China's hedge funds find their feet

By Allen Cheng

Value Partners’ chairman Cheah Cheng Hye says value investing is his main strategy and China his primary theme, and that despite spectacular growth, he believes that the best for the region is yet to come.

He founded what became Greater China’s first, and by far its biggest, hedge fund back in 1993, the same year Tsingtao Brewery Co listed on the Hong Kong stock exchange in the first initial public offering by a Chinese company since the communist takeover of China in 1949.

Cheah started off in Hong Kong’s Wanchai neighbourhood, famous for its red-light district and wild bars, renting a dingy office with two desks in a building that overlooked an outdoor vegetable market. He had just $5.6 million to invest; today the group has about $18 billion in assets under management.

Joseph Zeng of Greenwoods Asset Management, a hedge fund management company set up in Shanghai in 2004 and in Hong Kong in 2005, sees a similarly bright future. 

Zeng and the Greenwoods team have $12 billion in assets under management invested in public equities. They see plenty of opportunity in China’s capital markets as the nation accelerates reforms that they think will open up both inward and outward investment.

“We are concerned about short-term volatility, but very positive about longer-term prospects of Greater China markets,” Zeng tells Asiamoney from his office on the 36th floor of Jardine House in Hong Kong’s Central district. 

Founded by famous Chinese fund manager George Jiang, Greenwoods specializes in stock picking outstanding performers across China’s fast-growing sectors, ranging from consumer and e-commerce to education and pharmaceutical.

Cheah and Zeng, two of Greater China’s most successful hedge fund managers, speak enthusiastically when they talk about capital market opportunities in the years ahead. 

They and their firms are among the leaders of a growing pack of hedge funds coming out of China; many of these compete with their best-in-class peers from New York and London to manage money for a rapidly rising number of high net-worth individuals and institutional investors in Asia.

Though small compared with its equivalent in the US or Europe, China’s hedge fund industry is a growing force, says Jeff Nie, co-chairman of the Absolute Return Investment Management Association of China (Arimac), an industry group that represents alternative managers in the region.

There may be as many as 800 active hedge funds in China now, according to Nie. He estimates the industry’s assets under management could be as high as Rmb10 trillion ($1.6 trillion), although it is difficult to arrive at accurate figures because the authorities include private equity in the data collected about Chinese privately run, non-unit trust asset management houses. 

Despite a Chinese government crackdown on equity shorting during the stock market crisis of late 2015 and early 2016, China’s hedge fund industry is alive and well and pushing the limits again with direct shorts on equities, adds Nie.

“In the past 12 months, regulators have been relaxing restrictions, and the environment today is easier,” he says. 

Nie is certainly familiar with industry trends: he is chief risk officer of Keywise Capital Management (HK) Ltd, a Hong Kong-based alternative investment manager with $2.6 billion in AuM and a research team of analysts in Beijing. 

“Equity shorting, though expensive, remains legal; some fund managers with strong convictions still take direct positions,” he says.

Nie estimates there are now dozens of Chinese funds that manage $1 billion or more; among them, about a dozen or so have set up operations in Hong Kong, where there are no restrictions on short-selling, making the Special Administrative Region the primary offshore launch pad for alternative mainland managers seeking to go global.

The hedge fund industry in China has had its ups and downs. 

As recently as 2015, China’s regulators imposed temporary bans on short-selling during a stock market crisis that led to big declines in valuations. Regulators also investigated and punished a number of hedge fund managers and brokers for market manipulation in onshore markets. 

They have since reversed course, approving a number of tools that give hedge funds a wider range of choices to achieve alpha, without necessarily taking out short positions on an equity.

Direct shorting remains an expensive exercise. Officials formally legalized shorting in 2010, but initially restricted the number of equities available to just a few dozen, which resulted in high costs of borrowing, with brokerages charging an annual interest rate of 8.3% to 11% per equity loaned, more than three times the cost in other markets, according to Nie.

Since the temporary ban on shorts in 2015, regulators have liberalized the sector by allowing more than 1,000 equities to be made available for shorts, he says. 

Furthermore, they legalized a range of stock and commodity futures and index products that give alternative managers additional ability to hedge their portfolios, says Nie. He adds that many managers in China prefer to hedge by buying index futures, rather than taking the expensive option of shorting an equity directly. 

Chief among the most popular index hedging tools are SSE50 (Shenzhen Stock Exchange 50) and CSI300 (China Securities Index 300) index futures for big caps and the CSI500 Index Futures for small caps.

“There are now many new ways to hedge in China that do not require direct shorts on equities,” Nie says.

Joel Coverdale, Asia managing director and head of London-based portfolio optimization and risk-management software firm Axioma, says China has grown to become the firm’s single largest market in Asia since the crisis of 2015. Last year, it broke into the firm’s top 10 biggest markets by domestic revenues.  According to Coverdale, many Chinese hedge fund managers came to Axioma for help in finding new ways of hedging without actually taking equity short positions, which continue to be a risky exercise involving high expenses for wrong one-way bets.

“The 2015 stock market crisis and government crackdown on shorting forced managers to come up with alternative ways to hedge,” he says. “Our firm has been very successful in the US in the past 10 to 15 years, but where do we see the growth? It’s obviously in this region in the next 10 to 15 years. China will be a significant part of that growth.”

Nie agrees, saying that with improved prospects, China’s hedge fund industry has a great future and room for growth

He adds: “There are now dozens of firms with AuMs of $1 billion or more, and the billion-dollar club will be expanding.”

If any one firm can claim to be the grandfather of Chinese hedge funds, it would be Hong Kong-based Value Partners, which in 2003 became the first hedge fund in the region to have more than $1 billion in AuM. 

It is by far the largest, too. The firm, whose headquarters cover two floors of the central financial district’s Nexxus Building, employs more than 200 professionals, including 70 analysts and fund managers, and has offices in Singapore, Shanghai, Beijing, Shenzhen and London. It listed on the Hong Kong stock exchange in 2007 and remains the only asset manager listed there.

“We’ve come a long way, but we’ve only written the prelude of our story,” Cheah says. The company’s two top funds continue to outperform the markets. Its first, the $1.6 billion Classic Fund, which applies a combination of long and short strategies, delivered net returns of 40% in the 12 months to the end of February, compared with 34% for the Hang Seng Index during the same period.

From its launch in 1993 to the end of 2017, the fund delivered a total net return of 3,700%, beating by a long shot the 650% return for the Hang Seng Index. 

Value Partners’ $5.7 billion Greater China High Yield Income Fund made 10.1% in 2017: the average annual return from Asian high-yield bonds was 6.9%. Since its launch in 2012 to the end of 2017, this high-yield bond fund has returned 56%.

“The next chapter is for Value Partners to become a world-class asset manager that serves as an investment solutions provider to investors in China and a China investment expert to investors from the rest of the world,” Cheah says. 

The firm is expanding in two fronts, he adds; it may set up offices soon in the US to cater to institutional investors there, and will launch funds onshore in China catering to Chinese high net-worth investors, “just like how Hong Kong has long held a special role of being a conduit between China and the West”.

Value Partners’ chairman Cheah Cheng Hye

Cheah, who is ethnic Chinese and originally from Penang in Malaysia, began his career as a local news reporter for ‘The Star’ in Malaysia in the early 1980s. He moved to Hong Kong a few years later, working stints at various local newspapers before joining the Asia edition of the Wall Street Journal, where he honed his skills as a stock market reporter and began studying the concepts of bottom-up stock picking and value investing. 

In 1989, he switched industries by joining the UK brokerage Morgan, Grenfell & Co. where he launched the research team. Cheah then met the scion of a wealthy Hong Kong family, V-Nee Yeh, and the two set up Value Partners in 1993.

Over the intervening 25 years, Cheah has gone on to launch more than a dozen other funds and tailor-made strategies through managed accounts set up exclusively on behalf of high net-worth individual clients. 

In 2009, he and the team established a fund management firm in China and, with a private fund management licence obtained from the mainland, began raising funds from Chinese high net-worth individuals for onshore investments earlier this year.

Asian fund managers like Value Partners are entering a Golden Age,” he says. “I say this because something very exciting – perhaps one of the biggest opportunities ever seen in the history of asset management – is taking place in mainland China.”

The asset management industry in mainland China, he says, will see tremendous growth over the next decade, backed by the world’s largest savings pool and second-largest economy. 

“Investors there are also clearly looking to diversify their investments,” he says.

China’s reforms will drive the growth of the global asset management industry, according to a study released in November by Casey Quirk, the research unit of audit and accounting firm Deloitte. 

China’s fund flows will account for nearly half of the global industry’s net new flows in the coming years, Casey Quirk predicts, helping China to overtake the UK to become the world’s second-largest asset management market after the US in 2019. 

By 2030, according to Casey Quirk, fund industry assets under management in China will top $17 trillion, second only to the US.

Retail and high net-worth investors, according to the study, “will power China’s growth,” accounting for over half of the nation’s AuM by 2030. 

It is an assessment that has long been understood by global fund houses, many of whom – a total of 28 so far, with Value Partners being the one and only Hong Kong-domiciled firm among them – have jumped at the opportunity to acquire wholly foreign-owned enterprise licences to set up their own operations since the market was opened in June 2016. 

Previously, foreign fund managers had had to operate through joint ventures in which they were restricted to a maximum equity stake of 49%.  

Last November, officials announced they were lifting all limits on foreign ownership on financial institutions in the coming five years.

“China is the world’s second-largest economy and it has the world’s highest household savings rate,” says Yu Xiaobo, Value Partners’ investment director and head of China business. “It also has a growing middle class. All these factors are set to bolster demand for quality investment products in China. In the longer term, we hope to help service the investment management needs of retail investors in Mainland China as the private fund management licence may open the way for us to apply for a full mutual fund licence in the future.” The China business is a breakthrough for the firm as its investors have primarily come from just Hong Kong in the past.

Value Partners executives, in particular, are excited about China’s two Stock Connect programmes that link the Shanghai and Shenzhen exchanges with HKEx, the Hong Kong stock exchange. 

The Stock Connect programmes allow foreign investors in Hong Kong to trade China’s A-shares and investors in China to trade Hong Kong equities, completely bypassing China’s highly regulated capital and foreign exchange controls.

The programme gives foreign investors unprecedented access to China’s markets and is the primary reason index provider MSCI announced last year that it will be revising its Emerging Markets Index to include up to 5% of the A-share market in phases from May to September this year. 

Shan Lan, global head of index strategy and sales at Macquarie Bank, estimates that MSCI’s partial inclusion of A-shares will spur global investors’ appetite for Chinese listed equities, with passive funds buying up to $5 billion and active funds buying $18 billion within a few months of the inclusion.

China’s A-share market is the second-largest equity market in the world, notes Lan, adding that full inclusion of all eligible A-share stocks may push up A-shares’ weighting to 17% of the MSCI Emerging Markets Index and increase the weight of all Chinese equities – including those in Hong Kong and elsewhere offshore – to a weighting of about 42% of the MSCI index.

“We estimate a full inclusion may lead to up to $100 billion in cumulative inflows from passive funds, and up to $400 billion in cumulative inflows from active funds,” Lan says.

There are some reasons to be wary, Zeng warns. Greenwoods’ $2.3 billion Golden China Fund made a net return of 52% in 2017 and 25.5% a year on a compounded annualized basis from its launch in July 2004 to April 2018. However, Zeng sees short-term volatility for the hedge fund industry, especially as friction over trade between the US and China increases. 

“The trade war is [the] biggest headwind that affects investor sentiments,” Zeng says, “but it is both a risk and an opportunity.”

Zeng regards US demands that China improves its protection of intellectual property rights as a long-term positive in that it will force authorities to strengthen IP laws that provide protection to all innovators, both foreign and domestic.

“Many investors are concerned about a trade war,” Zeng says. “This is human nature – most investors are driven by sentiments, but we tell them it helps China to accelerate investments in research and development and protect intellectual property, both domestic and foreign.”

US pressure could push China to accelerate plans to achieve technology leadership in a number of key sectors, among them artificial intelligence and robotics, as laid out in president Xi Jinping’s ambitious Made in China 2025 strategy.

“Without pressure, there is no motivation,” Zeng says. “So, we think this is favourable for China in [the] long term.”

Zeng is particularly upbeat on China’s healthcare sector. Greenwoods’ China Healthcare Fund, launched in 2015, has delivered net returns of 57% in 2017 and 19% in the first three months of 2018 by investing in biotech and healthcare companies listed onshore, in Hong Kong and in the US.

Executives at Value Partners see other favourable trends, chief among them new market and structural changes that open up China’s large domestic capital markets. Last year’s launch of the China Bond Connect programme opened up the nation’s $10 trillion bond market to foreign investors who trade via Hong Kong.

“Demand for China’s bonds and credits will continue to rise in the years ahead, especially given how yields there are much higher than in the West,” says Eric Poon, head of sales and managing director at Value Partners. “This will be the case as China’s bond market grows, and as more central banks add the renminbi into reserves. With Bond Connect in place, investors will follow suit.”

The China Bond Connect will help propel the growth of Value Partners’ Greater China High Yield Income Fund, the firm’s chief executive, Au King Lun, tells Asiamoney. “The Bond Connect may even surpass the Stock Connect in terms of volume in the future.”

The China Foreign Exchange Trade System, which along with HKEx manages the Bond Connect, does not disclose the value of the contracts of bonds traded. But according to the website, in January foreign investors bought and sold 99,760 contracts of the top 10 traded bonds, up from 64,421 a year before. 

China’s Stock Connect, which was launched three years ago, traded Rmb243 billion ($38.6 billion) in January, more than four times the volume of January 2017.

Value Partners is taking the same bottom-up value investing approach to its fixed-income investments: visiting one company at a time and speaking to its executives. On average, Value Partners portfolio managers make 2,500 company visits a year as part of their due-diligence process. 

“When we talk to management, we don’t just take their word for granted,” says Au. “We do independent research.”

The Greater China High Yield Income Fund, for instance, invests in China and Hong Kong corporate bond issues that yield in the range of 7% to 9% annually. Au says Value Partners has recently launched one fund specializing in Asian and Chinese corporate private debt and another with a total return strategy.

Au says he does not see the rise of Asian and Chinese corporate debt levels to be a cause for concern for global investors, unlike many investors on Wall Street who fear rising corporate debt levels will lead to a financial crisis in the world’s second-largest economy. 

China simply will not suffer the impending financial crisis that many investors on Wall Street fear, Au says, at least not in the foreseeable future: “China basically has a closed banking system. The Chinese government doesn’t have much foreign debt. Most debt was denominated in renminbi and lent to state-owned enterprises. That is why China can deflate the debt bubble gradually. There is no external pressure on the China government and yet it is cracking down on rising corporate debt levels, and this is a good thing.”

That is not to say that China is immune from bear cycles. Cheah says the firm’s value investing strategy will guide the company through both ups and downs in the years ahead. 

“Value investing is, in fact, a strategy that performs consistently over the long term and across different stages of the market cycle,” Cheah says, adding that it is often during bear cycles that opportunities arise to buy quality companies at attractive valuations.

He looks for undervalued equities with strong fundamentals and he invests in them and holds for the long term. That includes investing in firms early in their value cycle; for example, he bought into Tencent Holdings, which owns China’s top social media app WeChat, more than a decade ago when it was a fraction of its valuation. He held the stock for a long time.

“If you look at the performance of our flagship Value Partners Classic Fund, it has achieved a net return, compounded, of 15.7% per annum since inception,” says Cheah, “well ahead of the Hang Seng Index’s 8.3% over the same period.”

He also notes that this fund has recorded a profit in 18 of its 25 years in existence.

“Value Partners remains a temple of value investing in Asia,” Cheah says. “For us, it’s about taking our value investing core and injecting it into an increasingly diverse suite of products across a wider range of asset classes to help our clients meet their evolving investment needs as we grow.”

The firm is diversifying as part of a strategic shift to spread risks across a wider range of asset classes. In June last year, the firm started its first foray into private equity, launching a real estate fund. By the end of 2017, the $114 million fund had made three investments, including two logistics centres in Japan. Later this year, the firm will launch a China private equity business based in Shenzhen to identify deals in China for global investors.

Greenwoods also has a private equity business run by an independent team, with around $2 billion in several PE funds that invest in pre-initial public offerings and PE deals.

Greenwoods, however, does not have an office in North America yet, whereas Value Partners wants to set up a sales and research presence in a large US city soon.

“North America is still the largest asset management market in the world and is a key investment destination for Chinese investors,” Cheah says. “If there is sufficient demand, we will indeed launch a research team in the US to cater to Chinese investors looking to invest offshore, especially given our commitment to meticulous on-the-ground research and fund performance.”

If Value Partners decides to enter the US markets, it would be the first Chinese hedge fund to do so. It is likely to be followed by many others as China’s hedge fund industry gears up for the global stage.