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When the Tokyo stock market closed on Wednesday afternoon, the sun was shining, a weekend of cherry blossoms lay in prospect and the once leaden-footed Topix index — the broad benchmark of corporate Japan — had skipped to within inches of its all-time high.
Tricky times, in other words, for some of the world’s biggest hedge funds. Good news, especially when fuelled by a fundamental change in the nature of a market, can sometimes be very tough going.
The problem, if it can be called that, is that Japan’s equity market is in excellent shape. Arguably, in terms of trajectory and narrative, the best shape it has ever been. Some weeks ago, the Nikkei 225 Average surpassed its December 1989 peak. It has gained nearly 22 per cent since the start of the year and has continued (as it did yesterday) to log new highs.
In a whirl of share buybacks, new merger and acquisitions rules, successful activism and top-down pressure to improve returns, companies, the government and the stock exchange itself have done enough to convince the world that this time is different. There are always plausible ways it could unravel but the story of positive change is holding.
For the better part of three decades, the story was very different. Once the late-1980s bubble had burst, and the economy entered its tussle with bad loans, deflation and corporate stagnation, the Tokyo market became an avatar of weariness and dreariness. There were moments, of course, when the whole thing moved decisively in one or another direction, but these stints were mostly shortlived.
Japan’s stock market, for all its sophistication, breadth and liquidity, became characterised by its tendency to return to the long-term mean. Other big markets would trade for extended periods on momentum; Japan did not. Colourful things would happen, but the gravitational pull of beige always won, and usually in a matter of days.
Crucially, though, the reliability of Japan’s “nothing to see here” market offered specific opportunities to certain hedge funds. Rapid, predictable mean reversion is very useful if you are running a long-short strategy and your risk managers are obsessed with maintaining neutrality in all things — whether that be country, market, sector or factor risk. For a certain type of hedge fund — a breed now dominated by the huge multi-manager platforms such as Citadel, Millennium, Polymer and others — neutrality reigns supreme and Japan, accordingly, has been very appealing.
Part of that appeal has been the depth of the market: you want neutrality but also a portfolio full of idiosyncratic risk (think of Pigeon, the baby-product manufacturer whose shares used to rise when an imperial pregnancy was announced) of a type that Japan is quite good at. There are thousands of companies to trawl for potential longs and shorts, and, despite the stagnancy of the market, plenty of stock-specific incidents to produce big movements on individual shares.
Generations of market participants learnt to sell their winners and buy the underperformers, said one manager whose hedge fund is now in urgent search of a new strategy.
Everything worked beautifully until about 18 months ago when the Japanese market became, in effect, momentum-driven. With the whole market rising at the same time, market neutrality has been far harder to maintain. Some funds continue to thrive but many of the multi-manager platforms, according to dozens of brokers and asset allocators, have found the rally to be the hardest environment they have operated in for many years.
And the momentum increasingly looks like more than just mood music. Shareholder activism is moving stock prices, and, critically, the fear of activism is pushing Japanese companies to pre-emptively reward shareholders with non-core asset sales and share buybacks. For pickers of stocks to sell short, this is nerve-racking, says one market strategist: you never know when a previously bad-looking company is going to do the right thing, announce a buyback and watch its shares fly.
Big, long-only money is coming into the Japanese market chasing high-quality companies with improving governance standards, exposure to global growth and a “not China” story. Significantly, momentum-chasing global investors who previously sought their fix in China are turning to Japan, say brokers, and bringing the momentum with them.
The new money coming in, explains one aggrieved manager, has a growth mindset that prefers to add to its winners and buy more on good news — the antithesis of the zero-sum mindset of many of the long-short platforms that have dominated trading in Japan equities for so long.