Asian Stock Focus: China's Volatile Mkt Aids Hedge Funds
By Laura Santini
HONG KONG (Dow Jones)--More and more China-focused hedge funds are springing up to take advantage of a volatile equity market.
Dynasty Asset Management of Shanghai launched its China Opportunities Fund, tackling small-capitalization and midcap stocks, this year. Hong Kong's Value Partners has started a hedge fund betting on both rising and falling stocks. Next month, Dalton Investments of Los Angeles will add a Greater China Fund to its roster.
"China is a very volatile market," says Jacky Choi, senior fund manager at Value Partners. "In this market, you can't be long all the time."
In contrast to long positions, in which buyers purchase shares and hold them for months or even years, short sales involve the near-term expectation that share prices will fall. In a typical short sale, an investor borrows shares from a broker and sells them, waits for the price to fall, then repurchases them at the lower price to repay the broker and pocket the difference.
Short sales allow hedge funds to satisfy several distinct objectives: gamble that a company's shares are heading down; grab returns out of the market's volatility by betting on movement in a basket of stocks; or offset the downside risk of shares held long in a portfolio.
Some new funds are watching possible developments that could push down China's stock market, including currency risk.
An upward revaluation of the Chinese currency, which some analysts believe China is getting closer to allowing by loosening its peg to the U.S. dollar, could hurt that country's exports. With a stronger yuan, manufacturing sectors would stand to lose over the longer term. In the short term, however, companies would be able to report stronger earnings in U.S. dollar terms.
Rising commodities prices also are a big concern. High oil prices would increase costs across the economy, denting Chinese companies' earnings. Another interest-rate increase also could damp enthusiasm for China shares. Bond prices, which tend to rise and dip with the stock market, fall amid higher interest rates.
Finally, some stock analysts doubt that the recent rally for China shares will continue. "There is room to come down in the medium term," says Steve Dai, portfolio manager at Dynasty Asset Management. In the firm's new China Opportunities Fund, Dai has taken short positions in several Chinese companies, including Maanshan Iron & Steel, Aluminum Corp. of China and Jiangxi Copper.
Option To Short Stocks, Indexes Holds Appeal
Even for the many investors who remain positive on the China market despite its problems, an option to short stocks or indexes holds appeal. Hedge funds relish a rocky market, where big rewards can be reaped from risking capital that the market will veer one way or the other.
This year has proved particularly choppy for the Hang Seng China Enterprises Index, which tracks shares of mainland companies that are traded in Hong Kong. The index has been on a roller coaster, plunging 34% through May 17, only to rise 36% since then. Last year, the index pursued a steady upward trajectory, finishing the year up 152%.
Value Partners' Choi says China's volatile stock market prompted the firm to launch a hedge fund that could place near-term bets on the overall direction of the market.
The fund represents a departure for Value Partners. The firm runs several long-only mutual funds for investors in Asia, including the China Mainland Focus Fund, run by Choi, which has returned 3.95% so far this year. In addition, the firm manages a limited partnership for U.S. investors that is weighted toward markets in China, Hong Kong and Taiwan.
Other hedge funds aim to mitigate risk by offsetting possible losses in their portfolio with gains from short sales.
Shu Yin Lee, an adviser in Shanghai to Dalton Investments, says selling short is appealing "largely because we have to hedge risk in areas where the market can be quite volatile."
Other new hedge-fund entrants in Hong Kong include Acru Asset Management, a new firm started by Billy Chan and Sam Lau, former managers at Invesco Asia and Baring Asset Management, respectively, and Apex Capital Management, opened in May by former HSBC portfolio manager Tat Auyeung.
China strictly prohibits short sales of mainland-traded shares. Class H shares traded in Hong Kong, however, are fair game. Generally, short sales cost far more to execute in Hong Kong than in the U.S. Brokers that lend stocks in Asia for investors to short charge between 1% and 5% of the total trade's value, compared with rates of 0.01% to 0.02% in the U.S.
Depending on how they are structured, derivatives can offer the same benefits as short sales. The Hong Kong exchange has created options contracts on several highly liquid stocks and launched futures and options on the H-share index. The contracts rank among the exchange's most actively traded products.
Hedge funds, however, are clamoring to short the volatile Class A shares trading on exchanges in Shanghai and Shenzhen. Class A shares, mostly restricted to Chinese citizens, are perceived as trading at levels that don't reflect the companies' real value, so hedge funds think they can squeeze out returns snapping up underpriced stocks and shorting the expensive ones.
Melvyn Ford, head of global equity finance at Merrill Lynch, says several hedge funds have asked the firm's prime brokerage unit about the possibility of doing "synthetic shorts," in which bankers use derivatives to structure a trade that allows a hedge fund to profit from a drop in a particular company's shares.
Ford says Merrill won't provide synthetic shorting. To do so could deplete the firm's inventory of Chinese shares, which foreign investors have limited rights to purchase. Other investment banks say Chinese regulators have warned them against engaging in synthetic shorting of Class A shares.
Some of the new hedge funds, while not ruling out H-share short-selling in the future, have held off. Apex's Auyeung says he still is encouraged by the Chinese market.
"There's a lot of positive news," Auyeung says, citing the continued overall strength of the Chinese economy and the U.S. market's strong performance following the election. "We're not shorting in this rally, but we will," he says.
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