As part of a drive to nurture a Korean-version of globally well-known hedge fund operators, such as Elliott Management, Asia’s fourth-largest economy began to induce more people to open hedge funds -- by lowering the bar to start one five years ago.
Under the revised law, any investor with at least 100 million won at hand is free to invest and hedge fund managers do not require a government license to register the business.
More financial professionals have since taken advantage of the new opportunity, where they can enjoy looser oversight and reporting rules, in order to allow them to carry out more flexible and speculative investment practices to maximize returns, while passing some of the risk off to investors. As of end-2019, the number of hedge fund managers had risen more than tenfold to 217 in less than five years. The combined net asset value of hedge funds rose more than doubled over the cited period, to 416.46 trillion won.
Under Korean rules, hedge funds are defined as private funds -- composed of no more than 49 investors -- which could leverage up to 400 percent of the fund’s net assets to invest in equities, short-term financing instruments, derivatives, real estate and infrastructure, among other assets.
Hedge funds differentiate themselves from another form of pooled funds, private equity funds, in that hedge funds can exercise no more than 10 percent of voting rights of a company, are allowed to extend corporate loans, and usually offer investors shorter maturity periods.
However, Korea is a difficult place to carry out and test hedging strategies in equity investment, with the result that their overall investment approach is different to their overseas peers.
According to the FSS, only slightly more than 3 out of 10 hedge funds were devoted to securities investment, indicating that almost 7 out of 10 are in other, less liquid asset classes.
“Many Korean hedge funds do not employ usual hedge fund strategies such as value-driven long-short strategies or event-driven strategies that capitalize on corporate events such as mergers and acquisitions,” said Auh Jun-kyung, assistant professor of finance at Yonsei University.
“(And) it is a tall order for hedge funds to adopt a quantitative investment strategy here due to taxation systems that levy taxes on each equity transaction, as well as a lack of professionals who can execute such algorithm-driven strategies.”
Particularly in terms of the popular long-short equity strategy, longstanding public disdain here against short selling has deterred hedge funds from taking short positions. Moreover, brokerage firms have been reluctant to lend securities to hedge funds. This forces brokerage firms dedicated to prime brokerage services to seek other sources of income such as total return swaps, in which an investing fund receives income and gains from an underlying asset in return for a fixed payment.
Moreover, naked short selling is illegal in Korea, meaning that hedge funds are not allowed to short sell securities without borrowing them beforehand. In addition, Korea has adopted regulations such as the uptick rule to prevent investors from short selling stocks at a lower price than the previous trading price.
Institutional investors have acted in tandem. The National Pension Service, Korea’s largest institutional investor, has halted stock lending from its massive equity holdings since 2018.
“Long-short pairs trading is nearly impossible in Korea,” said Kim Hag-ju, professor at Handong University and former chief investment officer of Woori Asset Management.
“Books of account kept by the Korean securities firms are too small, while Korean hedge funds are only allowed to use prime brokerage services by Korean securities firms (which don’t usually allow short selling),” he said.
This has forced Korean-style hedge funds to turn to assets that are illiquid and less marketable, and in some ways, that was what Korean authorities intended.