Hedge Fund Managers Find Silver Lining in Japan's Cloudy Markets

Of the 25 or so Japan-focused hedge funds tracked by the TASS database, a solid majority was up year-to-date through the end of February. The types of funds in positive territory varied widely in terms of the strategies they used, ranging from long/short equity to convertible arbitrage.

Although some investors have shied away from investing in Tokyo’s markets, hedge funds have proved something of a bright spot of late as Japan tries to crawl out from a decade-long recession.

Japan’s precarious economic outlook may be on a collision course with reality, managers said. In fact, buoyed by expectations of Bank of Japan intervention and new regulatory requirements that will bring mark-to-market reporting to the country for the first time in April, many investors are apparently looking to invest in Japan for the first time or bump up existing allocations.

Could a turnaround in Tokyo finally be at hand? Even true believers are being cautious in their optimism, but a recent upswing in the Nikkei has lifted spirits as well as March returns for many, managers said. In a single day of trading on Monday (March 26), the Nikkei jumped 5%, giving hedge fund managers heart that a turnaround may be in the works.

“Let’s face it Japan is the second biggest economy, but today only represents 11% of the global market cap as compared to the U.S.’s 53%,” said Geoffrey Bennett, president of San Francisco-based hedge fund manager Windham Pacific. “From that vantage, there’s plenty of upside.”

Windham Pacific runs long/short Japan-only equity strategy in two funds with combined assets of roughly $69 million. The firm’s BVI-based Windham Pacific fund was up over 3% for the year going into March.

“Our net exposure has been about 10% to 15% (to the Japanese equity market),” Mr. Bennett said. “At various times, different sectors have looked good, but what we’ve done is looked to produce steady, less-volatile returns.”

“We’ve found that it makes sense to pick up small returns each month that add up, while trying to limit volatility,” he said.

Other managers have said they tried to limit volatility by dramatically curtailing exposure. One U.K.-based hedge fund manager said that his long/short equity fund has weathered Japan’s stormy markets and by limiting exposure by 50%.

“For the last six months we have had a 50% exposure, which is to say that we are roughly half in cash these days,” he said. “Of the 50% we are invested, it’s split roughly half long and half short, providing a sort of market neutrality that has paid off. In this environment, it has been hard to see when the next downturn or upswing will come—even though you are looking for things to eventually rally.”

While few managers, if any are making a killing in Japan this year, many equity focused funds have held their ground in 2001 and outperformed the slumping Nikkei—and for that matter the Dow and Nasdaq.

The $52 million Caymans-based long/short equity Boyer Allan Japan Fund Inc. was up 0.7% for the year through February as was its $17 million U.S.-based twin. The strategy picked up nearly 1% for the month of February, coming on the tail of a double-digit loss in 2000.

The $57 million U.S.-based Rosehill Japan Fund and its $123 million BVI-based counterpart Rosehill Fund Ltd. were both up nearly 5.6% for February, with year-to-date performances of roughly 3.4%. For the 12-month period ending in February, returns both long/short funds came in at roughly 46%.

Two Whitney & Co. hedge fund’s launched in late 2000 have also held their ground in Japan’s difficult markets this year. The $30 million long/short U.S-based Whitney New Japan Fund was up 4.4% on the year through February, while the $7 million Whitney New Japan Crossover fund was up 4.5% over the same period.

Some larger funds have also apparently done well in Japan. The $873 million Millennium USA LP fund, a market-neutral vehicle, which invests a portion of its portfolio in Japan, was up 5.7% on the year through the end of February.

Convertible Arbitrage

Equity-based hedge funds aren’t the only one’s finding opportunities in Japan’s tumultuous markets. Convertible arbitrage players like New York-based West Broadway Partners have exploited volatility to exploit produce positive returns.

The $75 million West Broadway Global Arbitrage Fund was up 2.1% through February, drawing interest in the fund, which has produced an annualized rate of return of 20% as it nears its third anniversary in April.

The West Broadway Global Arbitrage Fund emphasizes Japanese convertibles, an arena that has been helped rather than hindered by recent equity market volatility, said Jean-Philippe Carriol, director.

“For the converts, volatility helps and there has been plenty of it in Japan,” Mr. Carriol said.

The Nikkei has historically exhibited an average volatility that is 16% or 17% higher than the S&P, making it fertile grounds for arbitrage dealings. To help manage risk, West Broadway sticks to blue-chip names in Japan and forgoes the weaker credits.

Unlike the U.S. (convertibles) market, 80% of returns in Japan are produced by delta trading or hedge on the underlying movement in price between the equity and bond That’s the opposite of situation you find in the U.S. market where 20% comes from delta trading,” he said. “The difference is that in the U.S. managers are getting value from the actual coupon. But in Japan, the interest rates are basically zero.”

The majority of investors in West Broadway’s Japan-focused strategy is based outside of the United States and includes European banks and insurance companies. Japan’s high volatility has many Europeans, who were active in the late 1980s, beginning to return to the sector, attracted by a steady return strategy and the low correlation to equities.

A number of hedge funds indicated that they expected higher inflows into funds in April, the same month that new regulatory requirements would force firms to mark-to-market. In fact, one manager indicated that he expected some $25 million to flow into his fund in April, based on commitments made in February and March.

The $518 million Penta Fund Ltd., which made headlines in 2000 by temporarily refusing to honor $120 million in redemption requests after losing half of its value, also seems to be holding ground of late. (Previous HedgeWorld Story)

The Japan-focused Penta fund, which had suffered due to a lack of liquidity in bond and equity markets fund was down only about 1.1% on the year through February. BVI-based Penta fund in late 2000 told investors (Previous HedgeWorld Story) that it was methodically converting more of fund assets to cash to allow the resumption of redemptions, a promise that it apparently kept with the announcement of a subsequent special withdrawal period this quarter.

Hedge fund managers indicated that investors looking at Japan should be mindful of currency risk and might want to consider tapping the market through a fund that hedged that risk. Many hedge fund managers in Japan run identical strategies across two funds—one U.S. Dollar-denominated and the other in Yen.

Liquidity

Recent overtures of intervention by the Bank of Japan aimed at easing the burden of banks weighed down by bad loans have convinced many managers that liquidity would soon be added to Tokyo equity markets.

The expected Bank of Japan action comes after a ratings scare for Japanese banking sector and a subsequent from promise of reform by government officials earlier in March that sent the Nikkei higher since mid-month.

“You have a situation where you are likely to have some more liquidity as well as transparency being added to the market because of selling pressure (of cross shares,)” said Mr. Bennett. “With the new reporting standards set to