Asia's hedge fund managers facing tougher test

By Jeffrey Hodgson - Analysis

HONG KONG (Reuters) - Asia's booming hedge fund industry will be tested in the coming year by heightened volatility that will catch out less talented managers who have coasted along on the multi-year bull run in regional stock markets.

Investors may be best off betting on the small but growing number of Asia-focused managers who use options and other trading tools to profit from heightened market turmoil, hedge fund executives said this month.

But given the limited number of players in this space compared with the more developed U.S. and European markets, they may simply have to be more selective when investing in Asian hedge funds, most of which bet on stocks and tend to do best when prices rise.

"In theory, volatility is the hedge fund's friend as they can make money on either side. More volatility in the markets should actually give them more opportunities," said Scott Lothian, head of manager research for Asia ex-Japan at investment consultant Watson Wyatt Worldwide.

"On the difference between a manager who does well and one who does badly, I think you'll start to see that gap widening ... there are fewer places to hide," he added.

Asian markets rallied on Wednesday following a bold half-percentage point interest rate cut by the U.S. Federal Reserve aimed a shielding the U.S. economy from a housing slump and the impact of global financial market turmoil.

But lurking in the background are a range of potential pitfalls for markets, including record oil prices, inflation pressures, the risk the latest cut won't revive U.S. growth and potential for further bad news from financial institutions.

Hedge fund executives at a recent conference in Hong Kong said given the range of uncertainties, the best bet for the year ahead is likely managers who can be "long vol", using derivatives to profit if volatility remains high.

For example, a fund could buy options on a stock index that are out of the money, betting they would turn profitable if the index jumps or sinks by a large amount.

"The expectation is volatility is going to be trending up, so what we see is the managers with the long vol strategies are likely to find opportunities," Eliza Lau, chief executive of fund of hedge fund firm SAIL Advisors Ltd, told Reuters on the sidelines of the event.

Lau, whose firm managed about $2.3 billion at the end of June, also thinks fixed-income arbitrage funds will provide attractive risk-adjusted returns, given the likelihood of a steepening yield curve in the region.

Among equity-focused hedge funds in Asia, the best risk/reward should be found among those geared to continued volatility, Daniel Wang, a portfolio manager with fund of hedge fund manager Vision Investment Management, told the event.

Several executives also said they liked the prospects for macro fund managers, who trade on trends in currencies, interest rates and other assets, particularly given the odds of further U.S. dollar weakness.

LACK OF SELECTION

The challenge for investors looking to Asia is finding ways to play these strategies.