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18 Sep 2006

Banks and Asian Central Hedge Funds

A number of Asian central banks, among the biggest investors in U.S. government debt, are looking at alternative targets for their vast dollar holdings.

Since 1997, currency reserves at Asia’s central banks have risen to about $3 trillion, leaving fewer dollar denominated securities in which hedge funds can trade, putting hedge funds on the defensive.

A report showing the U.S. economy is holding its ground may drive the dollar higher. Central banks such as the People’s Bank of China may see that as a perfect opportunity to sell a chunk of their U.S. holdings, pushing the market in a direction that traders don’t expect.

Central banks often carefully choose the moments when they expect an increase in market liquidity, when Federal Reserve officials speak or Japan releases inflation data, to make adjustments in their holdings. More and more, it’s turning Asia’s central banks into market heavyweights.

In the last couple of years, many speculators bet on a drop in U.S. debt prices. That left plenty of securities for purchases by foreign central banks.

The issue may be high on the list of topics discussed at next week’s IMF meeting in Singapore. It’s not about looking out for hedge funds; it’s about taming volatility in economies. Yet it’s also about exploring the wisdom of central banks amassing ever-growing stockpiles of reserves.

A recent paper from the Bank for International Settlements underlines the urgency. In it, BIS staffers Madhusudan Mohanty and Philip Turner express surprise that the reserve buildup hasn’t caused inflation.

In Taiwan, the current system for managing the nation’s $206.63 billion in reserves, the third-largest in the world, “might not be an efficient use of our resources,” says government minister Hu Sheng-cheng. Taiwan’s central bank has accumulated “too much” foreign exchange from Taiwanese exporters and from inflows to its capital markets, he says. Mr. Hu is heading a task force that will announce in the next few weeks details of a plan to use reserves to help local companies buy machinery and intellectual property rights overseas, he says.

Elsewhere in Asia in recent weeks, however, some governments have begun discussing plans to chip away at their dollar mountains. The initial amounts are small, but taken together they send a clear signal. South Korea’s plans are the most ambitious and could have the biggest impact on the dollar.

The International Monetary Fund’s last meeting in Asia was in 1997 and featured a debate about hedge funds. U.S. Treasury Secretary Robert Rubin argued that hedge funds were a vital source of liquidity when markets dry up. Asian policy makers saw them as predators causing undue volatility and overwhelming central banks. Either way, hedge funds are taking a backseat in Asia to the new Asian central banks.

Fund of Hedge Fund Investment

According to a Reuters poll this week, funds of hedge fund managers have downgraded expectations for returns over the next six months as global growth and a commodities bull run cooled.

A fund of hedge funds is an investment company that invests in hedge funds, rather than investing in individual securities. Not all funds of hedge funds register with the SEC. Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds.

The quarterly survey of 13 funds of hedge fund managers, which together manage more than $100 billion, showed they expected average returns, with only a few strategies, such as emerging markets, anticipated to bring above average results.

The poll, carried out between August 30 and September 8, showed a shift down in sentiment from the last survey, when half of all strategies were forecast to deliver superior returns in one or both of the following two quarters.

While some managers expect to benefit from an increase in volatility that has gripped markets in recent months, most are turning to strategies that aim to offer consistent returns in any market cycle, such as multi-strategy hedge funds which allocate funds to various sectors and regions.
And while managers trimmed down their exposure to emerging markets, they also forecast above average returns there in the fourth quarter this year.

These funds accounted for 44 percent of new money in 2005, down from 50 percent a year before. Total assets covered by the survey stood at $1.26 trillion (670 billion pounds) last year, up by about a fifth on 2004.

Investors have been encouraged to look beyond the traditional asset strongholds of listed equities, bonds and cash in recent years to reduce exposure to volatile stocks and be sure of getting income they need as populations age.

Funds of hedge funds allow investors to spread their money among a variety of hedge fund strategies in a single package deal.

Last year, pension funds globally invested more than $77 billion pounds of new money in alternative assets, up from $62 billion in 2004.

Property took the biggest share of pension funds’ new money to alternatives, at 35 percent, followed by 34 percent into funds of hedge funds.

Retirement funds are the single largest holder of alternative assets, accounting for about $465 billion, or 37 percent, of the total assets covered by the survey.