Savvy Fund Sees an Asia Backfire

The traders behind a Singapore-based hedge fund that outperformed last year are betting government efforts to stabilize Asia’s markets will backfire, yielding opportunities in foreign exchange and credit.

Last year, Artradis Fund Management’s flagship Barracuda fund returned 27% by betting on price swings in Asian stock markets through derivatives, or financial instruments whose value is based on an underlying investment. By contrast, the benchmark MSCI Asia ex-Japan index fell 27% in 2008.

While the plays on stock volatility were good to Artradis last year, now the firm is changing gears.

“We felt that the glory days of equity derivatives business in Asia were going to be restricted going forward,” partly because hedge funds bid up the prices of derivatives, squeezing returns, says Steve Diggle, one of the firm’s founders.

In addition, issuance of structured products containing derivatives has slowed, as wealthy individuals who bought these products in the boom have been burned and pulled back. “In order to grow, we needed to broaden to other markets and products,” Mr. Diggle says.

Artradis is wagering that government efforts in Asia to stimulate the economy and create stability will actually create market imbalances and, as a consequence, lucrative trading opportunities.

“Asian markets have a long history of government involvement,” with mixed results, says David Dredge, 44 years old, who recently left his job as deputy head of local markets at Royal Bank of Scotland Group in Singapore to help spearhead Artradis’s new effort.

Mr. Diggle and Richard Magides, in their mid-40s, previously worked together on the derivatives desks of Barings Bank in Singapore, where the rogue trader Nicholas Leeson caused the bank’s collapse in 1995. They founded Artradis in 2002 with about $4.5 million of mostly their own money. Since then, they have built it into one of the largest home-grown Asian funds, with about $2.5 billion under management.

When shares were rising, their funds produced lackluster returns. The situation reversed in mid-2007, when markets got clobbered and their bets on volatility paid off. Even amid success, Artradis was hit with massive redemptions of approximately $2.3 billion, which the firm attributes to the liquidity squeeze that forced clients and competitors to sell assets and raise cash quickly.

Also hurting the fund was the bankruptcy of Lehman Brothers, which the fund says owes it more than $100 million because of trades in which Lehman acted as counterparty and assets that have been frozen at the firm.

For investors in Asia, the ripple effects of U.S. stimulus efforts offer a road map, Mr. Dredge says. He points to moves by the U.S. Federal Reserve to stimulate lending. Concerns about inflation and the U.S. dollar have partly prompted investors to dump U.S. Treasury bonds, pushing up their yield and undoing Fed efforts to keep rates low. The trick for investors, he says, is to spot opportunities where government actions won’t be enough to override market forces.

The past week, short-term bank lending rates rose sharply in Asia as the region’s banks displayed concerns about the Fed’s ability to manage rates. “It follows that interest-rate volatility in the U.S. will be mirrored in Asia,” Mr. Dredge says.

Separately, the dollar’s weakness has led to gains in most Asian currencies this year, including the rupiah, the rupee and the baht. But expections that the dollar will continue declining could come to an abrupt halt, Mr. Dredge says. Some currencies, such as the Australian dollar, have weakened slightly this week amid worries that an economic recovery isn’t coming to fruition anytime soon.

Another possible macro shock could come if China and Hong Kong let their currencies appreciate against the U.S. dollar. While Hong Kong pegs its currency at a fixed rate to the dollar, China allows its currency to fluctuate, albeit in a highly managed way.

Big changes seem unlikely with either currency right away, though the wisdom of being so tightly bound to the dollar has come into question as fears grow about the dollar’s long-term prospects. Recently, Hong Kong’s monetary authority has intervened aggressively to uphold the 26-year-old peg.

From Laura Santini at the Wall Street Journal

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