re-cast the nature of the relationship between fund managers and allocators in order to address some of the fundamental challenges of investing in Asia, including issues such as mandate design, portfolio management, operations and transparency. We think that appropriate use of institutional investors negotiating leverage should be focused on creating infrastructure and strategies that allow Asian hedge fund portfolios to work together as integrated wholes while also allowing flexible deployment of tactical trades to better take advantage of the promise of this dynamic region. Custom Mandate Construction: Beyond the Least Common Denominator In our experience, the investment mandates of many Asian commingled funds are often relatively poorly designed, even those created by people whom we consider to be very talented investors. Generally, we find commingled funds in Asia bifurcate into two types. First, there are those which take on very significant beta exposures. We have found that this approach can generate eye-popping returns (and fees for beta), but often end badly and, hence, are generally not suitable for institutional investment. Then there are those which seek to be alpha extractors that is, they target low levels of beta and maintain tight risk controls, but often deliver low returns. They have the right idea, but the problem here is that many managers concentrate on business building and asset gathering rather than investing, and thereby focus more on managing downside risk (and AUM loss) than on generating upside returns. For example, very often we see portfolios with a few high-conviction positions where the manager has a real edge, and then a long tail of assets that exist primarily for volatility control. This isn t a terrible approach, but when combined into a portfolio of funds, one can end up with a set of exposures with low volatility but anemic returns. One solution to these mandate design issues is using separate accounts to construct customized exposure profiles. Customization can range from relaxing the risk limits of a manager s commingled fund or concentrating the fund into higher-conviction ideas to carving out sub-strategies or even significantly re-designing the mandate from the ground up based on a manager s core strengths. Constructing custom mandates has three major benefits: First, if done properly, it can increase the return profile of the fund without necessarily changing its correlations to other funds. When applied to a portfolio,

3 PAAMCO Page 3 such customization can create a stronger return stream at an acceptable risk level. Second, we believe customization self-sorts managers. In our view, managers who are passionate about investing should be drawn to the higher return potential of the custom accounts and be willing to accept the additional cost and effort it will take to run a separate fund. Managers who are business-profit maximizers may be less interested. Finally, custom mandates can help focus the manager so that the exposure profile they take on is more predictable, which in turn allows investors to treat the manager as a relatively known component of a broader portfolio rather than a provider of shifting exposures which may or may not fit well with the rest of the book. Volatility, Crowded Trades and Risk Budgets: Dynamic Management Asian markets continue to sit on the knife-edge of the global risk trade, and even welldeveloped markets like Japan are heavily influenced by foreign capital flows. Thus, Asian markets have historically been particularly volatile. Furthermore, a propensity for crowded trades due to common themes in equity investing and limited liquidity in some markets mean that there can be periods of significant overlapping factor and even idiosyncratic exposures among managers. Thus, the risk profile of a portfolio of funds in Asia can shift significantly over time as underlying exposures, managers and market conditions change. Relying on static geographic and strategy diversification to maintain risk control can lead to long periods of under-risking, punctuated with volatility spikes, leading to an inefficient use of a given risk budget. The volatility of Asian markets can also mean that if you are invested in a high-quality manager with directionality to an asset class, despite his or her skill, a negative move in the asset class may swamp whatever alpha they generate. Therefore, consistent exposure to significant asset-class directionality can be an outsized source of risk. Because managers cannot see each other s exposures, we feel it should fall to the allocator to make better use of their risk budget via dynamic risk allocations. We believe that allocators can smooth aggregate portfolio risk over market cycles and in response to changing exposures by: 1) increasing aggregate exposure when managers are less correlated and forward-looking views of market risk are benign, and 2) The risk profile of a portfolio of funds in Asia can shift significantly over time as underlying exposures, managers and market conditions change. Relying on static geographic and strategy diversification to maintain risk control can lead to long periods of underrisking, punctuated with volatility spikes, leading to an inefficient use of a given risk budget construction.

4 Page 4 PAAMCO We recommend clearly defining the responsibilities of the underlying manager and the allocator: the underlying managers are in charge of security selection and the allocator is tasked with exposure management and portfolio construction. reducing allocations when exposures are more correlated and when there are storm clouds on the horizon. In other words, we recommend defining the responsibilities of the underlying manager and the allocator more clearly: the underlying managers are in charge of security selection and the allocator is tasked with exposure management and aggregate portfolio construction. Furthermore, we believe that manager weighting should be done on a riskcontribution basis, rather than a dollar-invested basis: the highest-conviction managers should receive the largest share of the book s risk budget, not necessarily the largest share of assets. To further combat volatility, we feel that the bulk of core allocations should be largely market neutral, but we also feel there is a place for more short-term, directional, tactical allocations. Examples of tactical allocations could include: 1) a spread relationship that has changed significantly from historical norms, but in which there is an economic rationale for reversion; 2) a non-economic distortion in markets that is understood and which is expected to normalize over time; or 3) a trade that is very asymmetric by nature of the instrument itself. However, injecting a directional trade into a non-directional core can have very meaningful risk consequences. Therefore, the entire portfolio must be considered when tactical trades are made. Transparency and Operational Risk: Improving Infrastructure Two assumptions are implicit in the solutions discussed above: 1) Allocators can see the underlying exposures they are managing 2) Allocators have the infrastructure to control them as necessary We sometimes find managers to whom we would consider giving allocations, but who are unwilling or unable to invest in high-quality leadership on the operational side of the business. Without these two elements, the above portfolio management methodology is impossible to implement. Furthermore, we sometimes find managers to whom we would consider giving allocations, but who are unwilling or unable to invest in highquality leadership on the operational side of the business. This, in turn, can lead to a failure to build an institutionally-appropriate operational infrastructure. This makes them ineligible for investment consideration, in our view, shrinking the size of the investable universe. Internal and external separate account platforms have existed for some time, and

5 PAAMCO Page 5 focused their early iterations on fund governance, transparency and asset control and these are still extremely important benefits in Asia. However, technology and process improvements are now facilitating the evolution of platforms to the next generation of information provision and control: providing daily risk reporting, improved portfoliowide cash and collateral management, exposure control via leverage management among underlying exposures, deeper operational shadowing, improved end-client reporting and many other benefits. These new designs can provide all of the usual platform control, transparency and governance benefits, as well as enable the more aggressive portfolio management philosophy we have outlined above. Additionally, while platforms cannot overcome serious operational deficiencies at the manager level, they can, in certain circumstances, provide compensating controls where there are specific weaknesses in a manager s back and middle-office operations. We believe investors can improve the odds of success by undertaking new initiatives in the current period of challenging funding and flux in the balance of power between managers and allocators. Walking the Path The Chinese proverb (often understood to be a curse) may you live in interesting times seems particularly applicable to the current environment for hedge fund investors in Asia. We see so much potential, but Asian hedge funds have not fully delivered on their promise over the past few years. However, we remain confident in the long-term potential for hedge fund investing in the region, and believe investors can improve their odds of success by undertaking new initiatives in the current period of challenging funding and flux in the balance of power between managers and allocators. We have learned important lessons about both opportunities and limitations of investing in the region and believe this is the best path forward. The evolutionary changes we advocate which we think can help Asian fund portfolios better work together as integrated entities take effort, resources and time, as well as significant experience and specialized skills to manage. Moving to this approach will be challenging for many investors. Extending manager relationships into customized separate accounts and implementing dynamic exposure management are labor and negotiation-intensive. But the development of the operational, risk and portfolio management skills required to take Asian hedge fund investing to the next level may be the key to ensuring that the next few years of investing in Asia are not only interesting, but also profitable.

6 Page 6 PAAMCO Misha Graboi, JD, CFA, FRM Associate Director Portfolio and Account Management Misha is an Associate Director working in Portfolio and Account Management. He spent the summer of 2007 working at PAAMCO and joined full time in August In September 2009, Misha moved to PAAMCO s Singapore office to strengthen PAAMCO s Asian manager research team. Prior to PAAMCO, he was a Director of Rigel Associates, a middle-market financial advisory firm. Before joining Rigel, Misha was an Executive Director at Goldman Sachs International in their Equity Research division. He began his finance career at CIBC Oppenheimer, first as an investment banking analyst and then as an equity research associate. Misha holds an MBA from Harvard Business School, where he was a Baker scholar, and a Juris Doctorate (magna cum laude) from Harvard Law School. He holds a BS degree in Finance and International Business (magna cum laude) from Georgetown University.

7 The Eurekahedge Asian Hedge Fund Index (Bloomberg Ticker EHFI38) is an equally weighted index of 366 constituent funds. The index is designed to provide a broad measure of the performance of underlying hedge fund managers who invest exclusively in Asia. The index is base weighted at 100 at December 1999, does not contain duplicate funds and is denominated in local currencies. This document contains the current good faith opinions of the authors but not necessarily those of Pacific Alternative Asset Management Company, LLC and its subsidiaries (collectively, PAAMCO ). The document is meant for educational purposes only and should not be considered as investment advice or a recommendation of any type. This document may contain forward-looking statements. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. Any forward-looking statements speak only as of the date they are made and PAAMCO assumes no duty to and does not undertake to update forward-looking statements. Pacific Alternative Asset Management Company is a registered trademark in the United States, Canada, Japan, Singapore and Australia. PAAMCO is a registered trademark in the United States, Canada, Europe, Japan and Australia. Pacific Alternative Asset Management Company Europe and PAAMCO Europe are registered trademarks in Europe. Pacific Alternative Asset Management Company Asia and PAAMCO Asia are registered trademarks in Singapore.

8 Pacific Alternative Asset Management Company, LLC ( PAAMCO ) is an institutional fund of hedge funds investment firm dedicated to offering strategic alternative investment solutions to institutional investors around the world. PAAMCO s clients include large public and private pension plans, foundations, endowments, and financial institutions. Located in Irvine, California, with a European office in London, Pacific Alternative Asset Management Company Europe, LLP ( PAAMCO Europe ), and an Asian office in Singapore, Pacific Alternative Asset Management Company Asia, Pte. Ltd. ( PAAMCO Asia ), the firm is committed to meeting the needs and demands of its global institutional client base both now and in the future. PAAMCO is registered as an investment adviser with the U.S. Securities and Exchange Commission and as a commodity pool operator and commodity trading advisor with the Commodity Futures Trading Commission, and is a member of the National Futures Association. PAAMCO Europe is authorized and regulated by the Financial Conduct Authority. PAAMCO Asia is an Exempt Fund Manager under the Securities and Futures Act and an Exempt Financial Adviser under the Financial Advisers Act. UNITED STATES Jamboree Road, Suite 400 Irvine, CA United States Tel Fax UNITED KINGDOM 25 Victoria Street London SW1H 0EX United Kingdom Tel Fax SINGAPORE 50 Raffles Place #13-06 Singapore Land Tower Singapore Tel Fax