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Edward Cartwright: New dawn for Japanese hedge funds

February 18, 2010

Edward Cartwright is head of business development at alternative investment manager LGT Capital Partners in London. The firm runs $18 bln in hedge fund and private equity assets.

The views expressed here are entirely the author’s own and do not constitute Reuters point of view.

Edward CartwrightIf, like me, you have followed its stock market over the past 20 years, you may have concluded that far from being the land of the rising sun, Japan is the land of the false dawn.

After the initial collapse in prices in the early 1990s, countless commentators have tried to persuade investors that now is the time to re-engage with what is still (just) the world’s second largest economy.

With the exception of the rally immediately after the Asian financial crisis in the 1990s and the second half of 2005, pretty much all of these predictions have come to nothing, and more pertinently, many people have lost a lot of money thinking that Japanese stocks are finally worth buying. Even the two occasions when markets did forge ahead were swiftly followed by another big lurch downwards.

The systemic problems in Japan are well chronicled. Policy makers were incredibly slow to force financial institutions to address their non-performing loans; the Yen has, in general, strengthened at the worst possible time from an export
perspective; the demographics are stunningly scary; the central bank has run a zero interest rate policy for so long that its ability to influence matters is much reduced; and the new government looks almost as inept as the previous incumbents. I could go on but I think you get the gist.

We have increased the Japanese hedge fund exposure in Castle Asia Alternative, our London listed fund of Asian hedge funds, to 30 percent of total assets.

Why? Because conditions are starting to move quite dramatically in their favour.

1) VALUE INVESTING IS STARTING TO WORK AGAIN. If one looks at the small cap value and general value indices in 2009, they both outperformed the main TOPIX index by over 20 percent. After years of inventory (i.e. small cap ‘value’ stocks) having been sold, mostly by disaffected foreigners, the tide appears finally to have turned.

For the first time in a decade, there are a handful of companies with cash on their balance sheet which exceeds their
market cap. It is hard to see a further collapse from here.

2) MANY PEOPLE HAVE ABANDONED SHIP. Back in the middle of 2007, there were well over 200 hedge funds managing assets that exceeded $40 bln. Today, according to Eurekahedge, there are less than 70 managing a little less than $10 bln.

This decline in headcount and assets is pretty staggering. Meanwhile, although there has been significant net inflow into
the stock market from foreigners either side of Christmas, prior to that, asset allocators had been running for the exit for over two years.

3) ALPHA GENERATION IS NOW TWO DIMENSIONAL. Back in 2005, foreign capital was being poured into Japanese equities and many hedge funds were either heavily geared, significantly net long or both. This time it seems to be a much more sober story. Net market exposures in particular are low. This is further proved by the fact that the dispersion of returns generated by Japanese hedge funds in 2009 was vast (the best rising over 40 pct, the worst falling more than 30 pct).

4) TOP MANAGERS ARE STARTING TO PRODUCE IMPRESSIVE RETURNS. If one looks at the top decile of the Eurekahedge rankings for 2009, despite the underlying market having been dismal yet again, average returns were well in excess of 20 pct. That is impressive. Further, if you look at 2008 and 2009 returns together, several are now well above their high-water marks.

Darwinism has reduced the Japanese hedge fund universe to a group of managers that are battle hardened and pretty sensible. After three years of bloodletting in the small and mid cap markets, stability is beginning to return and traded volumes are, broadly, improving.

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