However, we recognise that the historic volatility of the Japanese market is unlikely to go away. Old Asia hands know that there have been many false dawns in the Japanese market over the past two decades, and it is only too easy for alpha generated by stock selection to be overwhelmed by beta when markets turn sour. Attractive as the stock specific opportunities are, returns can be more volatile than many investors would wish, particularly when the manager follows a market-relative approach rather than focusing on generating a positive absolute return.
We believe investing in Japan through a long/short equity hedge fund may be the solution many of these investors are looking for. This approach combines the ability to participate in the changes taking place in the Japanese economy by being long and short individual names, with a degree of protection from the volatility inherent in the market by controlling the net exposure of the fund through the use of futures.
With this in mind we are launching the Baring Japan Absolute Return Fund, a long/short equity hedge fund designed to offer investors the potential for attractive investment returns from the trading opportunities to be found in the Japanese market at a lower level of volatility than would typically be achieved by investing in a long-only product. Add in the low correlation of returns with other asset classes, and we believe the case for investing in Japan through a long/short equity hedge fund is a strong one.
Our approach to the hedge fund business at Baring Asset Management is straightforward. Rather than rush into the market, we have taken the decision to launch new funds only when we are convinced of the underlying investment case, where we already have a strong track record in the area, and when it is a logical extension of the approach we are already following in that market in our long-only business. Above all, the investment team must be eager to succeed in the hedge fund world.
The Baring China Absolute Return Fund, launched last year, is a case in point. As investment managers we were early into the Asian markets, opening an office in Hong Kong in 1976, and managing US$4.1 billion in assets there today. Our flagship fund in the region, the Baring Hong Kong China Fund, is close to US$500 million in size, and has an outstanding twenty-two year performance track record. The Baring China Absolute Return Fund draws on our established expertise in the region, and is a natural fit for the skills of the investment managers running it in Hong Kong.
That there are opportunities for nimble investors in Japan is beyond question. Structural reform is progressing apace, led by the financial sector, and potential winners and losers are being thrown into stark relief. A new report from accountancy firm KPMG and data provider Dealogic shows that more than a thousand merger and acquisition deals were done in the first half of this year, three-quarters higher again than for the equivalent period in 2004.
In fact, Japan has been top of the list of mergers and acquisitions by value in Asia for each of the last eight years. Not only does this provide some very exciting investment opportunities, but we believe these restructuring efforts could also benefit the overall economy by acting as a catalyst in the shift towards a focus on delivering shareholder value on the part of company management.
We believe our approach gives us an edge when it comes to identifying these investment opportunities, whether for the long or the short side of the book. It is based on the concept of "neglected alpha".
Too often, investors focus on companies which are already covered by many firms of investment analysts and managers. In turn, shares in these companies move rapidly with newsflow, and the potential for spotting new trends before others is limited. This can mean disappointment for investors. Yet, other stocks can be overlooked. They might have performed poorly, or be in unfashionable areas of the market, or they might be mid or small cap stocks and not covered by the largest brokers. However, these companies can offer excellent returns to investors if changes are spotted early. Our rigorous programme of quantitative and fundamental research, including many face to face business meetings, is designed to identify the winners and losers of the changing environment in Japan early.
A key part of our investment approach is the way we work closely together as a team. The three of us here in Tokyo have separate yet complementary skill sets which contribute to the "small team culture" in the office. The advantages of that "small team culture" are the very same that we believe Baring Asset Management offers investors as a "big, small company". These are rapid information flow and fast decision making, backed by the global resources and regional presence typical of a much larger company. We believe the new hedge fund is a natural fit for our team, and a logical extension of the way we already work.
We have been seeking out companies with "neglected alpha", or where we detect complacency by investors, since October 2002 in our "high alpha" mutual fund, Baring Japan Growth Trust, and we believe the same techniques can be beneficially extended to work for the Baring Japan Absolute Return Fund too. We follow a high conviction stock picking style, which naturally lends itself towards a fairly focused portfolio, typically 50 stocks on the long side and up to 30 stocks on the short side. Over time, we expect four-fifths of returns to be generated from stock picking, with the balance coming from sector allocation.
There is no doubt that the Japanese market is well suited to our investment approach. After all the disappointments in recent years, many investment brokers have either pulled out of Japan or sharply reduced the number of stocks they follow. This means fundamentally sound companies with excellent prospects for delivering faster than expected earnings growth can easily be overlooked by the market. We believe that being "on the ground" in Tokyo, and being prepared to look beyond the consensus with the aid of rigorous quantitative screening techniques gives us an edge, and allows us to identify these companies earlier than many competitors.
Much the same goes for companies which are in unfashionable areas of the market or, particularly, where the company has languished for years, perhaps saddled with an uncompetitive cost structure, but where new management have been brought in and are successfully turning the company around. Very often, the market is slow to detect this change, but careful analysis of the fundamentals and, importantly, meeting the management face to face, can help us to bring these companies into our portfolios. In turn, as the results from these companies continue to improve and the story becomes more widely known, the share price should appreciate, to the benefit of early investors.
Our approach is grounded in fundamental analysis relative to consensus. We start by looking at the pace and duration of corporate earnings, and whether they are likely to beat consensus expectations. We then examine the management's strategy and approach to running the company, their record of capital allocation, and how the share price valuation compares to history and to industry peers. Finally, we look at analyst forecasts for the company, and how these have been moving to get a sense of the consensus view. By comparing this with our independent assessment of the company, we start to get a good idea whether this is an investment idea worth pursuing or not.
These techniques apply equally, although in reverse, to our selection of candidates for the short side of the investment portfolio. Encouraging as the recovery in the Japanese economy is, there are always companies which fail miserably. They might lack a sustainable competitive edge, or lack pricing power in today's global markets. The management might lack vision or skill in execution. The company might even be fundamentally sound, but the share price might simply have moved too far. These are all potential inclusions on the short side of the book.
Havingidentified candidates for shorting, the next step of our process is to look at the technical data. We believe technical analysis can be very helpful in predicting short term price movement, and it forms an integral part of our investment process for selecting candidates for the short part of the portfolio.
Finally, we look for a catalyst which will precipitate the weakness we are expecting in the company. It is not enough for a company to have an unsustainable business model, since the share price can easily stay high for an extended period. Instead, we look for something which will force a change. That might be an earnings announcement which we believe will disappoint the market, or the probability of a downgrade by a prominent market analyst, but it must be something which is likely to force the price lower in the short term. Understanding how the market thinks is a prerequisite for trading shorts successfully.
In conclusion then, we believe Japan has changed. The economy has started to turn around, and the country is the natural business hub of the region, well placed to benefit from growing Asian prosperity. Merger and acquisition activity is picking up, and it is clear that there will be significant winners and losers in "new Japan".
We believe our investment process, which focuses on companies with "neglected alpha", gives us a competitive advantage in the Japanese market, as seen in the strong performance of our long-only product. We are confident that these same techniques can successfully be transferred over to our new long/short Japan equity hedge fund.
We have a talented and close investment team which has a history of working together, at Barings and elsewhere, and we believe our approach lends itself perfectly to running a hedge fund. It simply does not make sense for investors to restrict themselves only to the winners when there will also be clear losers in the reorganisation of corporate Japan.