Understanding Basel II : A Guide for Japanese Financial Institutions

"The freedom to fail is vital if you're going to succeed. Most successful people fail time and time again, and it is a measure of their strength that failure merely propels them into some new attempt at success."

Michael Korda (1933- ) novelist and former Editor-in-Chief at Simon & Shuster

The new reality of Japan's financial environment in the aftermath of Basel II has been hanging like the shadow of Father Time over the hedge fund and HFoF industry. Why? Beginning next fiscal year Japanese financial institutions will be constrained in their demand for product particularly when the investment strategy or asset exposure of a fund is tough to ascertain.

Basel II will force Japanese financial institutions (mainly money-center or city banks, regional banks and credit unions and other bank-like institutions) to set aside considerably higher levels of balance sheet capital as "risky" hedge fund assets fall under a new capital requirement regime. The new requirements will require capital set aside for certain hedge fund holdings to jump up dramatically from anywhere from 400% to 1,250%. Of course, this is going to put a big brake on demand for product.

How big will be the inevitable impact (of falling demand)? According to recent FSA figures recently outlined in a HSBC paper, investments by Japanese financial institutions in single managers and FoHFs rose from approx. US$51 billion to US$62 billion from 05 to 06 - figures far beyond those imagined by the many outside and domestic observers.

According to the FSA survey of 1,252 Japanese financial institutions. The breakdown was as follows:

Trust Banks: US$9.3 billion
Regional Banks: US$9.3 billion
Other: US$12.4 billion
City Banks: US$14.8 billion
Insurance Cos. : US$16.1 billion

Further, the numbers point to Japan's hedge fund industry being very concentrated with 17 domestic institutions accounting for 60% of the total (average investment of US$2.2 billion).

The crux though involves the Internal Ratings Based Approach to hedge fund investing by financial institutions. A solid understanding of what is at stake here can have a significant impact on the ability of the Japanese financial institution's future appetite for hedge fund product - whether single manager or FoHF.

If assets held in the fund are identifible then...
1/ Look through Method. This is simply the weighted average risk weight of assets contained in a fund.

If more than 50% of the assets in the fund are equities then...
2/ Adjusted Simple Majority Method. This treats the whole fund as if it is wholly invested in stocks and apply a risk weight of 300% (if listed stocks) and 400% (if non-listed stocks).

If the fund investment mandate is clear...
3/ Mandate Method. This involves a conservative estimate of individual assets in the fund based on the investment mandate and calculate a average risk weight.

If there is access to a daily/weekly mark to value the fund portfolio...
4/ Internal Method. This involves calculation of required capital based on NAV changes of fund estimates based on an FSA aqpproved internal VaR model.

And if it is impossible for the fund to hold high risk assets...
5/ Simple Method. Confirm whether the fund contains no mezzanine od subordinated traches of securitization deals, non-performing loans, or other "high risk assets" and apply a risk weight of 400%.

6/ Simple Method. Apply a risk weight of 1,250%.

Interesting to note that the methodological approach tries to bucket the risk but says nothing about use of leverage among other things...

Initial feedback among banks has been mixed from, "...we cannot invest in hedge fund product going forward" to "...lets find some innovative ways around this (e.g. swaps)"...to "If I am going to be penalized for investing in hedge funds I want even more high octane managers". Where the dust settles is still a big unknown.
Mahalo.

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.

Japan Long/Short Equity Gets That Sinking Feeling in 1Q07

"It is not the employer who pays the wages; he only handles the money. It is the product that pays wages."

Henry Ford (1863-1947), American automobile engineer and manufacturer

As global investors focus on first quarter performance of international investment holdings, the early showing by Asia and Japan focused hedge funds does not look particularly good.

For comparsion sake, consider some of the region's traditional market indices through the end March 2007 (with performance denominated in local currency terms) : Japan' Nikkei 225 Index +2.06%; TOPIX +1.94%; Shanghai A shares +18.87%; Singapore Times Straights +8.22%; Korea KOSPI +1.26%; Taiwan Weighted Index 0.78%; Thailand SET -0.90%; MSCI Pacific Free +2.80% and MSCI Pacific Free Pacific ex-Japan +4.93%. The bottom line is pretty much positive across the board, especially if Japan is excluded, which was a recurring theme in calendar year 2006.

Now take a look at hedge fund performance. Data commentary here is restricted to the universe provided by a well-known Swiss bank that is distributed on a weekly basis. The time series is mostly through end-March for the vast majority of funds.

Asia Long/short Equity. For 24 funds, total AUM of US$10.2 billion, average fund AUM of US$430 million. The average end Mar performance was 0.72%, with average YTD performance 0.68% on an equal-weighted basis. The performance spread was wide from +5.99% to -9.29%. The % of funds that were "winners" over Mar was 83%, and on a YTD basis 71%.

Japan Long/Short Equity. For 64 funds, total AUM of US$13.8 billion, average fund AUM of US$215 million. The average end Mar performance was -0.84%, with average YTD performance -0.03%. The performance spread for YTD was wide from +7.61% (for Steel Partners an investor activist) to -6.92% (for GCI's Rubato). The % of funds that were "winners" over Mar was 18%, while on a YTD basis 46%.

China Long/Short Equity. For a very small universe of 4 funds with AUM of US$661 million, average AUM of US$165 million, average monthly performance was 2.90%m with YTD performance of 13.22%. The performance spread was +26.97% to +13.00% on a YTD basis.

Bottom line is that being an investor in Asia has been fairly hazardous over the last 3 months. Further, investing in Japan has been even more of an issue, and that after taking fees into acount suggests that a passive, beta oriented approach was probably the best option. It might also suggest that investors need to be more open minded and creative in terms of alpha generating strategies in the region e.g. land, Asian real estate or REITS, gambling in Macao, or even activists.

Mahalo.