Constructing A Pure Alpha Japan Portfolio: Diversification And Systematic Bias

|
Includes: EWJ, FXY, MTU, SMFG
by: David Deuchar

Summary

Long-term market risk and short-term volatility have driven Japanese investors into value/small-cap equities, cash, and other high-liquidity "safe havens".

When the storm has passed, investors will be left caught with their pants down, unaware of their style bias and lack of diversification.

Japanese investors caught in the value trap of financials are already feeling the pain.

Large-cap equity and investment-grade corporate bonds are being ignored despite strong earnings growth.

This is Part 1 of a series about constructing a pure alpha Japan-oriented portfolio. The series will touch on topics such as diversification, tactical vs. passive strategy, systematic risks, generating alpha on the short side, etc. We will also discuss current market trends, identify outperforming assets past and present, and explore how best to capitalize on these trades. I would also like to invite everyone to participate in the comments below, as I would like to include discussion as part of future articles.

Introduction

Between the failure of Bill Ackman's bet on Valeant Pharmaceuticals (NYSE:VRX) or the drama and concern surrounding Ray Dalio's Bridgewater Associates, the performance of hedge funds and other similar asset management funds in the U.S. has come under significant public scrutiny as of late. Even Bridgewater's famed Pure Alpha fund has suffered in this latest bout of equity volatility and asset dislocations:

"...as of January 31, Pure Alpha fund was up a tidy 0.8%. Hardly bad in the current market environment. It is what happened since then that is disturbing, because according to sources, the fund lost over 4% in the subsequent week ending February 5 when it was suddenly down 3.8% YTD, and was down more than 5% in the next week, pushing its total MTD loss to -10.0% as of February 12, and -9.3% YTD. This means that in just 2 weeks, the fund which prides its lack of volatility and its Sharpe ratio, suffered a multiple-sigma volatility event, one which has seen it lose over 10%."

Investors naturally seek to develop patterns and bias towards certain strategies, however, with so many extraneous circumstances weighing on markets this year (e.g. monetary policy divergence, financial repression, etc.), such behavior will not be rewarded as it once was. The reliance on so-called "smart money" has already punished investors severely, with hedge fund assets falling back under $3 trillion since it first hit that milestone back in 2014. And with both tactical and passive strategies failing to outperform their benchmarks, I think it is necessary to step back and re-assess sound investment principles and how to apply them to any portfolio. As my area of expertise lies in the Land of the Rising Sun, we shall explore the process of constructing a 'pure alpha' Japan portfolio.

Defining Alpha

Alpha (α) is defined as the risk-adjusted returns that an investment provides in excess of a certain benchmark or index. While it can be used as a gauge of performance, it can also be used to gauge volatility and risk, in conjunction with beta (β) and the capital asset pricing model (CAPM). Putting aside the technical definition, alpha can be thought of as a sort of justification for investing with a particular manager or a particular strategy; if your fund is not attaining alpha, then why invest in it when you could simply invest in a benchmark index fund? It is this concept of alpha and post-modern portfolio theory (PMPT) as a whole that has driven so many investors into "smart money" funds with high levels of diversification and risk management expertise over the past few decades.

Seeking Alpha in Japan

Diversification

While the global financial media and Japan-based financial media in particular focus on the largest and most successful or most active fund managers, often overlooked is the performance of the myriad of Japan-oriented hedge funds, mutual funds, and unit investment trusts - their underperformance has been even more unfortunate as of late. Looking through the hundreds of these funds and their holdings or strategies, a common theme crops up that is seemingly obvious but extremely important nonetheless. That is a lack of diversification, not only across asset classes but within their respective categories as well.

Asset Class YTD Average Fund Return* YTD Benchmark** Performance +/- Benchmark Performance
Japan Bonds 14.19% 16.42% -2.23
Japan Small-Cap/Mid-Cap Equity 3.89% -0.86% 4.75
Japan Large-Cap Equity -2.75% -5.96% 3.21
Click to enlarge

*Averages/ratios calculated using data compiled from Morningstar; includes retail and institutional funds. Fund return based upon Nav to Nav or Bid to Bid income reinvested basis.

**Indices/Benchmarks:

  • MSCI Japan Small Cap NR JPY
  • MSCI Japan NR JPY
  • Citi Japanese GBI JPY

As you can see, the average performance of Japan-oriented funds, both retail and institutional, has been not that much better than the benchmarks as of late, with the exception of small-cap and value long funds. Year-to-date, the average fund has probably outperformed the benchmark by about 200 basis points; on a three-year annualized basis, that spread shrinks to about 35 basis points. Of course, this is including the performance of JGB (government bond) funds, which have been extremely volatile, and non-currency-hedged funds, but even excluding these funds, the performance spread is not all that improved. Keep in mind as well that the risk-free rate in Japan is negative, so managers do not have that high of a bar to surpass.

Asset Class 3-yr Annualized Average Fund Return 3-yr Annualized Benchmark Performance +/- Benchmark Performance Sharpe Ratio
Japan Bonds -1.58% -0.44% -1.14 -0.12
Japan Small-Cap/Mid-Cap Equity 10.95% 10.02% 0.93 0.81
Japan Large-Cap Equity 6.51% 5.81% 0.70 0.52
Click to enlarge

Even with the strong performance of small-cap and value long funds, the average fund cannot manage a Sharpe ratio above 1. So, why all this underperformance? We can identify three distinct phenomena.

(1) For one, the nature of the global economic debt cycle (long-term) we are currently in is one that rewards taking on less risk rather than more in spite of the fact that 'risk-free' assets in some countries have turned negative. And even with central banks pumping liquidity into financial assets with unprecedented measures, the days of easy long-term gains in equity are over. This is nowhere more true than in Japan. Unfortunately for investors, this is systematic or market risk that is undiversifiable and is simply the nature of the game everywhere at the moment.

(2) Second, the interconnectedness and volatility of markets at present demands at least an investment approach closely aligned with the principles of post-modern portfolio theory not tactical asset allocation. Unless you are an expert in a particular asset class, have insider information, or have an extremely small investment time-horizon, it simply makes no logical sense not to diversify across assets. An alpha-seeking strategy is important but will still fail to outperform if true diversification across asset classes is not present.

(3) Third, as mentioned above, as the BoJ has been forcibly injecting liquidity into the economy and engaging in financial repression via quantitative easing, interest rate policy, currency debasing, etc., it has encouraged investors to pursue investments in riskier assets such as high-yield bonds and small-caps. This distortion of liquidity is reflected in the distortion of domestic capital flows and equity valuations in Japan and hence the performance of non-diversified portfolios. Take, for example, the Polar Capital Japan Fund, which was highly concentrated in financials and consumer cyclical equities: it has underperformed its benchmark by as much as 1200 basis points year-to-date. As I detailed in my article Outlook For The Japanese Financial Sector - Window Of Opportunity Or Total Value Trap? last year, Japanese financials like Mitsubishi UFJ (NYSE:MTU) and Sumitomo Mitsui (NYSE:SMFG) seemed undervalued on the surface but specifically because of the financial repression necessary in Japan's credit situation, the financials would suffer, which they have greatly.

These three distinct phenomena (long-term market risk, short-term volatility, and short-term liquidity distortion/financial repression) are responsible for the flows into value and small-cap equity over the past few years - this development is not unique to Japan nor has it not happened many times before. This over-exposure to be long value/small-cap stocks is a critical concept to be aware of when investing in any Japan-oriented fund at the moment.

Systematic Bias (Style Management)

Related to diversification, the concept of systematic bias or style management is finally starting to gain more traction in the investment sphere; unfortunately, most discussion is related to the typical "growth vs. value" argument or temporary tactical moves but generally both retail investors and their institutional counterparts are becoming more aware of bias in their portfolio management that could lead to potential losses. This is important because especially non-diversified portfolios can suffer from considerable systematic bias towards certain asset classes or strategies and are slow to adapt in the presence of volatile circumstances.

Below I've listed just a sampling of the various bias that a portfolio can have:

  Strategy Style Liquidity Asset Class Directional Capitalization
Bias Long, short, long/short, neutral Growth, value, blend More-liquid, less-liquid Equity, currency, commodity Momentum, event-driven, macro, M/A Small, medium, large
Click to enlarge

For example, the highly long bias towards small-cap and value equities in Japan that has only recently rewarded investors with high rates of risk-adjusted return is only a temporary phenomenon. In a paper by Marc Goodman, Kenneth Shewer, and Richard Horwitz of Kenmar Global Investment Management written back in 2002, these 'fund of fund' managers examined the same phenomenon in the U.S. dot-com bubble at the start of the millennium. Through April 2000 - September 2002, small-cap/value stocks outperformed the S&P500 by 93%, in a self-sustaining feedback loop.

Eventually, reality reared its ugly head as the economy normalized, value earnings slowed, P/E ratios returned to normal levels, and investors returned to other assets. This prescient quote from the Kenmar managers says it all:

"Stacking funds with good historical performance does not create a risk-efficient portfolio of funds, and can lead to a 'style trap'. For example, several of the best performing long/short equity managers over the past few years (40%-plus annually) have, not surprisingly, very strong value biases. An investor who drives only by 'looking in the rear view mirror' could get trapped into simply stacking such funds and would probably suffer severe losses over the next couple of years."

Conclusion

In the short-term, returns from diversification may seem lackluster, and tactical asset allocation or market timing may seem to be a more profitable strategy. However, for long-term, sustainable wealth management, the returns from true diversification match those of equities, with one-third of the risk. Avoiding style bias and maximizing risk parity, you can improve your return to risk ratio, thereby increasing the amount of leverage your portfolio can manage as well.

This latest pouring into small-cap and value in Japan is just another historical example to add to the books. Who knows when the cycle will reverse, but we do know this: large-cap equity and investment-grade credit is being largely ignored in Japan despite very strong earnings growth the past few years. For conceptual reasons, I tend to favor large-caps in Japan, however, from a fundamental level, the large-cap sphere appears to be highly undervalued - an optimal opportunity for new investors to find strong companies to add to their portfolios and generate alpha.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.