In the 1990s, there were only a handful of Japan-focused hedge funds. The pace picked up right after 2000 and peaked in 2006 (Fig 1). However, since then we have witnessed a steady decline, as Japan-focused hedge fund managers throw in the towel or metamorphose into Pan-Asian funds. Today there are slightly less than 200 dedicated Japan hedge funds in a universe of about 1,000 Asian funds, 120 of which focus on the growth hotspots that are China and India.
Throughout much of 2006 and 2007, as most of the OECD and the Asia region enjoyed steady economic growth and buoyant equity markets, Japan languished oddly behind. No doubt slow economic growth in Japan over the past few years has kept markets in check, which has probably diminished opportunities for many a talented long-only fund manager, let alone hedge fund manager. In this regard, the opportunity cost of focusing on Japan versus other parts of Asia has been a significant factor in encouraging regional fund managers to cast their net more widely. But is a weak economy and market the sole cause? This seems unlikely.
Several other factors have undoubtedly contributed to the widespread disaffection with Japan. Foremost among these, I would argue, are political wavering and government intervention. It is generally acknowledged that the reforms pushed through by Junichiro Koizumi when he came to power in 2001 have had a positive impact. Koizumi succeeded in breaking the old mould and creating momentum for continued change even after stepping down as Prime Minister and handing leadership to his successors at the Liberal-Democratic Party (LDP) in 2006. However, since then, Japan has experienced a steady stream of policy errors, regulatory meddling and administrative mishaps.
This long litany of missteps commenced in 2006, with the Bank of Japan’s sharp contraction of the money supply and the premature hike in interest rates, which effectively killed off market momentum. Then, regulatory changes aimed at cracking down on predatory lending practices virtually decimated the consumer finance industry. Moreover, in mid-2007, regulators introduced a new system for vetting new buildings, but failed to deliver the appropriate software: this effectively brought building approvals to a standstill.
Furthermore, during this same period, regulators’ attitudes towards hedge fund and activist trading in Japan have been less than friendly. The acceptance by the courts of poison pills for various takeover targets has thwarted many of the reforms intended for the M&A space.
To complicate matters, along the way, the ruling party, the LDP, lost the upper house to the leading opposition party, the Democratic Party of Japan: some observers argue that this could be a major obstacle in getting the budget, and most other policies, approved. In essence, a weak political environment combined with over-zealous regulators does not bode well for investment confidence, and there is little doubt that this situation has stymied economic growth and weakened markets.
A major consequence of this loss of confidence is that Japan now trades at a discount to the region: over half of the companies listed on the Topix first section trade below book value, almost 10% of all listed companies trade below 10 times price-earning multiples, and at least 3% trade for less than cash. Such value should be enticing but professional investors are leery of Japan and are selling out of its equity markets. In recent surveys, professional money managers have either eliminated their allocation to Japan, or reduced it to a fraction of what it was in the past, as better opportunities elsewhere in Asia beckon. Weak policies and a restrictive regulatory environment only serve to heighten the unattractiveness of Japan to investors.
Japan-focused managers thus face a double challenge: to generate returns, and to convince clients to remain faithful to them rather than pursue other opportunities elsewhere. Unsurprisingly, many hedge fund managers have suffered significant asset reductions, while others have been forced to restructure their business in order to survive by focusing on other Asian markets. A few managers, finally, have simply thrown in the towel.
The market conditions facing managers could improve only if much-needed changes to the policy and regulatory environment are pushed through. For this to happen, the ruling party itself must change: a good start would be to choose new leaders who have the courage to face down the regulators and the will to push through the political and economic reform agenda introduced by Koizumi, chief amongst which should be policies and reforms that promote consumer-led growth.
This may be easier said than done in a place like Japan, but I fear that unless meaningful change is effected, the attractiveness of Japan will continue to pale in comparison with high-growth areas of Asia, and the prospects for sustainable returns from Japan-focused hedge funds will remain weak at best.
Steve Sénèque joined SPARX in 2007. Prior to that, he spent ten years in Geneva where he worked in fund research and fund of funds management, largely for private wealth management. Most of his time was spent with Optimal Investment Services (OIS), part of the Santander Group. At OIS he was a senior member of the investment committee and oversaw the Japan and the Global Multi-Strategy products. Prior to moving to Geneva in 1997, Sénèque spent most of his career in Australia and South-East Asia as an economist. He received his PhD in Economics from the Australian National University, Canberra, Australia, and a Bachelor of Business (Financial Management), from Curtin University, Perth Australia.