Kier Boley, investment manager at GAM, said Asian investors had been slow to embrace Asian hedge funds despite strong returns, a view backed by Eurekahedge hedge fund analyst Rajeev Baddepudi, who estimates about 65 per cent

of funding comes from Europe and 25 per cent to 30 per cent from North America.

Market researchers say Asian investors still have faith in traditional buying and selling of stocks. Asian investors believe the region's comparatively under-researched and inefficient markets still provide plenty of opportunities. In markets such as Australia, hedge funds also have to compete with alternative investments vehicles.

'Demand for real estate investment trusts (reits) and infrastructure funds has been growing strongly,' he said.

In the short term, other challenges faced by Asia-focused hedge funds include the rise in United States interest rates and the record oil prices, which have cast a shadow over the region.

'Because many of the regional currencies are linked in some way to the US dollar, rises in US interest rates are usually matched by rises in interest rates in Asia, outside Japan. In addition, almost all countries in the region are net importers of oil,' Mr Boley said.

European and North America investors have not been deterred, however, and are encouraged by their observations in Japan and India.

Mr Boley said: 'The environment was very challenging for hedge funds focused on the Japanese market [last year]. However, during 2005 there has been further improvement in Japan's macroeconomic fundamentals.

'The country is steadily, albeit slowly, moving from deflation to low inflation. The governor of the Bank of Japan has indicated that the long-standing zero interest rate policy may end reasonably soon. The recent, and crushing, electoral victory of Prime Minister Junichiro Koizumi makes it clear that he has a solid mandate for reform. The Nikkei 225 Index has moved decisively above 12,000. It has become much easier for hedge funds to make money in Japan.'

The other key development in the region this year has been the complete reappraisal of India's investment prospects, helped by positive policy.

'In part because of the government's apparent commitment to reform, India has been widely seen as being on the road to sustained high growth,' Mr Boley said. 'Share prices have soared, thanks mainly to inward portfolio investment that amounts to about US$20 billion.

' Much of the money has come from retail investors in Japan and Taiwan ... However, the Indian stock market has also been boosted by recently launched hedge funds, of which there are about 20.'

Most of these new hedge funds targeting the India stock market are pursuing directional strategies, adding to upward momentum in India's stock market.

Mr Boley said 2006 was set to be another good year for Asian hedge funds, with the region now possessing the same conditions that paved the way for a hedge fund boom in Europe in the 1990s - a positive investment environment characterised by low or falling interest rates and bond yields, and positive if unspectacular, economic growth; predictable corporate earnings, and firms paying greater attention to shareholder returns.

'Given the latest developments in Japan, it seems reasonable to look for a wave of new equity hedge funds that seek to exploit opportunities, particularly if the stock market continues to deliver good returns,' he said. 'The development of new hedge funds, assuming that it happens, will represent the second stage in Japan's financial renaissance after a very long period of deflation and a bear market.'

By contrast, a question mark hangs over India's outperforming market for 2006, with mutual funds and hedge funds both potential sources of volatility.

Mr Boley said: 'Some of the recently launched hedge funds that are focusing on India could find themselves forced to sell out of positions as a result of a correction that is widely unforeseen. ... the Indian stock market has been driven this year mainly by retail investors who have been investing through publicly offered, equity long only mutual funds.

'This kind of investor is often fickle and may liquidate positions simply because they or their adviser have noted the superior performance in the recent past of another asset class.'

Meanwhile, China may be the surprise package in the region over the next 12 months, proving its detractors wrong.

'The conventional wisdom is that China is not an attractive investment opportunity at present,' Mr Boley said. 'The performance of many leading stocks is held back by the possibility that the government or state-owned enterprises will seek to liquidate their frequently very large investments in them. Corporate governance is often poor. A number of commentators envisage that economic growth, which is difficult to quantify accurately, is likely to slow.

'However, there are a number of positive factors for China's stock markets. Equity valuations are undemanding, especially in relation to India, which is a 'hot' market where many leading stocks are trading at levels which imply that earnings per share will continue to grow at an annual rate of 30 per cent over the medium term, compared with 5 per cent earnings growth for China.

'Even if China's economic growth rate slows to 7 per cent, the country will still be expanding more rapidly than any other large economy. Perhaps most importantly, the massive IPOs that have been announced are likely to force major Chinese companies to adopt global 'best practice' in terms of disclosure and corporate governance.'

In a sign perhaps that Asia's hedge fund industry is emerging from its infancy, Mr Boley notes growing interest from the region's institutional investors - a trend supported by favourable government policy.

'In Australia, for instance, the regulators have accepted that hedge funds are important even if they are still only used by a minority of pension funds.

'In Singapore, the authorities have been actively courting hedge fund managers, whose presence is seen as being very helpful to its development as a regional financial services hub.

'There have also been signs recently that Japanese institutional investors, who have been using hedge funds for years, have lifted their appetite. This trend could continue,' he said.