Japan

No beta but plenty of alpha available

VERYAN ALLEN

“I have no personality” announced the incoming Prime Minister of Japan, Yasuo Fukuda, in a refreshing moment of honesty from a politician. Fortunately the losing competitor in the recent Japanese leadership race, Taro Aso, will still have time for the 20 or so comics he devours each week. It is for good reason that anyone that successfully invests in Japanese markets soon learns to ignore politics and maintain a very nimble, fully hedged or short-biased portfolio.

The poorly timed but not surprising resignation of Shinzo Abe had little affect on the markets other than sparking limit up rallies in comic-related stocks like Mandarake and Broccoli. Given the almost comical nature of Japanese politics, perhaps that is appropriate. While likely not much of a source for beta in the medium term, Japan remains one of the best countries to generate alpha for those with the skills to identify negative and positive investment themes without the helping hand of a bull market.

What does the change in political leadership actually mean for Japanese markets? If Gordon Brown or Angela Merkel abruptly resigned two days after delivering a major policy speech how would the markets in UK and Germany have taken it? Probably not very well. But in Japan, long ruled by political dynasties, vested interests and squabbling party factions, the shock was much more muted. While the July elections had probably sealed Abe’s fate, the resignation was unorthodox even by Japanese standards but the financial markets hardly noticed.

Recent Japanese prime ministers have all come from families of former prime ministers. There have been 58 different people ‘running’ Japan in the last 120 years, so very few stick around. Even given the appearance of a free election, most Prime Ministerial and cabinet selections are made in back-room deals. The only reason Fukuda didn’t run last time is that he and Abe were in the same faction. It was Fukuda’s turn and that is why he is now in charge. The ‘new’ cabinet is however almost identical to Abe’s which indicates that the Fukuda administration is unlikely to shake things up.

Japan faces many economic problems, most notably a heavy debt burden and an aging population. The need for tax, pensions and budgetary reform and a strategy for growth remain urgent. Policy momentum has stopped cold and the delay of structural reforms or even backtracking continues. Repairing credibility with foreign investors and filling the ongoing policy vacuum mean a vibrant stock market or rapid interest rate hikes appear a long way off.

Ahead of the game

Japan of course has many talented businessmen, entrepreneurs and technologists that have long since figured out a way to work with or around the politicians. While Fukuda was being sworn in, I was attending an electronics trade show just outside Tokyo. Seeing the 3 millimetre-wide TV screens, cutting edge robotics, nanotechnology and laptop computers with features that will not be available overseas for at least a year, is a healthy reminder that Japanese engineers and innovators, unlike politicians,remain at the top of their game. Whether it is technology, pharmaceuticals or car stocks, investors would be unwise to write off Japan just because of its political system.

More important than a change in political leadership is the recent privatisation of Japan Post, the world’s largest bank with over $2 trillion in assets. Perhaps the main achievement of Koizumi’s premiership, the affect of market forces on such a large pool of money should not to be underestimated. Japan postal savings were used for decades to finance pork barrel projects in rural constituencies, the bedrock powerbase of the LDP. While the process will be slow, the transition of this money into higher yielding assets including hedge funds has already begun.

2007 marks the year when the large population cohort born in 1947 retires. It is ironic that the nation with the longest life expectancy has the youngest retirement age. There are people retiring this year on generous pensions who will be receiving them for several decades while the population declines.

The ‘silvering’ of Japan has often been depicted as a negative but it is worth noting that most of the individual savings in Japan are with 50-70 year olds and there is increasing evidence they are now prepared to spend. If older Japanese consumers, having saved their entire working career, consume more it will be a positive catalyst for the economy. Also the appetite among this age group for international investments continues to grow.

Some say that due to complicated regulations and lack of a bull market that Tokyo is losing its status as a financial centre. Considering that Japan has the world’s largest government bond market, that the yen is apparently the funding currency of choice for the world’s leveraged hedge funds and that the percentage of institutions and individuals with a hedge fund allocation in their portfolios is higher than any other country, I am not so sure that is the case.

It depends on how you define a financial centre. But with a clear performance gap between those funds who trade from Japan versus those who try to trade from outside Japan coupled with the vast inefficiencies in the Japanese equity, credit, commodities and real estate markets, any alternative asset manager or fund of funds with global ambitions cannot risk NOT being in Japan.

Japan remains very much a traders’ market rather than long term investors’ market, as it always has been. The emphasis remains on risk management and hedging. Unfortunately many Japan-focused hedge funds are long-biased bottom up stock pickers dependent on value beta. Unlike much of the rest of Asia, Japan has an easily locatable and cheap to borrow universe of liquid stocks.

Higher frequency strategies are attractive with the cheapest execution costs both in terms of commissions and market impact. When volatility or top down macro events occur, it is not surprising that stock picking funds tend to do relatively poorly. As everywhere, strategy diversification is the key. For short term trading, volatility arbitrage, distressed assets and new asset strategies, Japan remains one of the best markets globally.

Japanese real estate is rife with long and short opportunities for hedge funds. I am curious as to why Pacific Ocean beachfront property situated within 2 hours of one of the largest and most expensive cities in the world can be purchased for under STG 50,000. I also wonder why large ski chalets next to Olympic standard downhill runs are also available for less than STG 50,000.

In the bubble years Japanese real estate was notoriously expensive; infamous examples include the Emperor’s Palace being valued at more than California. Having been overvalued in the 1980s, could some pockets of real estate in Japan now be undervalued in the 2000s? J-Reits and hedging through property derivatives ensure that this remains an interesting area for investors.

The Bank of Japan still has rates at 0.5% which means interest rate differentials continue tofavour the carry trade. A member of the BoJ committee, and inflation hawk, Miyako Suda voiced concern of the Japanese economy overheating if they didn’t raise rates quickly.

That would be a nice problem to have. But whether the Nikkei goes to 20,000 or 10,000 or the yen goes to 130 or 100 there is a vast range of Japan investment opportunities for hedge funds no matter whose turn it is to be Prime Minister.

Veryan Allen helps Japanese institutions evaluate alternative investments and blogs on hedge funds