Hedge Fund Development in Hong Kong

1. Hedge FundDevelopment inHong Kong Group4 034037 Chan Ching On (Peter) 034080 Wong Chi Hui (Sam) 034081 Wun Ho Chun (Calvin) 034082 Yuen Wai Keung (Gary) 034093 Chan Pun Kam (Kim) 034108 Chan Chun Fat (Eric /發)

2. Mutual Fund-Portfolio Theory • Long 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!

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

4. Hedge Fund Strategies • Normal with short selling • Technical (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

5. Hedge Fund Strategies Illustrated with Hong Kong examples

6. Market Neutral - Arbitrage Example: Tracker Fund V.S. Hang Seng Index Future

8. Hedge out most market risk by taking offsetting positions

9. Market Neutral – Securities Hedging Examples: 857 V.S. 386 941 V.S. 728 330 V.S. 709

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

15. Designated Securities Eligible for Short Selling Listed by Stock Code Order (Effective: 1 March 2006) *Stock exempt from tick rule Source: http://www.hkex.com.hk/tradinfo/secshortsell/stkcdorder.htm

16. In a Bear market

17. Real example of Hedge Fund employing Macro Strategy 1992 Quantum Fund at London (Soros) 1997 Financial Crisis in HK

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.

19. Black Wednesday • 16 September 1992, Wednesday • Soros 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↑)

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

21. 1997 Asia Financial Crisis • From 1985 until July 2nd 199725 Thai baht = 1 US dollar • An American hedge fund had already sold $400 million of the Thai currency, devaluing56 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

22. HK

23. 1997 Asia Financial Crisis • October 1997, 3 months after soveriegnty7.8 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 valueprofit = 50-25 = 25, foreign exchange gain

25. HKMA has more thanUS$80 billion of foreign reserves, which is equivalent to 700% of M1 The strong reserves make the market confident against any attack. HKMA sold US$1 billion to defend.

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%

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)

29. Reasons of failure of hedge fund manager • Not 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

30. RecentDevelopmentand Some Influenceof Hedge fund

31. Development of Hedge fund • Assets 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

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)

34. Hedge fund news – TCL 2005 • TCI → The Children’s Investment Fund Management (now have US$3 billion AUM) • In late of Nov. 2005 → Link REIT’s trading volume increase suddenly • Some FI suspect some Hedge fund hold more than 5% shareholding • 1 Dec. → TCI hold 383.724 million units (17.95%) of trust. • However, they only acquire 0.41& in IPO

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

37. Some Influence of Hedge fund • Authorized 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

38. Some Influence of Hedge fund • More 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. 2005 → SFC change their policy on disclosure requirement • Now request all listed REITs need to disclose >5% shareholding

39. Regulation of Hedge Fund

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

41. Specific requirements on hedge funds • Fund 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

42. Fund managers’ qualifications • key 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

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

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

45. Appointments of representations and agents • key 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

46. Growth of HK Hedge Fund Market

47. Growth of HK Hedge Fund Market • Since 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

48. Growth of HK Hedge Fund Market • The 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

49. Growth of HK Hedge Fund Market • In 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

50. Growth of HK Hedge Fund Market • However, 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