BIS Hangover Leads Japan Banks to Single Managers

"If one wants to be successful, one must think; one must think until it hurts. One must worry a problem in one's mind until it seems there cannot be another aspect of it that hasn't been considered."

Lord Thomson of Fleet (1894 - 1976), former chairman, Thomson Organization

Irony is a beautiful thing - except when it means a business model which had been chugging along successfully over the last few years suddenly enters into Japan's Tsunami Redemption of 2005/06. That is what hit many fund of hedge fund (FoHF) firms in Japan.

At the risk of going over previously stated insider views, an estimated US$12-15 billion in FoHF was redeemed during the period, the bulk of it from many of Japan's financial institutions. That means it came out of an estimated universe size of just over US$53 billion (according to FSA data). The fact is that other institutional investors also played a role in dumping FoHF product as performance disappointed.

Today, that leaves the revamped size Japan's hedge fund marketplace well short of the US$50+ billion high watermark achieved in the good ole days. In fact, it puts it closer to the US$35-38 billion level.

Feedback gleaned from various marketing trips by FoHF managers to Tokyo attests to a confused local picture.

Confused because aside from internal balance sheet considerations related to underlying asset classifications in HFoFs, a significant stumbling block to any pick-up in FoHF sales relates to transparency. Apparently, many investors demand to see full transparency of underlying managers and their portfolio exposures, features that the run-of-the-mill hedge fund of fund with a healthy US$2 -10 billion in AUM is not likely to have, let alone disclose.

The news for U.S. and European based HFoFs is not so good for 2007. Tokyo is now a black hole for potential product sales unless (like astute organizations such a Frank Russell) one has local contacts nutured as a consultant and an up-and-running distribution channel in the form of a brokerge license that feeds product directly into the arms of Japanese pension fund community. In this situation, Frank Russell has been a clear winner leaving the so-called best performing FOHFs in their wake.

Ironically, this might also "help" local institutional FoHF providers, who, one would expect, would at least have a closer ear to the ground in terms of what is expected from local investors. At the very least it buys them time to try and fill the product gap , if not with their own seeded FoHF then with their own seeded single manager product (see previous commentary).

Interesting too that this simplified situation has exceptions. For instance, one city bank based in Tokyo is mulling the following - rather than stunting their appetite for hedge funds the new BIS will actually promote it as they go for so-called more high octane single managers to make up for the yield that they would have gained from their FoHF exposure! So, a recommendation that was designed to curtail risk is actually resulting in a defiant attitude to actually take on more risk and go for higher octane performance.

Moreover, one group of the heaviest users of hedge funds, the regional banks, have stated privately that they will now step up their allocations to single managers, providing they can get a certain degree of transparency.

This is a very strong indication that single hedge funds should now think very carefully about more of a direct marketing campaign to Japanese investors, in order to capture some of the allocation potential that is likely in the months and year ahead. Certainly, this type of talk must be encouraging for those distributors who are looking to advance their managed account platforms.

In this regard, strategies that are scalable potentially global in nature and that provide good downside protection if and when equity markets tumble, should become popular. Brand name manager that have previously been picked up by the larger FoHFs may also make it given their name recognition among Japanese end investors.

One should also remember that the BIS rules have only minimal impact on those managers specializing in fixed income. So, FoHFs with a fixed income arbitrage bias should be in a position to do particularly well, as should well established single managers in this strategy.

The irony is that as many PB units are effectively responsible in a reporting sense to their equity departments, they have no incentive (and in many cases authority) to promote fixed income products - even if those are the types of products that the Japanese marketplace demands!

On another note, FoHFs will save themselves a lot of unnecessary money by seriously re-thinking how to re-position their products and fee structures in order not to be totally disintermediated by the very alpha producers they initially served to promote in a pooled format. The writer has already mentioned this potential in The Rise of the Mega Fund (Nov 30 2006) as well with regards to the upcoming 130-30 product phenomena.

The Bottom Line

This will clearly be a good time for PBs to "get busy" promoting worthy single managers in Japan- even to the previously "hot money" investors known as regional banks. The FSA pointed out in a 2005 report that a total of 64 financial institutions were actively investing in hedge fund product.

Further, if they have any foresight they would discover just what transparency investors are looking for and provide the "boilerplate" portal (in Japanese language) to willing and able managers. Who knows, they might even stumble onto another potential money-earner making the rounds again - the managed account platform. What an opportunity! Mahalo.

Japanese Distributors Ponder Seeding Ventures...Again

"If you have made mistakes...there is always another chance for you...you may have a fresh start any moment you choose, for this thing we call 'failure' is not the falling down, but the staying down."

Mary Pickford (1893 - 1979), actress

After a number of years dabbling in hedge fund seeding talk is circulating again in Tokyo that several alternative investment product distributors are looking to get into the hedge fund seeding/incubation business. As ever, a key question remains what business model will the "winners" employ?

Japanese institutional investors have not been strangers to the seeding business. It is a well known fact that Japanese trading companies with a penchant for risk-taking have been historically the best suited to the private equity type of risk tolerance that exists.

Itochu famously gave a helping hand to Charles Hall of the Clinton Group back in the day, and was handsomly rewarded when he eventually bought out his Japanese seeder many years later.

Another interloper was Orix which was notable for having been an early investor behind a number of the most famous U.S. managers back in the 1990s. Apparently they took this experience one step further by taking it onshore in the early 2000s only to shutter it, presumably due to lack of performance.

And then there were the haphazard experiences of a few domestic Japanese regional banks that sought to opem up internal "prop desks" and retro-fit some kind of hedge fund structure around them to offer their clients (at typically higher fees). Due to risk management issues and the fact that the PMs were still the same "salaried employees" this was not even close to being an actual practicing hedge fund operation. More often than not it was a cleverly disguised marketing gimick taking advantage of a commodities run-up or global macro opportunity that saw huge profits in those strategies a year or so earlier.

More recent forays into seeding (single hedge fund managers) has come from brokers out of the U.S. most notably Nikko and Nomura. The former bought in a CTA team and built an initial track record in the early 2000s and then sold capacity to Japanese institutional investors. For a liquid model targeting financial futures ot did rather well managing to raise approx. US$800 million in its heyday. Nomura too had established a large fixed income vehicle which soaked up billions of AUM from institutional investors (including pension funds) to its outpost in Hong Kong. Later, that business then effectively split off and went independent once the broker decided to curtail its balance sheet risk profile.

Trust banks have also been dipping their toes into the seeding waters. Sumitomo Trust "teamed up" with Morgan Stanley offering access to emerging managers who might have been interested in launching under the legal unbrella of the biggest trust product distributor to Japan's pension market. The trouble is that the Hong Kong structure has not exactly attracted a whole swath of emerging managers. In the early days, they were not even offering start-up capital/working capital for wannabe managers and yet they wanted to take 30% of the economics of their business- hardly a solid foundation for success.

Other Japanese asset management companies have tried to "cloak" internal quant models that provide low risk-adjusted returns to domestic investors. Interestingly, no foreign FoHF firms would go near these products or invest in them because of their under-performance. That was interesting, as it showed that for non-Japanese investors a hedge fund approach was focusing pretty much on absolute performance for their global portfolios, whereas, for Japanese institutional investors the focus was more on capital preservation in Japanese equities often utilizing a beta-neutral investment philosophy (which often meant low returns). A few asset managers affiliated to life insurance companies have found this out the hard way - by trial and error.

But in 2007 times may be changing.

Now, it might be with swollen financial coffers local distributors will plan to grow back client demand for hedge fund product after the Redemption Tsunami of 2005/06. They now know that to build real future capacity in the hedge fund business they will have to be closer to the alpha producers. They cannot rely on their traditional "gatekeepers" - the foreign-led fund of hedge funds.

The choices are numerous. Perhaps they may be best served by seeding managers in more of a "hands-off approach" - as external prop desks utilizing an external platform/risk manager working under a separate brand and vehicle. Here they add capital and presumably share in risk analytics and the reporting/client contacts that happens as capacity is eventually pushed downstream (to the pensions). In this model they might even share in the ecnomics of the business. That might be one long-term option.

Another might be to go back to the internal prop desk model, one currently being nutured by UAM (United Asset Managers), ironically, a foreign hedge fund/asset manager who offer institutional quality infrastructure and capacity to foreign and Japanese institutional investors. The problem here is that domestic financial institutions still do not offer genuinely rewarding financial packages wihout disrupting their own incentive structures. Many senior managers still don't "get it" that with risk should come reward, even significant reward! Of course, one way around the short run need to hand over cash may be to jointly establish with employees an enterprise that can IPO so that all participants win: the PMs, the seed provider firms as well as the bureaucrat managers. This is a model that Nikko Alternatives in NY favors.

At the end of the day real success will be determined by offering the market quality products that are liquid, provide transparency and that are scalable to soak up the many billions of yen that are waiting to be put to work.

So what is the business and revenue model that has worked best in the west, and that could be imported into Japan? That is the 64 trillion Yen question. Mahalo.

Asia's Hedge Fund Top Performers

"I think it is an immutable law in business that words are words, explanations are explanations, promises are promises - but only performance is reality."

Harold Geneen, b.1910
former chief executive, International Telephone & Telegraph Company

With little more than 50 days into 2007 I thought I would take a look at the performance of a small universe of managers with Asia-related strategies for clues to their future performance. Data was courtesy of a Switzerland-based private bank who gets performance estimates on a weekly basis.

Asia: 21 funds of a diversified equity strategy type with combined AUM of US$7.86 billion, avg. AUM of US$372 million. The equal weighted average performance so far is +1.13% (range of
-7.86% to 4.26%). In this universe, positive performance was achieved by 81% of funds, while positive performance over +3.0% was achieved by 24% of funds. It is worth remembering that MSCI Pacific Free Index (in US$) as of Feb 12 was +2.02%. The top three standout performers on a YTD basis were: Eastern Advisor, Hamon Oriental and Tantallon.


Japan: 34 funds of a diversified equity type (and there is overlap with Asia) with combined AUM of US$13.9 billion, avg. AUM of US$410 million. The equal weighted average performance so far is +o.67% (range of -7.29% to +6.32%). In this universe, positive performance was achieved by 59% of funds, while positive performance over +3.0% was achieved by a mere 12% of funds. The MSCI Japan Index (in US$) as of Feb 12 was +1.48%. The top three standout performers on a YTD basis were: Arcus Japan Fund (Yen), Oberon Strategic and 788 Japan Fund.

Bottom line: It is still early in the year and the Nikkei and TOPIX have been rallying firmly since Feb-12 so that performance catch up is possible. This author still contends that those investors who have remained committed to Japan, especially with managers with a defined hedge and deep research-led capability should prevail in the performance race through 1H07.

The real question for investors remains "is it beta or alpha that I am buying?" Judging from last year's performance dichotomy between Japan and Asia managers more often not investors are "buying beta". Mahalo.

Sparx Bruised But Not Bloodied by JASDAQ

"The only limits are, as always, those of vision"

James Broughton

It seems that one large hedge fund complex after another has been hitting the headlines as well as the IPO jackpot over the last 6 months- whether in the U.K. or most recently on U.S. public markets. The managers love it as they can release some of the enterprise value of their respective firms at a time when equities are hitting all time highs; investment bankers love it as they represent a new source of fee income; and, judging by successful first day rallies, investors appear to love them too...and then you look at Japan and the recent experience of one of the most mature publically list hedge fund firms located in Japan - Sparx Group.

Back in October 3Q06 redemptions fell over 14% as the portfolio manager of Asia's largest asset management and hedge fund complex resigned. AUM at the Sparx Active Strategy Fund fell 29% to Yen 442 billion. At that time presumably the prospect of key-man risk was not sufficient to trigger the pullback of a long-time investor and supporter: CalPERS. But the same was not true of Sparx's European institutional investors who bolted en masse. Not helping matters was last year's particularly brutal performance of Japanese small cap markets, a sector in which Sparx has been able to ride out the bad times during previous market cycles.

Ironically, it was the activity of hedge funds that resulted in the temporary "beat down" of Sparx to a low of Yen62,000 on Nov 16 2006. Since then, stock price of Sparx on JASDAQ has nearly doubled to Yen 120,000 on Jan 22, 2007 before the current consolidation around Yen99,500.

Interestingly, with Japan's broad equity market TOPIX Index at 15-year highs (up 6% YTD)and the Nikkei 225 Index at its highest levels since May 2000 (up 4% YTD) as long as actions of the BoJ do not surprise (which they did not today), one might see another leg up in Sparx Group performance - especially if the trend of consolidation among banks and hedge fund firms in the US and Europe eventually makes its way to Japan.

Remember too, that when the head of Steel Partners Japan's Tokyo office recently left (a US$4 BLN activist fund) they did not see any significant fall-off in investor appetite for the fund. In fact, Kuroda the former head has already set up his own fund structure focusing on so-called friendly Japan activist opportunities in Fugen Capital.

Not ironically then, what this tells me is that contrary to short term price action I would look closely at Sparx as an interesting upside opportunity. After all, the firm is the owner of alternative investment "product", is building some sort of regional franchise and is only missing domestic Japanese distribution platform to soak up the juiciest mainstream Japanese institutional investor assets (read: pension plan money). Maybe a merger with an established Japanese bank might not be too far away, especially if the acquirer can wrest control of the 60% of stock that is held by insiders (read: CEO and founder Abe). Mahalo.

Mid-Size Hedge Funds Face Strategic Squeeze

"All things being equal, people will buy from a friend. All things being not quite so equal, people will still buy from a friend."

Mark McCormack, b.1930, Chairman and CEO, IMG

A recent takeaway from a curiously titled hedge fund conference in NY ("Battle of the Quants"), centered on the economies of scale enjoyed by large hedge funds. It was a nugget offered by the keynote speaker, David Mordecai of Risk Economics Limited.

According to Mordecai, basic economics are at work in the hedge fund industry. Tobin's Law states that abnormal rents earned will eventually be arbitraged away to the point where price will be equal to marginal cost.

He quoted data that pointed to the incredible cost/financing advantages enjoyed by the largest hedge funds in the business. Apparently, those single managers with AUM over US$5 billion now enjoy average cost advantages of at least 300 basis points. To get there he said one has to take account of the cost of short rebate, borrowing long against Fed Funds financing rate which together can amount to 100 basis points on the notional amount. This, together with a modest leverage assumption of approx. 2.5 or 3 to 1 produces the 300 bps implicit funding advantage. This is before the hedge fund even puts on any trades.

Add to that the anecdotal evidence produced by The Financial Times. They unearthed a situation where a prime broker was actually paying a big fund to do business i.e. the fund was being paid to do financing with the broker.

What does this mean?

Certainly, it means that the largest funds will continue to enjoy these advantages. In much the same way that they do in the U.S. and possiblly Europe, expect similar cut-throat financing competition to flow over to Asia (if it is not already taking place). Of course the exact definition of "size" among Asian hedge funds will have to be modifed for this argument to be transferable. For example, at the last count there were close to a dozen hedge funds with AUM over US$1 billion, and fewer still with AUM over US$5 billion that could be called "Asian" as opposed to being global - where most of the cosgt advantages currently reside.

Second, if big funds hold the proverbial negotiating hammer with prime brokers, the medium sized funds are getting squeezed. Not only are they typically not quite yet "institutional" in AUM or infrastructure but they cannot enjoy the financing advantages of their bigger rivals. So, their business model must try to decide whether to "go big" or "go niche". In the latter case, they might eke out alpha in smaller more exotic opportunities and situations which are likely to be size constrained. This is certainly the dilemma that they face wherever they are, especially if it relates to Asia.
Mahalo.