1 Hedge Fund Development in Hong KongGroup4 Chan Ching On (Peter) Wong Chi Hui (Sam) Wun Ho Chun (Calvin) Yuen Wai Keung (Gary) Chan Pun Kam (Kim) Chan Chun Fat (Eric /發)

2 Mutual Fund-Portfolio TheoryLong position; No derivatives and leverage Diversification of firm-specific risk Only subject to economy-wide risk E.g. Tracker Fund 盈富基金 (Index Fund) Hang Seng Index ↑=Tracker Fund ↑ But HSI ↓= Tracker Fund ↓ Relative return (Correlation with market = 1) I can be your Fund Manager! ERIC

3 Hedge Fund Absolute return (correlation with market=0) Market-neutral, no matter Bull or Bear Both long and short position; derivatives and leverage Return Highly depends on Fund Manager’s skill Solve Agency problem of fund manager: >invest their own wealth into the fund >performance-based commissions (may 20% of profit) Hedge Fund can be risky investment and subject to substantial loss ERIC

4 Hedge Fund Strategies Normal with short sellingTechnical (statistical, accounting, historical data, compute modeling, mechanical) Event-driven (merger or convertible bond) Emerging market (BRIC 黃金四國) Distressed securities (big discounts due to reorganization/liquidation) Macro (global economies, govt.policies, interest rate, foreign currency, bond market, commodity) Fund of hedge funds ERIC

5 Illustrated with Hong Kong examplesHedge Fund Strategies Illustrated with Hong Kong examples SAM

6 Market Neutral - ArbitrageExample: Tracker Fund V.S. Hang Seng Index Future SAM

7 SAM

8 Hedge out most market risk by taking offsetting positionsHSIF higher than HIS HSIF lower than HSI short HSIF long HSIF Long Tracker Fund short sell Tracker Fund at the same time and equal amount Profit is made on the HSI future settlement day when selling all the contracts (on the 2nd last trading day of the month) SAM

9 Market Neutral – Securities HedgingExamples: 857 V.S. 386 941 V.S. 728 330 V.S. 709 SAM

10 SAM

11 At point 1 (time 1) Buy 857, short sell At point 2 (time 2) Buy back 386, sell at the same time and equal amount SAM

12 SAM

13 SAM

14 SAM

15 Designated Securities Eligible for Short SellingListed by Stock Code Order (Effective: 1 March 2006) *Stock exempt from tick rule Source: No. Stock Code Stock Short Name 1 CHEUNG KONG 5 HSBC HOLDINGS 　… 　…… ……………………　 156 728 CHINA TELECOM 105 386 SINOPEC CORP 152 709 GIORDANO INT'L 250 *2800 TRACKER FUND* SAM

16 In a Bear market SAM

17 Real example of Hedge Fund employing Macro Strategy1992 Quantum Fund at London (Soros) 1997 Financial Crisis in HK ERIC

18 George Soros (born August 12, 1930 in Budapest, Hungary as Schwartz Gyorgy) is a financial speculator, stock investor, philanthropist, liberal political activist and philosopher. He is currently the chairman and founder of Soros Fund Management. In 1970 he co-founded the Quantum Fund with Jim Rogers. It returned 3,365% during the next ten years, and created the bulk of the Soros fortune. ERIC

19 Black Wednesday 16 September 1992, WednesdaySoros became instantly famous when he on behalf of Quantum Fund sold short more than US$10bn worth of pounds Bank of England has ever raised interest rate from 10% to 12% (↑8 x 25 points) to defend by attracting buyer of pounds (Interest rate↑, Investment↓, Property market↓, Stock market↓, Spending↓ Unemployment rate↑) ERIC

20 Black Wednesday By 7pm that evening, British government announced Britain would leave the ERM (European Exchange Rate Mechanism) and to devalue the pound sterling, and Soros earned an estimated US$ 1.1 billion in the process Government lost and Hedge Fund won ERIC

21 1997 Asia Financial Crisis From 1985 until July 2nd Thai baht = 1 US dollar An American hedge fund had already sold $400 million of the Thai currency, devaluing 56 Thai baht = 1 US dollar (>50% dropped) Thai stock market dropped 75% of value After the collapse of Thai baht, Malaysia, Indonesia, Hong Kong were also attacked by speculative pressure ERIC

22 HK ERIC

23 1997 Asia Financial Crisis October 1997, 3 months after soveriegnty 7.8 HK dollars = 1 US dollars Macro strategy: borrow Thai baht from bank, say, borrow 1 billion baht at 25 baht:1 dollar, sell Thai baht in the market until devaluation, get US$ from Thai reserve at bank, buy devalued Thai baht, say, 50 baht :1 dollar, repay 1 billion baht at 50:1→ repay half of its value profit = = 25, foreign exchange gain ERIC

24 ERIC

25 HKMA has more than US$80 billion of foreign reserves, which is equivalent to 700% of M1The strong reserves make the market confident against any attack. HKMA sold US$1 billion to defend. ERIC

26 1997 Asia Financial Crisis Apart from buying as much as HK$ from the speculators, another defending measure adopted by HKMA and Donald Tsang (Financial Secretary at the time) include: at August 15, 1998, overnight interest rate ↑ from 8% to 23% (at a point, 500%) Interest rate ↑, stock market collapse, hedge fund can profit from short selling Between 20 and 23 October, Hang Seng Index dipped by 23% ERIC

27 ERIC

28 1997 Asia Financial Crisis Best way of driving speculators away is making them lose. Thus, HK govt. declared war with speculators openly, entered stock market and bought shares being shorted and Hang Seng Index Futures contract (in 2001, HK govt. left the market by establishing Tracker Fund) ERIC

29 Reasons of failure of hedge fund managerNot mainly due to HK govt’ tactics But default payment of Russian Govt. Bond and the collapse of LTCM, making contraction of hedge fund activities such as leverage with margin lending As a result, hedge fund attacks on Asia financial system closed ERIC

30 Recent Development and Some Influence of Hedge fundCALVIN

31 Development of Hedge fundAssets under management (AUM) in global hedge fund industry doubled from US$480 billion in 1999 to US$1 trillion in end-Sept 2005 Size is still small compared with traditional fund ↑interest in investors and fund house → sustain the growth CALVIN

32 Development of Hedge fund (con’t)History of HK hedge funds is so short HK is one of the place in the world to allow the sale of hedge fund to retail public I 2002 At end 2004 → 113 hedge funds operating in HK (AUM to US$12.4 billion) 13 were retail hedge funds authorized by the SFC (AUM US$1.2 billion) Biggest fund amount to more than US$500 million 6 are managed by SFC licensed managers ( totally US$830 million) CALVIN

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34 Hedge fund news – TCL 2005 TCI → The Children’s Investment Fund Management (now have US$3 billion AUM) In late of Nov → Link REIT’s trading volume increase suddenly Some FI suspect some Hedge fund hold more than 5% shareholding 1 Dec. → TCI hold million units (17.95%) of trust. However, they only acquire 0.41& in IPO CALVIN

35 TCI TCI acquire Link REIT → get 4-5% interest?Want ↑ Link’s debt ratio (debt to asset ratio) → borrow $ from outside →pay to holder Link have 34 billion total asset &12.2 billion debt Link can borrow more 3.2 billion → pay extra $1.5 to each unit TCI can make a high revenue CALVIN

36

37 Some Influence of Hedge fundAuthorized by SFC and should follow the SFC’s hedge fund guidelines SFC regularly review the guideline in order to protect the investor and make the development CALVIN

38 Some Influence of Hedge fundMore people concern TCI (hedge fund) will make some unreasonable demand on Link and other REITs SFC’ disclosure requirement → REITs is not the same as other listed co. Dec → SFC change their policy on disclosure requirement Now request all listed REITs need to disclose >5% shareholding CALVIN

39 Regulation of Hedge FundGARY

40 Regulation of Hedge FundAuthorized hedge funds are governed by the SFC's Code on Unit Trusts and Mutual Funds. SFC authorization ≠ a seal of recommendation. GARY

41 Specific requirements on hedge fundsFund managers’ qualifications Amount of assets under management (AUM) Risk management profile and internal control system Appointments of representations and agents Performance fee Information disclosure and other structural measures GARY

42 Fund managers’ qualificationskey personnel of fund managers of single hedge funds and Fund of Hedge Funds (FoHFs) must have: - a minimum of 5-year general experience in managing hedge funds, - at least 2 years of which is specific to the particular strategy applied in that hedge fund GARY

43 Amount of assets under management (AUM)at least US$100 million AUM for fund manager of a single hedge fund or a FoHFs GARY

44 Risk management profile and internal control systemto commensurate with their business profile and risk exposure, the fund managers should have: - proper, clearly written risk management - control procedures GARY

45 Appointments of representations and agentskey parties, such as administrators, custodians and prime brokers must have sufficient competence in their own areas the fund managers also need to provide adequate information and training to their selling agents GARY

46 Growth of HK Hedge Fund MarketKIM

47 Growth of HK Hedge Fund MarketSince May 2002, the Securities and Futures Commission (SFC) issued the guidelines on Hedge Fund for its authorization and they were effective SFC divided Hedge Fund into 3 categories Single Hedge Fund Fund of Hedge Funds Hedge Fund with a capital guarantee KIM

48 Growth of HK Hedge Fund MarketThe SFC also issues the Guidelines on Hedge Funds Reporting Requirements for the details regarding hedge funds’ on-going reporting obligations The Circular to Registered Persons Regarding the Marketing of Hedge Funds to remind financial intermediaries of their obligations to assess KIM

49 Growth of HK Hedge Fund MarketIn September, 2005, the SFC announced new hedge fund guidelines and effective immediately The SFC published its conclusions on the Consultation Paper on the Review of the Hedge Fund Guidelines KIM

50 Growth of HK Hedge Fund MarketHowever, for the consideration the responses and the need to ensure investor protection, the SFC has decided that: the minimum subscription of single hedge funds is maintained at US$50,000 There will not be a relaxation of the current restriction imposed on the level of collateralisation to prime brokers for SFC-authorised hedge funds KIM

51 Demand from Hedge FundsKIM

52 Demand from Hedge FundsThe findings from a HKIFA survey indicate that whilst there is latent demand for this type of products The early adopters probably are the more seasoned investors, one out of five fund investors (about 21% of the respondents) would consider investing in hedge funds. As expected, the percentage is much lower for non-fund investors – only about 2%. The most common reason for not buying is unfamiliarity. Experience from overseas markets indicates that the early adopters are usually the more informed and sophisticated investors KIM

53 Demand from Hedge FundsThis pattern also applies to banks and other distributors, which account for over 90% of fund sales in Hong Kong. This is usually supplemented by a series of very thorough training initiatives so as to ensure that the sales processes are properly conducted The investment strategies of hedge funds are more diverse than the traditional mutual fund products Also, they generally require much more time and resources for education and for communication with the staff and investors KIM

54 Demand from Hedge FundsKIM

55 Demand from Hedge FundsReasons for the decreasing demand Global equity markets have picked up since the latter part of 2003, which lead investors to return to the more traditional long-only products. S&P Investment Performance Measurement Report indicates that for the year of 2004, hedge funds managed by HKIFA members registered an average return of 8.8%, lower than the average return of 27.3% for the full year of 2003. KIM

56 Trend of Development PETER

57 Trend of Development Lower minimum investment limitMore hedge fund fund-house launch office at Hong Kong because of Qualified Domestic Institutional Investor (QDII) PETER

58 Recommendation PETER

59 Recommendation Lower minimum subscription amountMore clear and simple taxation Balance of regulation More promotion of hedge fund PETER

60 Conclusion

61 The End