Arif Imam was with Morgan Stanley (New York and Tokyo) from 1997 to 2006, most recently as managing director, global head of distribution and marketing (Japan). He was responsible for Japan equity distribution, corporate marketing, product development and alpha strategies teams. Arif started out as a systems engineer at Eckert Research Int’l (Tokyo) before joining Deloitte & Touche, CS First Boston and Smith Barney.
Arif is assisted by two other partners, Alexandre de Bethmann, CFA (CIO and portfolio manager) and Douglas Butcher (head trader and risk manager).
- Could you briefly tell us your rationale behind launching a Japan-focused large-cap fund as your first fund? What is it about Japanese large caps, as compared to small and mid caps that draws you to investing in them? How would you compare the return generating potential of Japanese large-cap stocks to small- and mid-cap stocks?
Having worked as Morgan Stanley’s head of global distribution, it came to my attention over the last three years that hardly anyone was focused on large-cap stocks in the L/S space in Japan. Most common hedge funds cropping up were small/mid cap, event driven, multi strategy or quant-related funds; almost no one was focused on large caps specifically.
All the three partners’ careers have mainly been focused on large-cap stocks, and over this combined 60 years of experience we produced plenty of alpha for our respective employers and clients from this space. We are determined to show investors in Japan that the large-cap space is the main and potentially only arena in which funds can run a true hedged product to keep risks at bay and also deliver significant positive alpha. As for returns, just take a look at the yearly performance of the top 10 stocks in the Topix 30 Index to see the significant amount of alpha that is being generated by those large-cap stocks. You will not get that performance by merely indexing yourself to the Topix 30 index. Further, if you look at the top- and bottom-10 performing stocks in this index every year, for the past several years, you will also see that there is solid rotation amongst them which means there are plenty of ideas and opportunities being presented by the market. It is this return generating potential of large-cap stocks that excites us most and is the focus of our fund.
- As per recent Eurekahedge research, Japan-focused funds have seen quite a bit of outflows in the recent months. How do you propose to attract investors to your fund? What is the USP of the Japan Large Cap L/S Fund?
These outflows are primarily coming from small/mid-cap or all-cap L/S funds. The poor performance of these hedge funds over the last two years stems mainly from the inability to be truly hedged and the sudden lack of liquidity in the small/mid-cap space. Back in early 2005, while still at Morgan Stanley, we were fearful of what would happen in the raging small/mid-cap space if all investors tried to sell at the same time and the underlying liquidity concerns came to fore. To help our clients, we put forth Morgan Stanley resources to try and develop a synthetic future on the small/mid-cap indices in order to provide hedge funds in this space the opportunity to appropriately hedge themselves with an instrument of like nature. By mid 2005 we found it an impossible task to accomplish and it was at this point that we became fearful of the potential coming outcome. Investors and managers were oblivious due to the magnificent returns they were enjoying, and as with most hedge fund disasters, it was liquidity that dried up on them to cause a precipitous drop in prices. The small/mid-cap space has proven time and again that it is only an appropriate venue for long-only biases, not a hedged bias as it cannot be hedged correctly or appropriately. One needs only to take a look at a long-term chart of any small-cap index in Japan to deduce that it is a very volatile area of investing in Japan, not one for the faint of heart; liquidity in the long side and especially the short side is fleeting, and hence not a venue suited for running an effective hedged strategy.
Having now seen several instances of hedge fund blow-ups, in and outside of Japan (starting from LTCM, to Amaranth, Japan’s small/mid-cap space and today’s subprime-related mishaps at Bear Stearns etc), it should dawn on investors that the common golden thread between all of these funds’ problems has been liquidity. In the large-cap equity space you get abundant liquidity in the long, short and derivative arenas of equity investing. With this liquidity comes the ability to run efficient strategies to reduce investors’ risks and enhance their returns. As more investors acknowledge this basic simple fact then you will see more flows going to funds that are focused in investment spaces where a true hedged product can be run precisely and effectively. Money does not want to exit from Japan, it just wants to be held in trust with funds that today either don’t have capacity or don’t exist, and this creates a large opportunity for us.
- What sort of a selection/filtration process does a stock go through before you invest in it? What kind of research do you put into selecting stocks, and sectors at large?
Working with the fund’s investment universe of the largest 250 stocks in Japan, our investment process involves four distinct areas:
- Top-down themes;
- Top-down quantitative internal screens;
- Bottom-up analysis of a company’s operating profit margin trajectory and business cycle stages; and
- Bottom-up analysis of the margin of safety versus expected return of an investment.
Working down from our overall universe of 250 stocks, we derive our Research Focus Universe, Validated Investment Universe and Final Portfolio from the rigorous analysis of the intersection of these four distinct areas.
We update our top-down themes daily and review them weekly, and stocks emanating from this are placed into our Research Focus Universe. Our quantitative internal screen is run monthly and monitored daily. It ranks our entire universe by a multi-variable factor model that we developed in-house, and generates a list of most to least attractive stock ideas for both the long and short side. The screen serves as an internal reference index as we do track the performance of the stocks it provides us on a monthly basis, without any subjective bias. All quant screen-generated long and short stocks are included into our Research Focus Universe.
The next step is to run each stock in the Research Focus Universe through our 360-degree fundamental research process and our in-house developed DCF model to give us each stock’s upside potential and downside risk (our margin of safety analysis). After exhaustive fundamental research is finished, the Research Focus Universe is filtered down to a Validated Investment Universe. To get to our Final Portfolio, our portfolio construction process runs the stocks in our Validated Investment Universe through multiple risk parameters (ie sector weights and stock price correlation) to ensure that we have a balanced and effectively hedged portfolio.
- How concentrated is your fund’s portfolio? And to what extent do you plan on diversifying it – in terms of number of stocks as well as across sectors?
We typically run about 15 to 17 stocks on the long side, all equally weighted, hence around 6-7% size per position. The short side does not have equally weighted positions as it depends on what type of risk we are attempting to hedge out and alpha generating opportunities we see there. Our investment strategy is clearly focused on creating pure alpha for our investors, no quasi indexing, no tails, etc. To reiterate, with this strategy also comes high capacity and scalability of our product. Our investment process does not change regardless of our AUM size (ie it’s the same process whether we have US$10 million or US$1 billion). We use GICS Industry Groups as our sector classifications and have a limit of not being more than 20% in any one given sector. We also run our potential portfolio through a price correlation analysis in order to make sure that we are not running a directional portfolio or one gigantic pair trade, and this helps us ensure that our hedging will be effective when instituted.
- With the extent of volatility seen across equities of late, it’s rather important for funds to have some sort of risk management tools in place in order to minimise risks/losses to their investments. What sort of risk management tools and practices have you adopted to safeguard your portfolio?
We believe that risk management in the investment world today is of paramount importance. Both my partner Douglas Butcher and I have experience in the risk management area, both at the franchise level as well as the portfolio trading level. We both will perform the function of risk management jointly because, at its basic level, equity investment risk can be dissected into two forms: investment idea/content risk and trading risk. All investment ideas generated will be reviewed for content and trading risk with the help of both in-house and externally developed tools that we will be utilising. We will be vigil in recognising and managing the fund’s volatility levels, correlations, sector exposures, hedge ratios, and we do employ a hard stop-loss of 20% on all of our investments. With this combined risk management effort, we will pursue the highest standards in our effort to protect the assets of the fund and the shareholders.
- Would you be using leverage for your portfolio? If so, to what extent? What would the usual ratio of long to short positions, in your portfolio, be?
Any time you run a short book you are taking on leverage for the fund but we do intend to keep it within reason. Due to the process in which we pick stocks for our portfolio, we see no reason to ever run a net short book. Our typical net exposure will run at 60-70%. Furthermore, because we are in the large-cap space, we can expeditiously and cost effectively tilt our portfolio to a more defensive or offensive stance on both the long and short side with ease, depending on our stance towards the market.
- You have mentioned Alpha Capture as part of your investment strategy. Having said that, do you have any maximum risk (in terms of a ceiling Sharpe ratio) or minimum expected (or targeted) return in mind, for your funds investments?
Risk-adjusted returns are a big focus point for us as we try to get to the holy grail in investing – low risk with high returns. Our targeted Sharpe ratio is between 1.0 and 1.5, we don’t think we can get to 2.0 due to our investment process. The floor of 1.0 is carefully monitored and we will try to protect that the best we can. Our alpha capture involves the use of very simple options strategies, which again can only be done in the large-cap domain due to the available liquidity in large-cap stock options. Japan’s options market is still in its infancy stages and we see this arena growing over the upcoming years. Having said that, some very simple forms of options strategies can be undertaken today that we intend to employ. It always amazed us as to why more investors don’t employ overwriting on their existing positions. If your portfolio stock is 10% away from your target price and you know you are going to sell it there, then why would you not sell a call option on your position to take in the premium? Worst case is you have the stock called away, but you were going to sell it anyways, and you’ve already taken in the option premium to further close the gap on your target price.
Another way to capture alpha is to do a cash extraction trade in which you sell all or a portion of your existing stock position that has generated significant alpha for you, hence locking in your alpha, and replace that position with an option if you feel there is further upside to the stock. This is plain vanilla usage of options, nothing exotic, yet it is a very under-utilised strategy in Japan.
- Given your expected risks and returns for your portfolio, what sort of an investor-profile is this fund ideally suited for?
We would only sell to QIBs like certain HNW investors and institutions – they are best suited for the risks associated with investing in a hedge fund.
- Going forward, to what extent do you see Japanese markets being influenced (and impacted) by global factors (for instance, the recent sell-off in equities, triggered by problems in the US subprime mortgage markets)? What factors, according to you, would contribute the most to equities in Japan remaining healthy (global, macro-economic, political, etc)?
- And lastly, could you also briefly give us your near-term and medium-term outlook for Japanese markets?
Combined answer for 9 and 10:
In today’s world, all markets are influenced by global factors as the effects of globalisation are felt across the board. Japan though, having been a long standing export-oriented manufacturing economy, has had global factors playing a critical role in evaluating its economic outlook for a long time now. Any investment manager looking at Sony, Samsung or Apple in their respective markets better know what the other competitors are up to, otherwise they are not doing the level of analysis required today on any of those stocks as a standalone investment. The astute investment manager became globalised well before the actual companies they were analysing did. If everyone understands that the world’s economies are becoming more and more interlaced with each other, then it should be an easy deduction for most that a healthy global economy is at the forefront of helping along all global equity markets, including Japan. It’s been interesting to watch Japan’s evolution since their asset bubble burst in late 1989. As each of the core Japanese companies attempted to save themselves by cutting costs, moving factories offshore, getting closer to their end customers, etc, in many ways it epitomises how the world became so globalised in the first place.
Today, with the advent of free trade in Asia, Japan’s economy would be impacted greatly if free trade pacts were agreed upon between themselves and India and China. Japan continues to provide the world with the best-selling cars, TVs, cameras, steel, machinery, specialty chemicals, and now are doing it in the most cost-effective manner which in turn is generating an abundance of cash flow for their future endeavours. It could be said that the ultimate product be one where the hardware is constructed by Japan and the software within developed by Indian software engineers (Japanese have been terrible in software development for their consumer durable products, with the one big exception being the video game industry that they dominate worldwide).
In a global economic downturn, will Japan be affected, absolutely yes but so will every other market and perhaps the other ones in a much larger way. One big difference between Japan and the other markets is that Japan today remains one of the only places in the world that is not suffering from either an asset or credit bubble. Valuations also favour Japan and continue to show the largest positive spread between earnings yield (over 5% on our work) and risk-free rates (JGB yields at 2.0%). They might be supplying the world with cheap credit which in turn is fuelling a significantly leveraged credit and asset bubble in other parts of the globe, but they certainly have not been smitten by their own cheap credit at home. If the US goes down, international markets will follow, and Japan should find a floor quicker given the valuation support.
Shaka Captial Management LLC
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