Japanese markets have been off to a strong start in 2024. After many long years of suffering from a lack of investor interest, Japan has finally awakened and seems to be every investor’s new “best idea”. Many global investors seem to be busy dusting off their prior Japan playbooks, trying to frantically understand how the rules might have changed, and who may be best suited to guide them through Japan’s new dawn.
The weak Yen, the “normalization” of monetary policy and the Japanese government’s strong support for reforms (both of markets and the country more broadly) has everyone trading Japan abuzz with excitement. One clear symbol that things are changing is that the percentage of foreign workers in Japan has increased from approximately 1% to around 3%, which, though may not seem significant, is a massive change. Anyone going to a 7-Eleven (a ubiquitous convenience store chain in Japan) will notice that, more often than not, the person behind the counter now is a foreigner rather than Japanese. Having spoken to over 50 hedge fund managers trading Japan so far this year, the chorus is that they all see these changes as unprecedented and a once in a multi-generation shift.
There is seemingly no shortage of long as well as short ideas emanating from all these changes, and a cogent case can be made this this isn’t an ephemeral opportunity but one that will take years to fully play out. The excitement among fund managers is palpable and is being reflected in year-to-date returns. High single digit, high Sharpe ratio returns are not unusual, nor are double digit returns through mid-May. The optimistic narrative conveyed by many managers has so far been validated by their performance.
Predictably though, most investors are looking at the rise in the NIKKEI (up approximately 22% year to date at the time of publishing) and the TOPIX indices (up a similar amount) and conclude that either they should approach Japan from a long-only view (which then becomes either a macro or a valuation bet), or else, if they are a bit more daring, allocate to activist managers. Long-only investors then further tend to limit themselves to small and mid-caps, which comes with its own set off issues and flow-related volatility. If investors decide to look at Japan as a long only destination, then perhaps they need to be more open minded. Few, for example, consider the possibility of concentrated portfolios of high-quality global leaders (there is a reason Warren Buffet got excited about Japan….), even though that is an approach that has worked better than others over the past decades.
Considering Japan only from a long only perspective is too simplistic though. Japan is one of the best hedge fund alpha markets globally, rife with inefficiencies, and hence being limited to a beta-driven strategy means leaving a lot of opportunities on the table and suffering volatility and global flow-related dislocations. Historically, approaching Japan long-only was not a profitable strategy and severely underperformed hedge fund strategies. Additionally, given that the Japanese government, together with the Tokyo Stock Exchange, de facto have become the largest activists in the market, it is questionable why investors should need to suffer the inherent illiquidity in most activist strategies, when this has become an inbuilt market driver. Tellingly, several Japanese hedge fund managers have told me that often the first thing investors new to Japan want to know is what percentage of a fund’s strategy is tied to activism. When they find out that this generally is a very small part of most strategies, and that the way in which Japanese managers think about activism is very different from what western investors are accustomed to, they tend to not only be very surprised, as they thought that this was the only game in town, but often also immediately then lose interest because their thesis for investing in Japan seems inexorably tied to the corporate governance reform taking place and they do not fully understand what this really means in terms of performance drivers and opportunity set.
This shows a very clear lack of understanding of the myriad return drivers in Japan and the fact that the market is a lot more complex and multidimensional than generally appreciated. This myopic view of Japan by foreign allocators leads to disappointment on both sides. Investors are saying that they cannot figure out how to invest in Japan, who to invest with, and how to find the products that they think they want to express “their Japan thesis”, and fund managers are frustrated by the fact that foreign investors “just don’t get the opportunity in Japan”. The upshot is that great opportunities will be missed by investors, and local managers won’t have the capital to capitalize on what they perceive to be an unprecedented set of opportunities. It is therefore fair to say, that despite the recent increase in interest in Japan, it is a market that remains poorly understood and that many investors are still looking at Japan through the wrong lens. The risk is that great returns will be left on the table, and the industry won’t grow as much as it could and should.
In terms of demand for Japanese hedge funds, there has been a significant increase in requests for, and funding of, single managed accounts rather than fund investments in the first half of this year. This is due to several factors, not least being a lack of institutional size and quality funds. Many Japanese hedge funds remain sub-scale (with the majority being below $100m in AUM), and operationally not robust enough for institutional investors to confidently make an allocation. The size issue also naturally limits the amount institutional investors can allocate due to concerns about investor concentration. A managed account, for those investors sophisticated enough to be able to administer one, solves both the vehicle and some of the operational concerns.
However, it is by no means a panacea. The downside to this is of course that not all investors are willing or able to allocate in such a manner, nor is every manager willing or able to accept managed accounts or deal with the operational burden this entails. Hence, this approach is usually reserved only for the largest and most sophisticated investors. The other issue faced by investors is that many funds have limited capacity, and so even if they are operationally robust, they may not be able to digest all the capital that institutions may wish to allocate. The challenges faced by investors looking to invest in Japanese hedge funds have therefore not changed from those described in our last Japan hedge fund industry survey.
While performance has been very good, and investor interest clearly significantly increased, we have not yet seen significant increases in the AUMs of comingled Japanese hedge funds, outside of the aforementioned AUM increases from managed accounts. The coming months may herald a shift, however, as allocators become more familiar with the full opportunity set in Japan. Additionally, prime brokers have also been busy generating more visibility for Japanese managers providing them with more opportunities to interact with global investors. Japanese hedge funds deserve both more attention and more AUM, and the current resurgence in interest in Japan may just be what they were waiting for.
**********
Patrick Ghali is Managing Partner at Sussex Partners
***
The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group
