In Japan, hedge funds are subject to the highest degree of regulation in Asia, but risk management remains an inscrutable practice. In America, implementation of Basel II is hardly witnessed. In Western Europe, it is not present at all.
Yet it is alive and kicking in Japan, and three of the megabanks command IRB status under the Basel II rules. That means the directors of those banks are supposed to understand the nuances of its risk implications. Assuming that they do understand their risk portfolios might be a case of 'Emperor’s New Clothes'. The knee-jerk reaction to Basel II caused a flight from hedge fund investment last year.
“I think the regional banks have started to migrate back to hedge funds,” says Shinichiro Shiraki, the CIO of Monex Alternative Investments, speaking at the Hedge Funds World conference in Tokyo.
Basel II is not likely to be limited just to the banks and in time will roll out to other institutions, including the Japanese life insurance industry.
Whilst high profile, Basel II is just one part of the risk management cocktail for Japanese hedge funds. It is a highly regulated environment in Tokyo, but remains one that puts most onus on the investor himself to conduct his own due diligence.
Moderating the Tokyo panel was Bear Stearns’ Stefan Nilsson. (And Bear Stearns knows a bit about hedge fund risk management.) He is also founder and president of the Tokyo Hedge Funds club.
“People here talk a lot about risk management, but often don't do an awful lot [about it],” said Nilsson. “They frequently have nothing more than in-house spreadsheets and that’s scary. Some might make great returns in spite of that, but that’s not skill, it's just pure luck.”
Japan remains an opaque space for hedge funds, made harder by the linguistic and cultural skills required to operate here. One who has done so is Ed Rogers, an ex-prime broker who set up his own shop in 2006 and is now the CEO and CIO of fund of funds advisory Rogers Investment Advisors.
“Sometimes the hedge fund’s 125-page offering memorandum does not correspond with their pitch book,” says Rogers. “So I hire a girl with an MBA who reads every single page of it and writes me a report. But managers can still ‘walk off the reservation’. So if I catch a hedge fund unexpectedly betting the ranch on say, a cut in Fed interest rates, then I’m redeeming.”
Daunting. So what do the managers themselves think of the risk parameters by which they elect to abide?
Lilik Takahashi set up Piala Capital Management in 2007, after working at Pequot Capital Management. “The best risk management tool I have is to figure out what I can lose in a one month value-at-risk,” he says. “I’d draw investor’s attention to managers who have suffered drawdowns and then are trying to recoup their losses. That is where you might see them taking on more risk.”
HSBC looks at approximately 1,000 hedge funds and reckons that half of the failures are due to operational issues rather than lousy performance. In Japan they assess that the key topics for risk management discussion today include liquidity, gates and leverage.
“I also think that a manager performing too well might be a flag for over-concentration and low risk controls,” says Frank Packard, head of HSBC’s north Asia Alternative Investment Group. “Another matter I like to think about is which service providers a Japanese hedge fund uses. If they’re using, say, Deutsche Bank as prime broker, you know that they’re getting a certain level of service, but if they’re dealing with someone that you’ve never heard of, then it might be a whole lot different.”
So, there are the risk tools available in Japan. Secondly, there are the zen-like levels of analytical intuition required to fathom it all. A third component are the new “OQ” hedge fund ratings from Moodys. A new product from the ratings agencies, a nice little earner for them no doubt, but tarnished by the fact that they currently give 90% of the funds they rate the highest mark possible.
“Relying on those OQ ratings could be a danger,” says Frank Packard. “These are very difficult questions surrounding hedge funds.”
The ratings agencies missed the Asian crisis in 1997. Then, oops, they missed the credit crunch too, with all those triple-A ratings they’d dished out to CDOs. So, it must be third-time lucky. The industrious ratings agencies surely couldn’t get hedge funds wrong, could they?