The 2007 Japan Story: Financial Investors Flee and Japan Managers Bleed

"We shall not perish as a people even if we get our money supply wrong - but if we get our human relationships wrong, we shall destroy ourselves."

Rt. Reverend Robert Runcie, b.1921
then Archbishop of Canterbury

A disappointing end to 2007 looks intact for Japan and the hedge fund industry.

First, the aftermath of financial institution's newly defined attitude to Basel II led to an estimated US$8-12 billion in redemptions by Japanese investors from hedge fund of funds and single managers. These are this author's conservative estimates.

Second, the performance of hedge fund managers with a Japan long/short equity focus have been almost (universally) pathetic. For instance, an early December 2007 HSBC report of hedge fund manager performance had 5 out of the bottom 20 listed as being Japan Long/Short Equity managers. On an equal weighted basis, average performance was MINUS 16.47%. In contrast, 4 out of the top 20 performing funds were Asia (excl. Japan) Long/Short Equity managers with an equal weighted performance of POSITIVE 70.09%.

This means that Japan is undergoing a double-whammy of poor fundamentals reflecting a negative outlook on Japan Inc. added to which a potentially negative technical institutional outlook in which financial institutions continue to search for alpha - but in ways that do not draw on additional capital requirements on their collective balance sheets.

Japanese business and the financial authorities are no doubt nervous heading into 2008. The exchanges must also be wringing their hands at the drop off in activity too.

Clearly, further changes are needed to make investing in Japan's industrial base more attractive (tax, legal and administratively related). They need to make life easier too for hedge funds - whether setting up onshore or even "helping" to promote greater efficiency in the system and not the opposite with regards to legislation helping poison pill defenses against so-called activist fund managers.

Ironically, a great way to take advantage of this situation would be for foreign hedge funds to short Japanese hedge funds, including one of the best known, Sparx. With the outlook for sales likely to stagnate given disappointing returns from their flagship Japan Long/Short Equity Fund, one might reasonably expect some shorting activity on the JASDAQ-listed equity.

Luckily on the investor side the picture is not totally glum. Anecdotal evidence suggests that hedge fund product is still in demand from pension plans in Japan, whether private or public. The authorities would be wise to speed up the debate to "when" and "how" to get into these strategies very soon in order to revitalize a situation that stands to ossify much like Japan's aging population issue which remains conveniently hidden in some distant cupboard. The time for action in now, or the hedge fund industry in Japan will slip to second place in Asia. Ironically, you might even see the GS conference eventually head offshore to HK or Singapore. Mahalo.