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Hedge Fund Investment in Japan
Ted Uemae, Alternative Investment Products

January 2004

The total assets invested in hedge funds by Japanese investors at the end of 2002 is estimated to be around US$20.5 billion, which is slightly over 3% of the global investment in hedge funds.

Asset allocated in Hedge Funds by Japanese Investors as of Dec 2002*

Japanese Investor @ December 2002 (US$bn)
Insurance Company 8.5
Banks 5.0
Pension Fund 3.8
Corporate 1.0
High Net Worth 1.2
Others 1.0
TOTAL 20.5
* by AIP-Tokyo 2003

* by AIP-Tokyo 2003

This asset size will hopefully grow in coming years; however the growth in 2003 is expected to be quite limited. It could even be negative.

This article attempts to provide some ideas on how to evaluate future opportunities in hedge fund investment in Japan by looking at the recent history in hedge fund investments by major Japanese institutional investors.

  • Some Japanese major banks and trading companies started hedge fund investments around 1996 and they could be considered as the first generation hedge fund investors in Japan. Although other major institutional investors, such as life insurance companies, had started their studies on hedge fund investments from early 1998, shocking news about LTCM and the collapse of some fixed income arbitragers forced them to suspend or give up such new investments.

  • Not many institutional investors started on their hedge fund investments during 1999 due to the superb performance of Nikkei since the beginning of 1999. Furthermore their fears as a result of the 1998 shock had not been fully alleviated.

  • The big crush on IT shares in early 2000 in Europe, USA and then in Japan, definitely offered an opportunity to Japanese institutional investors, including Japanese Pension Funds, to introduce hedge funds into their portfolios. They interviewed managers, consultants and prime-brokers from mid to late 2000, but most of them could only start investing in hedge funds after April 2001 - the first month of the new fiscal year.

  • As required in their due diligence process, most institutional investors required a minimum of 3-year track records, which would have included the strain of 1998. The investors could not help but show major concerns over such big drawdowns. Consequently most of them felt quite comfortable to start with market neutral based or arbitrage based strategies which had very little volatility in performance numbers, and they preferred similar strategies for constructing or investing in funds of funds. Some of them avoided directional trading, such as global macro, managed futures, or higher volatility strategy, such as emerging markets.

  • After going through all the marketing materials and prospectuses of managers, it did not take major institutional investors long to get attracted to the good performance numbers generated in 1999. Thanks to these numbers, it was quite natural to expect 15%-20% annual returns for aggressive strategies, or 8%-12% for conservative ones from the very beginning of their investments.

  • Simultaneously hedge fund performance slackened due to lower interest rates and poor performance in equity markets in Europe and the US. But Japanese institutional investors who had just participated in hedge fund investments in 2000 or 2001 as a new comer were annoyed not by the flat performance but by a big gap between their high expectations and the actual figures reported by the managers.

  • Things got from bad to worse in 2002. FoF performances in 2002 were generally flat in US$ terms. The final figures in Japanese Yen after considering currency hedging cost was negative for some FoFs. Once again, these figures disappointed the institutional investors.

The following is a list for CSFB-Tremont Hedge Fund Index, S&P500 and Nikkei 225 from 1997 through 2002.

1997 1998 1999 2000 2001 2002
S&P500 31.01% 26.67% 19.53% -10.14% -13.04% -23.37%
Nikkei225 -21.19% -9.29% 36.79% -27.19% -23.52% -18.63%
CSFB-Tremont Hedge Fund Index Convertible Arb. 14.48% -4.41% 16.04% 25.64% 14.58% 4.05%
Eqty-Mkt Neutral 14.83% 13.31% 15.33% 14.99% 9.31% 7.42%
Fixed Income Arb 9.34% -8.16% 12.11% 6.29% 8.04% 5.75%
Evnt Driv-Distrsd 20.73% -1.68% 22.18% 1.95% 20.01% -0.69%
Evnt Driv-Multi 20.53% -8.98% 23.00% 11.84% 6.79% 1.22%
Evnt Driv-Risk Arb. 9.84% 5.58% 13.23% 14.69% 5.68% -3.46%
Eqty-Long/Short 21.46% 17.18% 47.23% 2.08% -3.65% -1.60%
Emerging Mkt 26.59% -37.66% 44.82% -5.52% 5.84% 7.36%
Global Macro 37.11% -3.64% 5.81% 11.67% 18.38% 14.66%
Managed Futures 3.12% 20.64% -4.69% 4.24% 1.90% 18.33%

  • Having experienced such unfavourable situations, interest in hedge fund investments in Japan seemed to taper off in early 2003. Although some argued that the overall hedge fund performance is still better than the Nikkei's, the problem was largely the big gap between their high expected returns and the actual numbers.

  • Japanese banks and life insurance companies have had big exposures to Japanese equities due to cross-holdings or pure investments. The more Japanese equities continued to fall, the less risk tolerant they were on their portfolios. Consequently some of them were forced to liquidate the so-called risky or riskier assets, such as hedge funds, in their portfolios. They had taken up hedge fund investments because of the ultra low interest rate and poor Nikkei performance in Japan. Then they were forced to redeem or suspend such hedge fund investments, which has been performing better than the Nikkei, because they were less risk tolerant and the hedge fund performance did not meet their expectations during the last 12-24 months.

  • Japanese institutional investors are often very risk cautious, and therefore they try to avoid investing in high volatility strategies, such as emerging market, global macro and managed futures. But these strategies, such as managed futures, sometimes show exceptional performance, and this would get the Japanese investors interested all of a sudden. If they have a quick decision-making process, it could work. But the reality is Japanese institutional investors generally engage in a time-consuming decision-making process. The problem they freqently face here is they may bump into a next drawdown right after they have obtained an approval and started an investment.

  • For Japanese institutional investors with a long-term investment horizon, it should be a good idea to cover various strategies rather than concentrating on the so-called lower risk strategies. Diversification should be employed not only for risk control purposes, but to prepare for all weather conditions for the sake of profit taking.

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