Japan-only Hedge Funds Slip into Growing Irrelevance in Asia

"A man is rich in proportion to the number of things he can afford to let alone."

Henry David Thoreau, (1817-1862), author, poet and abolitionist

The data keeps pointing to a very uncomfortable truth; one that has been in the making for a number of years. Stock market capitalization of countries in Asia are increasing in US$ terms almost everywhere - except in Japan.

As equity business tends to form the bulk of trading activity across the region's exchanges this has a big impact on hedge fund location, capital allocations, prime brokerage resources, income disparity across various exchanges and the use of direct market access technology for executing buy and sell transactions.

In the good old days, Japanese stocks were heavily traded, and their brokers were high on global league tables in terms of analyst coverage, investment banking business, IPO volume and equity traded. The rest of Asia was the rump with Korea struggling to break out. Hedge fund activity was rampant in the region especially when Japan was awash with liquidity, a stock market that went-wild in the 1980s only to stumble somewhat in the 1990s as deflation and a bank crisis hit the markets and market sentiment.

2003/04 marked a temporary reprieve as global hedge funds bought ahead of a government backstop behind the big banks. This, plus the promise to keep rates low, allowed investors to buy the banks without peril. Japan Inc. recovered and hedge fund AUM exploded together with their influence on the local exchanges and their activity at conferences, such as the GS Tokyo Hedge Fund Conference. Hedge funds dominated Japanese equity markets, and accounted for as much as 30-33% of Tokyo SE market capitalization.

Those days are no more. More hedge funds have closed than opened in Japan, however hard US and European prime brokers try to announce otherwise -- almost every other month!

The trend of equity market capitalization is a partial reflection of hedge fund activity in the region. Comparing 2006 to end of 2009 data, the value of Japanese stock market capitalization has fallen 28%. Over $1 trillion has disappeared. It is gone- probably to other markets in the region that offer more growth, greater liquidity, IPOs and generally more positive prospects.

And it is not only a case of FX translation too. Japan market cap now accounts for just under 23% of total Asia market capitalization which runs at around $14.4 trillion. Back in 2006, Japan market capitalization represented 40% of Asia market capitalization.

Just as Japan has slumped, Chinese equity markets are enjoying a period of incredible growth. The combination of Shanghai, Szechen and HK stock market cap growth now exceeds that of Japan by over $2.5 trillion. China now represents 41% of total Asia market capitalization.

With year on year growth also picking up in Asia ex. Japan big opportunities are now opening up to grow more hedge fund business out of Singapore, Hong Kong and a new batch of low cost centers with solid infrastructure as affordable commercial real estate is likely to be a negative factor for many firms in the coming years.

Indian stock market capitalization from 2006 to end 2009 has grown by 38%. Like other countries, a net phase in market development will be the extension of company coverage to include more mid- and small-cap stocks and the proliferation of indices that allow for passive (low cost) exposure by the region's institutional investors including banks, insurers, and SWFs.

Sadly, the prospects for Japan look bleak. Investors should be aware that the pan-Asian hedge fund strategies are more likely to produce positive alpha in this next investment phase. The days of a Japan-only strategy are pretty much heading the same way as their zombie economy. Long live a pan-Asia, multi-strategy hedge fund approach.

On a not totally unrelated note: in the same way that a few forward thinking Japanese companies encouraged the promotion of westerners to senior management and board level positions in the mid 2000s, they might want to now do the same to include more Asians at critical board-level decisions if they are going to be able to appreciate the medium-term changes going on in the region's markets. Japan has to get out of depending on capital to come to Tokyo, and instead allow capital to move out to where there are positive NPV projects in the rest of Asia.

It may be time to learn Mandarin, Thai, Tagalog and many of the other regional languages and cultures as corporate development including M&A activity almost certainly intensifies. Mahalo!