Wanted in 2008: Japan Long/Short Equity Managers with Shorting Experience

"This [poor Japanese equity performance] seems to reflect that our country is losing its attractiveness as a place of investment, while 'oil money' and other huge excess funds flow around the world."

Atsushi Saito
CEO, Tokyo Stock Exchange

Right out of the 2008 trading gate the Japan's Nikkei 225 Index lost 4.03% (616.37 points) to stand at 14,691.41. This follows on from the minus 11.1% performance the equity index posted over calendar year 2007.

While the comments from the head of the TSE (see above) were decidedly negative, it has become increasingly clear that, despite claims to the contrary, having your domestic stock market at the "investment mercy" of overseas professionals (and a number them hedge funds to boot) is not healthy. To claim that the market is offering value as a number of broker like to hype at this time of year is naive.

The real issue is to look at the composition of the players and to understand their motivations and the market value proposition to them.

"Value" to a Japanese institutional investor is not the same definition as "value" to a western institutional investor. And data shows that Japanese institutional investors have not been buying their market despite the decline of the market towards cheaper levels in 2007. Something is out of whack when your hometime institutions do not buy their own market!

Some hedge fund managers believe that "locals" will only start buying once the Nikkei 225 Index has dropped to the 12,000 mark. This means that Japan's equity markets have another 18% fall potential. Yikes.

The good news is that the CEO of the TSE, Saito-san, is apparently not content to sit on his laurels and senses the acute fragility of Japan's marketplace. Lets hope that the FSA, BoJ and others appreciate the situation too. We need a series of investment catalysts and not mundane broker-speak "Japan is cheap" prognostications. Good luck catching a falling knife.

In the good old days Japan Inc. would have imposed rigidities on the equity markets to make shorting more difficult. Ironically, what is needed is to impose the reverse, to cut taxes on transactions, capital gains and corporate profits and to make subtle changes to the legal system so that inefficient Japan Inc. management teams can no longer "hide" from prospective rabble rousing activists.

The TSE should also step up its international program of JVs and tie-ups with markets and exchanges overseas so as to capture some of the trading volumes in those growing markets. Further the local markets probably need an "extreme makeover" with new instruments (e.g. niche oriented ETFs) for investors both retail and institutional.

For family offices and hedge fund of fund managers, Japan in 2008 represents a conundrum of sorts. It is underweight in a lot of their portfolios on the passive side (many owned the ETF, EWJ).

A further worry for investors is that today's Japan long/short equity managers are either too big and unwieldly to get in and out of positions or simply do not and have not any credible ability/experience where hedging is concerned. This must change and soon!!!

If Japan long/short equity managers cannot generate alpha on the short side of their often long-biased book I anticipate more serious net outflows from investors. Even onshore bank products that claim to have a shorting methodology will lose assets as local Japanese investors "head for the matresses".

It might be a good time for some shrewd hedge fund manager to raise money for a short-bias Japan fund and I am sure that quite a few hedge of fund managers might just be interested enough to take a punt. Mahalo.