On March 11th, Japan was hit by the largest earthquake in its known history with a magnitude of 9.0. The subsequent tsunami had tragic consequences on the Tohoku coastline. The human scale of the tragedy was immense with the ultimate death toll likely to be close to 30,000. The ongoing nuclear uncertainty has also added to a nation’s collective shock. In many respects the combination of shock and fear of the unknown added to a more extreme market reaction than justified purely on economic grounds.

If we consider the market prior to the tragic events, Japan had been a beneficiary of the developed markets (DM) versus emerging markets (EM) trade.  The broad thesis was that QE II was driving a US recovery but also creating inflation. Inflation was a much more serious problems for emerging markets and less so for developed markets.  Japan has traditionally a favorable correlation with US growth, and rising developed world bond yields.  During the 4 months from November 2010 to February 2011 the broad based Topix index returned 17.3% at a time when the Asian ex. Japan markets changed little. This was a most serious setback for many equity investors who have been underweight Japan for years, and overweight emerging markets. This has created favorable foreign flows as this position unwound. Many hedge funds also had to reposition from using Japan as their easy hedge for their other Asian longs and some had opportunistically gone long.

In March tensions in the Middle East and the related impact in oil had brought the rally to a halt and brought about some profit taking.  The market had just closed on March 11th when the earthquake and tsunami hit. International reaction was initially measured and based on futures trading in the US time zone with a correction of 2-3% predicted. What transpired the next week was much worse as domestic Japanese investors panicked; part due to shock as the scale of human tragedy unfolded, part due to nuclear uncertainty and part due to a reluctance to rely on fundamentals after 20 years of near deflation.  Foreigners tended to use the selloff as an opportunity to reduce their underweight positions. Most markets reached their extremes during Tuesday 15th when very briefly the nuclear uncertainty caused even the foreigners to pause buying.

To put this sell off into context, all of Tohoku accounts for 8% of Japan’s GDP and the most effected Miyagi prefecture 1.7%.  Clearly, the market reaction was hard to justify economically. However, the foreign buying kept up and the market rebounded and then stabilized. Foreigners bought Yen 955bn of equity that week which is the second highest week on record.  The view of many of the buyers was that for many stocks in the external sectors there would be a profit hit from power outages and supply chain disruption. This would only last 1 or 2 quarters and the long term cash flow of the businesses would revert over time and long term fundamental values should change little.  Many optimistically felt the crisis might prove a catalyst for change which Japan has lacked to date.

The Yen was also volatile rising to 79 on the thesis Japan would repatriate assets and the memory of a 20% Yen appreciation after the Kobe earthquake. The BOJ kept liquidity high and with the support of the G7 kept the Yen above 80, eventually stabilizing around 83.

Japanese long short managers

By far the majority of dedicated Japanese hedge fund managers focus on long short equities. It is fair to say that even before the events of 2011, it has been a challenging environment with no easy years since 2005. There has been a large decrease in assets in the strategy and many managers have shut down in the last 5 years. In relative terms the hedge fund managers have done well staying flat when the market has halved, but lack of absolute returns have driven outflows. This has left a core of highly experienced surviving managers who have adapted to Japans difficult conditions. By nature they are less long biased and more tactical than high conviction in their investment style.  We would classify them into 3 broad groups:

•    Neutral managers that take minimal market exposure, though the styles range from tactical short term trading to longer term fundamental pairs

•    Low net long biased managers where the net typically ranges from 20% to 50%, with a fairly fundamental investment process

•    More tactical directional managers.

We had observed that prior to March many of the long biased managers were up close to the maximum levels of long bias. We also saw many of the more tactical managers take some net risk as well.  We saw some divergence in the reaction to the early March correction. The more tactical managers reduced their net exposures, but the more fundamental managers tended to hold on.

Once the March 11 events happened, only a few used the brief window of US listed ADRs and US time zone futures to de-risk. Most were still trying to understand the facts as the scale of the tragedy and uncertain nuclear situation was not at that stage apparent.  The first reaction of most managers was that the sell off was over done on Monday the 14th, and even more so on the 15th. However, most showed discipline in holding their net exposures at around the same levels; with few believing it was right to stop loss positions. Most did look to take profit on the shorts and took down their gross books aggressively by also reducing the more marginal longs.  They then switched their long books around to exploit the most mispriced opportunities as much of the selling had not been in line with fundamentals.  The changing environment has seem them reduce longs in certain sectors; Retail, as they think the recovery will now stall, and Banking, as there may be credit losses from more marginal business being pushed over the edge.

Performance on the 14th and 15th was poor. Even the more neutral funds lost several percent due to a combination of a reversal of recent winners and more extreme sell offs in small and mid caps. The more long bias managers were down around 10% at the end of the 15th. As the market rebounded and stabilized, the most unjustifiably sold down stock corrected quickly and managers captured a high level of alpha.  By month end a significant portion of the losses has been recovered, especially for the larger managers, many remaining up year to date.  The smaller managers did less well as more adopted a harder stop loss approach, whereas the large managers stuck more to fundamentals.

Towards the end of March and early April we saw a reduction in net exposures. Many managers believe this is a good level to own Japan in the longer term. However, in the short term the news flow will largely be poor for the next three months. The external sectors will be quantifying their losses due to supply chain disruption. The domestic sectors are going to see consumption number collapse as there is a strong culture of restraint after such a terrible human tragedy. Therefore, there is an expectation that it will take a number of months before the market starts to look through the current quarter.

In general, managers did a good job navigating very difficult conditions.  In many respects Japanese managers have been through the most challenging last 5 years and they have a strong disciplined skill set. Even in such unfortunate time, Japan remains a good alpha market. However, the emotional toll was high and we have observed a few cases of managers deciding to take a break from the industry.

Impact on other strategies

March proved a reasonably flat month for global hedge funds and even Asian hedge fund managers were overall up, so the contagion was fairly limited. One reason many strategies made money was the reversal of the DM versus EM trade and to some degree the events in Japan may have been part of the catalyst.  This supported a recovery in risk assets generally in the second half of the month after a weak first half dominated by the combined effects of the Middle East and Japan.

The more systematic strategies such as CTAs and GTAAs did struggle with losses of over 1%, and higher for a few of the large managers. Intra month losses were even worse.  Many assets classes had a “V shaped” sell off and recovery and this does not favor strategies which tend to use a hard stop loss approach. A lot of the losses came in equities and the Yen. Some of the more discretionary directional strategies, such as Global Macro and Commodities, had very mixed results with a huge divergence in returns. Once again the swings caused by the Middle East, Japan and the subsequent risk asset recovery, created both opportunity or risk of being stopped out at the wrong time.

One of the more esoteric strategies that did suffer was Insurance. The events in Japan come on the back of losses due to the Christchurch earthquake and Australian floods.

One of the areas we might have expected more trouble would have been convertible bonds, which often overreact in a crisis. One of the features of Japan’s market is that it is very easy to hedge the credit risk and spreads in Japan are relatively tight, so no one is incentivized to keep unnecessary credit risk. Therefore, the scope for losses was very limited. Convertible bonds rarely trade in line with increasing volatility in a crisis but they do benefit from some ability to trade the gamma. We saw some contagion in the rest of Asia but prices had recovered by the month end.

Most of the cases of significant manager losses across all strategies were very idiosyncratic. Typically they had too big a bet and got stopped at the wrong time, or were caught out in a short option position.

Outlook

The optimists think that the estimated $300bn rebuilding cost, of which $48.5bn is approved, will revitalize the Japanese economy and could be the catalyst to stimulate the recovery. The cynics point out with Japan’s poor demographics and the hollowing out of the countryside; they can’t possibly find a way to spend the money. The pessimists believe that this will drive the government to a fiscal crisis and even if they raise taxes that will just crush the domestic economy.

We believe that this makes any macro trade on Japan challenging. However, we still believe that Japan is a good alpha market and opportunities at the micro level remain abundant. We extend out sympathies to all the people in Japan and encourage hedge fund investors not to ignore this market.

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