Japan’s Evolving Hedge Fund Market

Unlike the U.S. where high net-worth and family offices dominate hedge fund investments, Japan is very much an institutional driven market. The large financial institutions have thus far dominated investments into hedge funds. As a result there has always been a greater focus on transparency, liquidity, risk management and operational issues. There is a much higher hurdle rate with respect to disclosure, length of track record, the size of assets under management and the quality of the investment process. Even the High Net Worth and retail segments of the market have been institutionalised due to the high degree of market intermediation by domestic securities companies and banks. Products created for these investors have primarily been in capital or principal protected structures with exposure to underlying hedge fund assets.

Japanese institutional investors have had a relatively long history with alternative investment products. Trading companies, with their worldwide operations and expertise in commodities, began to invest in Commodity Trading Advisor’s in the early 1990’s following the enactment of the Commodity Fund Law in 1991. Structured as yen denominated funds they focused primarily on managed futures. By the time of the LTCM debacle there was in fact considerable investment in CTA’s and hedge funds employing global macro strategies. However, as a reaction to the LTCM crisis, most institutions began curtailing their exposure to the asset class. In addition, asset allocation restrictions and a lack of familiarity with alternative strategies kept many institutions sidelined until the late 1990’s when life insurance companies, city banks and trust banks began to invest in a wider range of hedge fund strategies. Most of the investments made at that time were through fund of hedge funds, rather than single managers and were primarily concentrated in market neutral strategies. More recently we have seen a shift towards direct investments in single managers and a growing trend towards allocations to more diverse investment strategies.

At a recent industry conference in Tokyo it was estimated that Japanese investors had allocated approximately US$ 40 billion into offshore hedge funds. Teneo Partners believes the actual figure is substantially higher, closer to US$ 60 billion. According to an article in the Nikkei Kinyu, seven of the largest life insurance companies alone had over US$ 11 billion invested in offshore hedge funds as of March 2003. Recent estimates put the total global hedge fund universe at over US$1 trillion, which implies that Japanese investors account for no more than 4% of the total global investments in this asset class.

However, many Western observers fail to recognise that there is a nascent domestic hedge fund market that we estimate to be approximately US$10 billion in size. The figures quoted in the paragraph above, reflect only those investments by Japanese investors into offshore funds. They fail to factor in the presence of a rapidly growing domestic market. Both domestic and foreign asset management companies such as Goldman Sachs Asset Management and Tokio Marine & Fire Asset Management run domestic hedge funds for both institutional and pension fund clients.We estimate there are twenty three Japan based asset management companies who together manage over eighty hedge funds, which are denominated in Japanese Yen and are registered locally. Many Japanese investors find it easier to perform due diligence and receive approval to invest in these local funds. Moreover, some Japanese pension funds will only invest in those hedge funds that are registered locally and are managed by an asset management company that holds a Discretionary Investment Management license. As pension allocations to hedge funds increase, we expect this market to grow exponentially.

Although it is difficult to achieve agreement on an actual figure, there is a widespread conviction that investments in hedge funds and other alternative products are substantial and will continue to grow.

Pension funds represent the principle incremental demand for the growing domestic market in Japan with allocations to hedge funds doubling over the last financial year. Another major source of incremental investments into hedge funds over the last two years has been the High Net Worth and retail investor. Securities companies have created products for low-end retail investors with banks focusing on products primarily for High New Worth Individuals. As a result, in Japan, the entire spectrum of the retail market has effectively been targeted. Conversely, insurance companies and banks that accounted for the majority of investments in the late 1990’s and early 2000’s have slowed the pace of their investments.

The key to success in Japan is in understanding market trends and meeting the requirements of institutional investors as they move through their long and tedious due diligence processes. This can make for a lengthy and complicated sales process, however given the size of the institutional investor market and their growing appetite for alternative products, it is well worth the time and effort required.

The rise in the number of Japan-related hedge funds has mirrored the overall explosive growth of the global hedge fund industry. Until recently most of the Japan related hedge funds were run by foreign mangers located either in New York or London. They came out of major mutual fund companies where they gained experience in managing long only Japanese equity portfolios. In the late 1990’s a number of ex Soros and Tiger managers began to populate the landscape in Tokyo. To these were added traders from proprietary trading desks at foreign brokerage firms, who left to establish their own hedge funds. Still, most of the hedge fund managers were “gaijin” or foreign nationals. The exceptions were Tower Investment Management who got their start in 1998 and Sparx Asset Management who initiated its hedge fund operations in 1999. These firms were established and run by Japanese who catered to the domestic Japanese investor base in addition to U.S. and European investors.

As the focus on hedge funds grew in Japan and as institutional investors increased their allocation to the new asset class, there was increased speculation about allocations from the pension industry. The Pension Fund Association of Japan had been guarded in its opinion of the hedge fund industry. However, in 2000 Noboru Terada who at the time was the Executive Director of the Japan Pension Fund Association publicly suggested that pension funds should consider the asset class but should initially invest via a Japan long short equity vehicle. The following day several of the large Japanese asset management companies announced that they were launching long-short funds. This proved to be the catalyst for a move into hedge funds by the asset management industry in Japan.

These large institutional money managers took quite a different approach to managing Japan equity long short versus their independent counterparts. Most of the institutions developed quantitative models that created outputs listing undervalued stock for their long book and overvalued stock for their short book. Others entered the fray by creating funds that went long specific equities and hedged the portfolio by shorting the index against those long positions.

Not all large asset managers took the decision to create long short funds. There was reluctance from some asset managers because of potential conflicts with their wide range of corporate clients whose stock a manager might wish to short. This is a particularly sensitive issue in Japan. Even some of the large domestic banking and financial groups will not invest in Japan long short strategies for fear of alienating their corporate clients.

In spite of this what we find encouraging is that a new breed of independent Japanese managers running hedged equity strategies is emerging. Recently we have seen Japanese nationals such as Hideto Fujino at Rheos Capital Works Inc and Ken Nishizawa at Melchior bringing their considerable domestic long only expertise to foreign hedge fund firms. Still more are following the trail of Tower and Sparx, creating their own independent asset management companies. Asuka Asset Management, GCI Asset Management and Moonlight Asset Management have established full-fledged Discretionary Investment Management companies in order to manage both offshore and domestic funds.

According to Institutional Investor, the percentage of foreign analysts in their All-Japan team was twenty five percent in 1996 but had fallen to just six percent of the 2004 team as local analysts with deep industry contacts and with experience over several business cycles rose to prominence. In much the same way we expect over time the number of hedge funds run by Japanese to increase dramatically. Teneo Partners is well positioned to take advantage of this burgeoning market.