Delivering Alpha in Japan

Lessons from the past few years

Originally published in the November 2007 issue

At a time when almost every major equity market is registering strong year-to-date returns, Japan continues to disappoint. In fact, the Japanese market has witnessed a two-year drift since it peaked with the Livedoor scandal in early 2006: Topix stood at 1650 at the end of December 2005, 1681 at the end of December 2006 and 1616 at the end of September 2007.

To compound the difficulties of market participants, this sideways shift has not been devoid of volatility. Indeed, there have been a total of 10 significant market corrections over the period, with two seeing greater than 15% market slumps. Against this background, Japanese hedge fund managers as a group have struggled, while their Asia ex-Japan peers have been racking up over-sized fund returns. Not surprisingly, given the huge disparity of returns, the 'irrelevance of Japan' arguments (last trundled out in early 2003, just before a massive bull market doubled the major indices in 24 months) have been making a comeback. Why invest in Japan when it is low growth, has an unattractive tax system and continues to support an anti-shareholder regulatory regime?

Recognising the facts

To us, however, the acceptance of such arguments contradicts many of the fundamental reasons for investing in hedge funds in the first place. It also by extension underestimates some of the risks of investing in Asia ex-Japan hedge funds.

Let's start by recognising there must be some basic long term market efficiency in place. If Japan's fundamentals are so bad and Asia's are so good, then before too long these facts should be recognised in the respective region's stock prices – at which point forward looking risk-adjusted returns should be equal. More critical is the beta-alpha argument as to what investors should be buying when they invest in a hedge fund. If an investor does want to buy beta then why pay 1.5% or 2% management fees and 20% performance fees for a hedge fund rather than a more fee-friendly long only fund? Further hedge funds should (although they frequently do not) offer the prospect of non-correlated returns, which are particularly valuable during periods of market stress. If there is a criticism to be levelled at the Japanese hedge fund community, it is that too many funds became highly correlated 'beta jockeys' during the bull market of 2004 and 2005.

However, it was these funds that tended to be rewarded by investors with huge fund inflows and, as a result, it was these funds whose AUMs bloated out at the top of the market. Nonetheless, a number of funds in Japan have offered alpha-based performance and a lack of correlation with the underlying index over the last two years. The traits in common to these funds deserve scrutiny and may hold some lessons for investors in Asia ex-Japan.

First, the better performers did not fall into the trap of expanding AUM too quickly based on liquidity observed at the top of the market. Between June 2005 and December 2005 average daily value traded rose from Y1 trillion per day to nearly Y3 trillion per day. Thereafter it fell back toward Y2 trillion per day as 2006 progressed. While seemingly not a precipitous decline, the downdraft in liquidity caused more and more problems since it become concentrated in an ever narrower band of larger cap names. By way of illustration, volume of shares traded on the Topix 2nd Section peaked earlier in September 2005 and then fell by over two-thirds by the following summer. A hypothetical $1 billion market cap stock trading $10 million dollars a day in the summer of 2005 would have allowed an AUM $500 million hedge fund to build a 2% position within five days without an appreciable price impact. By the spring of 2006, if that same hedge fund had grown to $1 billion while the daily volume of the stock in question had fallen to $5 million a day, then that same 2% position would take 20 days to exit assuming the same 20% of average daily volume, posing an entirely different liquidity (and potential redemption) management problem.

Secondly, the boom and partial bust cycle of 2005 and 2006 also unmasked unmatched style biases in the long and short portfolios with a vengeance. Long small- to mid-cap, short large cap and futures positions had been much in vogue in Japan from 2003. However, as most cycles mature, market breadth narrows and fewer stocks are relied upon to take the market higher. In 2006, the sideways walk of the indices masked some stunningly good performances from super large cap stocks like Nintendo, Japan Tobacco, Nippon Steel, Canon, Honda and Toyota (all returning over 30% in yen terms). Meanwhile, the smaller cap indices were suffering; JASDAQ, for example, was down 34% for the year. The ability to select hedge funds that could manage such style risks as a bull market matured was vital to investment success in Japan in 2006 and 2007 and will likely be key to Asian performance in 2008.

Success from the bad times as well as the good

A third key criteria for success is to select hedge fund managers who can perform in down markets (the 'hedge' bit in hedge fund). Since Gartmore's AlphaGen Hokuto was launched in November 2000, there have been eleven quarters in which Topix has been down. Over each of these down quarters, the index on average declined by 7.6%, while Hokuto rose by 1.0%. Conversely, during positive return quarters, Topix rose 6.3% while Hokuto returned 1.6%. That ability to conserve capital, and even make some money during the bad times, has been critical to overall out-performance, allowing Hokuto to return 45.5% net of fees (JPY terms) since inception until 30 September 2007, against only 13.5% for Topix.

Finally, drawdown management skills are a critical criterion for success. Funds with a significant beta exposure will go into drawdown every time the market corrects. The key is whether the fund managers have a clearly delineated strategy for responding to such situations. In 2006, the market experienced two significant corrections in January and February. On both occasions, a hedge fund manager who hanged tough and held his or her positions would have seen the markets and performance bounce back quickly.

Emboldened by the two recent successes, the same fund manager going into the May market correction would have been tempted to adopt the same strategy. In the event this proved a grave mistake, as the Topix decline of nearly 20% pushed many fund managers over-reliant on beta into major fund draw-downs. Large draw-downs are poison to performance as precious time must be spent placating investors and reassuring team members rather than managing the portfolio.

The underlying philosophy of the AlphaGen Hokuto Fund is to focus on market expectations – and critically judge each and every potential investment against the expectations that are already discounted in the share price. If this can be done successfully, it helps avoid some of the pitfalls discussed above such as the sharp market reversal in mid-2006 and again in August 2007, ahead of which expectations had become excessive and portfolios overly-concentrated in the same areas of the market. It also means that the recent tendency to consider Japan 'irrelevant' in a broader Asian context is in itself providing opportunities – either because excess pessimism is being priced in to share prices, or because some investors are more occupied elsewhere in the region, allowing those of us with disciplined, Japan-focused strategies more opportunity to spot pricing anomalies.

So in conclusion, Japan still provides plenty of opportunity for fund managers to extract performance from alpha (and even beta-driven returns will eventually return) and identifying such managers will still benefit overall portfolio returns. Conversely, as the Asia ex-Japan bull-run matures, selecting fund managers who do not need a bull market to perform or could cope with a prolonged market correction may become more important – as the lessons from Japan since 2005 have shown.

John Stewart is a hedge fund manager and is Head of Japanese Equities at Gartmore Investment Management