Uncovering the Japan Long-Short Equity Enigma
"A man who carries a cat by the tail learns something he can learn in no other way".
Mark Twain (1835 - 1910), writer
A hedge fund allocator recently asked me: "Can you recommend any good Japan long/short managers?". I had to stop and think for a moment. A couple of years ago I would have had at least 10-15 names. Not anymore...
It is common knowledge now that "good" managers had built significant reputations and track records over the last 4-5 years effectively going long Japan small and mid-caps and shorting large caps. What has been unknown is just how many managers had been playing this well-known game.
A leading prime broker servicing a large cross section of Japan long/short hedge fund managers ran some numbers recently that shed new light on a still unclear strategy that continues to suck up the bulk of investable AUM heading into Asia.
The disappointing performance thoughout 2006 and 1Q07 of Japan long/short equity laid bare my dilemma. This is especially the case as many of the same managers that produced 20-25% returns in 2005, were down almost the same -20-25% in 2006. It seems just a little too freaky, eh?
The prime broker in question found that a significant number of managers in the Japan long/short equity space (numbering close to 90) exhibited the highest correlation with the TSE Section 1 small cap index of of 0.84 over the last 5 years to end 2006 and over the last 2 years this had risen 0.95! Those Sherlock Holmes due diligence-style investors would probably have guessed a high correlation, based on the performance of small and mid-cap IPOs back in the good ole days! But now even that source of "alpha" has dried up.
Many of the bigger players often carried significant positions in such small and mid-cap situations, benefiting from end month re-pricing in the not-so-often traded stock. This type of pricing situation is not too uncommon in emerging markets.
Another situation worth consideration has been the fact that many Japan long/short managers do not use their shorts to generate alpha but rather to avoid the argument that they may be levered long shops (which they often are). It is important for an investor to really ask about long and short book profit attribution to see if the manager really knows how to protect the downside of his book and/or even to generate returns.
How hedged is your Japan Long/Short manager? This is the crux of the issue. Some managers say they dynamically hedge. Most keep static allocations with net exposure 40% plus or minus 5%. They don't try to protect NAV during corrections as they don't have a reliable timing tool and if they are late setting up their hedges they often sacrifice the inevitable NAV rebound. Also, many use index futures and options as hedges and these are not well correlated against the TSE Section 1 small cap universe.
Which brings me back thinking about good the name of "good" Japan Long/Short managers as well as the inevitable question: is what we are seeing in Japan Long/Short Equity symptomatic of a cyclical or secular change?
Mahalo.
"A man who carries a cat by the tail learns something he can learn in no other way".
Mark Twain (1835 - 1910), writer
A hedge fund allocator recently asked me: "Can you recommend any good Japan long/short managers?". I had to stop and think for a moment. A couple of years ago I would have had at least 10-15 names. Not anymore...
It is common knowledge now that "good" managers had built significant reputations and track records over the last 4-5 years effectively going long Japan small and mid-caps and shorting large caps. What has been unknown is just how many managers had been playing this well-known game.
A leading prime broker servicing a large cross section of Japan long/short hedge fund managers ran some numbers recently that shed new light on a still unclear strategy that continues to suck up the bulk of investable AUM heading into Asia.
The disappointing performance thoughout 2006 and 1Q07 of Japan long/short equity laid bare my dilemma. This is especially the case as many of the same managers that produced 20-25% returns in 2005, were down almost the same -20-25% in 2006. It seems just a little too freaky, eh?
The prime broker in question found that a significant number of managers in the Japan long/short equity space (numbering close to 90) exhibited the highest correlation with the TSE Section 1 small cap index of of 0.84 over the last 5 years to end 2006 and over the last 2 years this had risen 0.95! Those Sherlock Holmes due diligence-style investors would probably have guessed a high correlation, based on the performance of small and mid-cap IPOs back in the good ole days! But now even that source of "alpha" has dried up.
Many of the bigger players often carried significant positions in such small and mid-cap situations, benefiting from end month re-pricing in the not-so-often traded stock. This type of pricing situation is not too uncommon in emerging markets.
Another situation worth consideration has been the fact that many Japan long/short managers do not use their shorts to generate alpha but rather to avoid the argument that they may be levered long shops (which they often are). It is important for an investor to really ask about long and short book profit attribution to see if the manager really knows how to protect the downside of his book and/or even to generate returns.
How hedged is your Japan Long/Short manager? This is the crux of the issue. Some managers say they dynamically hedge. Most keep static allocations with net exposure 40% plus or minus 5%. They don't try to protect NAV during corrections as they don't have a reliable timing tool and if they are late setting up their hedges they often sacrifice the inevitable NAV rebound. Also, many use index futures and options as hedges and these are not well correlated against the TSE Section 1 small cap universe.
Which brings me back thinking about good the name of "good" Japan Long/Short managers as well as the inevitable question: is what we are seeing in Japan Long/Short Equity symptomatic of a cyclical or secular change?
Mahalo.
posted by Franklin Scruggins | 3:43 PM
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