Will Korean-Style Hedge Funds Flourish?

The debt crisis in Europe, the slowdown of China’s growth, and the intermittent recovery in the United States all pose uncertainties to the future of the South Korean economy. Can Korea continue to weather the brewing storms as it did when it sailed through the recent global financial crisis with positive growth? That growth was only 0.2%, but the country bounced back the next year with a 6.1% growth rate, due to the government’s macroeconomic policies and robust and renewed domestic and export demands. And, unlike many other nations, Korea has kept its public debt under control, coming in at only 23% or so of GDP. Korea’s free trade agreements (FTA) with such major economies as the EU and the United States have boosted exports for all sides, and this year Korea has commenced talks aimed at securing a FTA’s with China and Japan.

This economic growth and stability, however, is just a backdrop to some more interesting developments in Korea’s financial services sector. Many are hopeful that recent legislative changes will accelerate the development of Korea’s nascent hedge fund industry.

Policymakers aim to position the country as a financial hub in the region by 2015, and just a few years ago, Korea passed sweeping financial market legislation in an attempt to consolidate and revitalize its capital markets. Recently, it amended the financial laws once again to create an environment favorable to homegrown hedge funds. However, what Korea is doing has been attempted in numerous other countries without success. How will Korea’s financial reforms fare given the current situation overseas?

Unlike their foreign counterparts, Korean-style hedge funds have lower leverage, and they do provide more information for domestic investors. They also cap leverage at 400% of the funds’ capital.

Korea’s capital-market conditions are still developing, and restrictions on debt may limit the ability of local hedge funds to carry out some of the common strategies that hedge funds elsewhere use to attain maximum return on investments. Given the situation, they are likely to be limited to either equity long-short or CTA (managed futures) strategies. Indeed, 11 out of the 12 hedge funds that registered with the Financial Services Commission (FSC) last December named “equity long-short” as their main investment strategy. And this strategy could be further constrained with Korea’s ban on short-selling of financial stocks.

Korea has also placed a high-entry barrier to retail investors. Membership to Korean-style hedge funds is restricted to individual investors who can put up at least ₩500 million. There have already been calls to lower the investment requirement for individual hedge fund investors, at least for as long as the measure does not make inroads on the publicly-offered funds. Yet others argue that all investors should have access to the alternative investing strategies and diversification potential of hedge funds.

In an attempt to guard against systemic risk and enhance investor protection, Korean regulators have already strengthened reporting requirements for hedge funds. Korean-style hedge fund managers are required to submit a quarterly report on their major strategies and the types of assets in which they invest, as well as their leverage and derivatives positions.

Some experts predict that Korea’s hedge fund industry will grow to ₩42 trillion in the first three years, while others put the figure at ₩18.5 trillion based on the growth of the global hedge fund industry. But, even with the lower figure, the number still looks optimistic given Korea’s developing capital markets and regulatory system.

According to the Financial Services Commission, the registered hedge funds have pooled ₩150 billion in seed money as capital three months after the amended to the Capital Market Consolidation Act (CMCA) took effect in September. How big the hedge fund industry will grow in the short-term will largely depend on the participation of such large institutions as the National Pension Service and some wealthy individuals. Whether it will sustain its growth will be up to how the Korean-style hedge funds perform.

For more analysis on Korean markets, follow the Korea Investment Conference on Twitter (#KIC12) or tune in to the live streaming sessions:

• “Global Uncertainties: U.S., Europe, China and Implications for Asia and South Korea,” with Richard Duncan.
• “North Korea: Geopolitical Challenges for South Korea,” with Brian Myers.