Japanese market has room for more hedge funds

Japan’s hedge fund sector faces a strange anomaly. The stock market is the second largest in the world after the US. But there is very little hedge fund money around.

There is only about $40bn invested in Japan-focused hedge funds, compared with $900bn in US-focused funds, according to research house Eurekahedge.

Analysts sense opportunities for hedge funds, but warn that managers must act fast before the best of them vanish.

“More shareholders are taking an activist approach, so companies are shaping up. In a couple of years strange situations will turn into normal situations, so the opportunities will disappear,” says one executive who recruits hedge fund talent for a US investment bank in Tokyo.

One factor that creates opportunities for Japan funds is the low number of companies covered by a large group of equity analysts.

One market observer puts this at under 300, compared with the approximately 2,400 companies listed on the dominant Tokyo Stock Exchange.

This leaves many small, mid and even quite large-cap companies languishing at prices that do not reflect their true value.

The other boon for hedge funds is that the structure of the Japanese equity market has changed. One manager specialising in shareholder activism points to the gradual unwinding in the large cross-shareholdings that protected complacent management. This has allowed Japanese shareholders “to become more active”.

“Management is now under pressure to end inefficiencies”, the manager says.

Nevertheless, Japan-focused funds have “performed fairly woefully as a whole”, says Kirby Daley, Fimat’s Hong Kong head of hedge fund capital introductions.

As a result, Mr Daley thinks there will even be a net outflow from Japan-focused funds over the next few months.

Japan hedge funds produced a stellar return of 24 per cent in 2005 when Japan’s stock market boomed, says Eurekahedge. But the next year they dropped 3 per cent, compared with a modest rise in the Nikkei. Their performance also looked poor measured against an overall 14 per cent return for hedge funds globally.

Cynics argued this happened because most were not acting like real hedge funds. The bulk of Japan-focused funds are long-short funds with a long bias. In 2005, they piggy-backed on the market boom, boosting returns further by going overweight on small-cap stocks, which rose the most. In 2006 large-caps stuttered, small-caps plunged, and managers were caught out.

But even the more activist funds, which do not just rely on stock rallies, have made slow progress in a country where many long-term shareholders in a company see themselves as guardians of its legacy.

Steel Partners’ failed bid for brewer Sapporo this year was a case in point. It offered a high premium above the share price, but “virtually every domestic shareholder voted against”, says an activist manager. He says shareholders were not primarily motivated by money, unlike in other countries.

“It was more like, ‘what does this mean for my beer?” he says.

Optimists counter that money-making opportunities exist precisely because shareholder value does not yet rule in Japan.

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