Can Korea Successfully Cultivate a Home-Grown Hedge Fund Industry?
Korea-style hedge funds and prime brokers were a popular topic within Korean financial circles long before their launch in December 2011. In mid-June, the subject become the talk of the town as two conferences that focused on Korean hedge funds took place in Seoul: the Korean Hedge Fund Conference, hosted by Korea’s Financial Services Commission (FSC), the Financial Supervisory Service (FSS), the Korea Capital Market Institute (KCMI), and the New York Hedge Fund Roundtable (NYHFR); and the Korea Investment Conference, hosted by CFA Korea and CFA Institute. The Korea Financial Investment Association (KOFIA), an industry group, was also involved in both events.
The regulatory regime governing hedge funds in Korea has changed dramatically. Building on the liberalization and consumer protection initiatives relating to the Capital Markets Consolidation Act (2009), a number of key changes were approved in 2011 to pave the way for the introduction of Korea-style hedge funds in order to meet the growing demand for alternative investment vehicles that provide more effective portfolio diversification for Korean investors. Korean officials are also aiming to further enhance the breadth and depth of domestic capital markets — and nurture a few world-class investment banks and asset managers.
By amending the Enforcement Decree of the Financial Investment Services and Capital Markets Act, the range of hedge fund investors was recently broadened as private individuals who could invest a minimum of KRW 500 million (around US$430,000) were added to the qualified investor category. The revision also included relaxing restrictions relating to leverage (raised from 300% to 400%), derivatives (raised from 100% to 400%), and investment in distressed restructuring firms. There are also specific requirements on track record, manpower, and paid-in capital for hedge fund management firms to satisfy. (For example, a minimum of KRW 6 billion, or around US$5.2 million in paid-in capital, is mandatory.) At the same time, reporting duties — including detailed quarterly disclosure of the main strategies, and use of leverage and derivatives, etc. — are tightening up.
The FSC also approved revisions to the Regulations on Financial Investment Business in November 2011 to stipulate new criteria for hedge fund professionals and for asset management firms to enter the hedge fund business. Additionally, so-called “Chinese walls” must be introduced within hedge fund operations to avoid conflicts of interest, and improved computation rules have been promulgated for value-at-risk models. Only asset management firms with KRW 10 trillion (around US$8.6 billion) in assets under management qualify to set up a hedge fund business, and a minimum of three qualified fund managers with requisite professional experience are required.
Also, in December, KOFIA issued a set of best-practice guidelines for hedge funds and prime brokerage services, covering internal controls, risk management, conflict of interest avoidance, leverage limits, investment restrictions, disclosure, marketing and distribution, liquidation and termination, and related issues.
These regulatory changes are expected to foster the development of homegrown hedge funds and prime brokers in Korea. However, hedge funds historically are known to be lightly regulated. Is there too much regulation? Are the regulations too tight? Are they effective and appropriate? Can Korea-style hedge funds help improve the South Korean financial market? What is the best way to cultivate and nurture the ecosystem encompassing hedge funds, prime brokers, and various service providers?
At the Korea Investment Conference, an executive panel discussed many of these issues in depth. The panelists included:
- Michael Chin, CEO, UBS Hana Asset Management;
- Bill Fung, visiting research professor at the Hedge Fund Centre of London Business School and chairman of Maple Financial Group;
- Michael Kim, managing director, Daewoo Securities;
- Bruce Wonil Lee, CFA, CEO and CIO of Value-in-Action, Allianz Global Investors Korea; and
- Patrick Mange, deputy CEO, Shinhan BNP Paribas Asset Management.
Moderating the session was Michael Kim, CFA, executive managing director, Hanadaetoo Securities, and president of CFA Korea.
Some notable takeaways:
- Hedge funds as an asset class are needed in Korea to fill a gap and allow better diversification in investment portfolios. The demand is there. However, some simple regulatory fine-tuning, which can readily be done, is required.
- The industry is either overregulated in some aspects or inappropriately regulated in others. For example, there is no firewall between the front and back office within the typical prime brokerage operation.
- Managers’ styles are “regulatory-driven” and largely overlapping currently. There are one or two styles only, and offerings are still in the early stages of evolution.
- The bulk of the funds are still oriented toward Korea’s domestic market. Expanding to overseas markets is key for getting better performance and risk diversification.
- Panelists estimated that in the entire hedge fund industry about 40%–45% of assets are invested in long–short equity strategies. In Asia, this is even more pronounced as the bond market is relatively small. It is a natural first step in the Korean hedge fund industry for this type of strategy to dominate. There is no shortage of talent in managing long–short strategies. There are many long-only funds that have already been running long–short strategies.
- Regulations that are effective in protecting the retail investor and regulations that are effective in protecting the integrity of the market or developing Korea’s capital markets could in fact be quite different and inconsistent. The authorities need to decide what the top priorities are — and set regulatory initiatives accordingly. By definition, hedge funds are lightly regulated, but panelists felt that this is not the case currently in Korea.
- Of the 15 Korea-style hedge funds currently in operation, about 80% are reporting negative performance with high volatility. In Korea, retail investors tend to have the misconception that hedge funds are high-risk, high-return vehicles. Korea-style hedge fund managers appear to be chasing high-return performance to cater to retail investors but are ignoring the needs of institutional investors, who are looking for yield and stable return products given the relatively low interest rate environment.
- At this stage, there is substantial need to import talent. A number of Koreans from Wall Street and London have returned home and have joined Korean hedge fund firms. Some are finding local clients (seed capital investors or institutional investors) rather difficult to deal with as they tend to ask about performance on a daily basis, without recognizing that it is generally necessary to take a longer view when investing in hedge funds.
- Panelists felt that the service infrastructure — for example, prime broker firms, lawyers, accountants, and other skilled professionals and support staff — are generally available in Korea. However, more work is required to develop the market infrastructure. For example, even though index option volume has a top ranking globally, there are essentially no single stock options.
- Some regulations are actually working against clients rather than protecting them. For example, each prime broker has to build Chinese walls around the business unit servicing hedge funds. Hedge fund clients are not permitted to use research from other sources (for example, research from long-only investment units). This is working against the clients. There are no such walls in Hong Kong and Singapore. In addition, entry costs appear quite high. A minimum investment of around US$430,000 for a Korea-style hedge fund or around US$90,000 for a fund of hedge funds are both rather high entry points compared to those in Singapore and Hong Kong.
- Availability of talent is plentiful on the investment side, according to the panelists. However, in the prime brokerage space, there is a lack of good administrative systems, risk management systems, trading platforms, and securities lending services. Talent is also hard to find. The regulations tend to protect local prime brokers.
As the world’s 13th largest economy and 8th largest exporter, with a population of almost 50 million and OECD-level GDP per capita, Korea will continue to experience fast growth in private and corporate wealth as well as pension and insurance assets. The demand for investment products is expected to remain strong. Continuing accelerated development of the capital markets and wealth management vehicles, in particular Korea-style hedge funds, is likely given that Korea has already built some highly successful industrial sectors and the public equity market has a diversity of world-class companies listed. On the high side, for example, an executive director at Mirae Asset Financial Group projected industry AUM to reach KRW 40 trillion (US$35 billion) by 2014.
Nevertheless, key questions relating to the ecosystem’s prospects remain. Will industry groups and government authorities move fast and effectively enough to fine-tune regulations to foster innovation and growth in the industry? And, at the same time, can they ensure that consumers are properly protected and systemic risks managed? Will lifestyle and personal finance conditions be made attractive enough in Korea (despite geopolitical challenges from north of the Demilitarized Zone) for international hedge fund and prime brokerage talent to move in and work alongside locals to help boost operations and professional skills to world-class levels?
These are undoubtedly the key factors to watch. The hurdles may appear daunting, but Korea has an enviable track record when it comes to building new industries. Someday soon the country’s brand-name hedge funds could well rival the success of its world-class automobile and electronics brands.
Seoul Tower photo from Shutterstock.