In the fall of 1992, George Soros rose to prominence by winning his gamble against the British Pound, earning not only a place in history but, $1.5 billion in profits. Today, many prominent names in the hedge fund industry are seeking similar results at the expense of the Chinese Yuan Renminbi (RMB).

The fluctuation in the value of the RMB against the U.S. dollar has been modest when compared to Euro (EUR) against the U. S. dollar, which begs the question, why target the RMB rather than the EUR?  For example, On May 1st, 2011, the dollar reached its lowest point in the last five years against the EUR with $1 buying 0.6787 EUR. Today, $1 will buy .9209 EURs. In other words, the value of the dollar against the EUR has risen 35.69 percent. On the other hand, the dollar reached its five year low of 6.0810 against the RMB on May 24th, 2015. On January 31st, 2016, the dollar bought 6.5802 RMB, an 8.21 percentage increase. This suggests that the RMB is more than four times less volatile than the EUR.

So Why Target the RMB?

The reasons are many. For one, China’s economic engine is losing steam. While growth is still robust by Western standards, year-over-year gross domestic product stood at 6.9 percent, China’s weakest performance since 1990. China’s GDP is predicted to continue to shrink through 2016.

Additionally, China’s stock market is forecast to see continued declines through 2016. Other worrisome signs include the Manufacturing Purchasing Managers Index, which has been below 50 for 6 straight months. This is significant because anything below 50 is regarded to be indicative of a contracting manufacturing sector. Another statistic which bodes ill for China (and South Korea) is that South Korea’s exports to China fell 21.5 percent year-over-year. China is South Korea’s largest trading partner and weakening Chinese demand for South Korean consumer goods is a tell that should not be ignored. Another factor is the relative isolation in which China’s central bank operates.

While the points highlighted above do not encompass all the issues facing China, they provide a representative sample of the direction things are moving and offer insight into the reasons these high profile hedge funds are betting against the Yuan Renminbi.

Will They Succeed?

Economic conditions in China certainly seem to favor shorting the RMB, but the global economy is much different today than in 1992. Central banks are no longer in a strong position to thwart speculators largely because of the enormous growth in foreign currency trading which can top $5 trillion per day. China’s weakness lies in its central bank’s lack of ability to work collectively with other central banks, which is much the same position the Bank of England found itself in the early 1990’s.

Final Thoughts

How this gambit will play out over the next couple of years is anyone’s guess. However, one thing is likely—George Soros will retain his number one spot for having made the most money on a currency trading strategy in the history of hedge funds.

 

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Hedge funds, in the aggregate, turned in an abysmal performance in 2015. Moreover, this appalling performance hangs like an albatross around the necks of funds both small and large, making the prospect of growing assets under management (AUM) that much more challenging in 2016. For hedge funds, AUM is not an end unto itself, as many would have you believe, but rather, a key element for a successful fund.

Separating Fact from Fiction

Much has been written about the small, nimble hedge fund and the advantages they enjoy over larger, clumsy firms. While this may have had a degree of merit in the past, the evolving dynamics of the industry have made this view somewhat arcane.

Here’s Why

The principal driver of escalating operating costs in the modern hedge fund can be traced to increased regulatory burdens. At the same time, the traditional “two and twenty” fee model has suffered considerable erosion in the wake of consecutive years of industry underperformance, significantly reducing fee revenue. As a result, assets under management must necessarily rise to achieve break-even.  Some experts have cited $500 million as the minimum base required to support the expenses incurred by a hedge fund.

Meeting regulatory requirements in today’s hedge fund requires substantial increases in expenditures on technology. Investors also drive technology costs upward with greater demands for transparency and timely reporting, which can only be achieved, in a cost effective way, through technology. Additionally, greater use of technology exacerbates cyber security concerns and effectively addressing those concerns comes at a price. Lastly, the investment in technology is not an option if a hedge fund is to remain competitive.

Small Hedge Funds May Be on the Road to Extinction

Given the fiscal realities, it is difficult to envision a world in which small hedge funds can survive, much less thrive. However, technology can also provide a mechanism for reducing costs and enhancing efficiencies. One example of this is employing technology to integrate front to back office reporting.

Another option, already commonplace in the industry, is to outsource back office operations altogether. Outsourcing can often put skills sets and technology at the disposal of a firm that would otherwise be out of reach from a budget perspective. The point is this; small hedge fund managers must have a laser-like focus on controlling the costs of operating the business if they are to survive the headwinds of change confronting the industry.

The irony in all this is that small hedge funds need to become larger hedge funds in terms of AUM at a moment in time when the tools needed to accomplish this growth are on the wrong side of the small fund’s fiscal boundary.  Unless small fund managers can develop a means to acquire the tools they need to compete for funds and grow AUM, it is very possible that we will be witness to the extinction of a large number of small hedge fund firms. The current volatility in world markets will only serve to hasten their demise. Many small funds find themselves at this crossroads today.

 

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