Tuesday, April 17, 2007

Thinner than Gruel

Attention all Japanese Equity Fund Managers: If you are outperforming the index, then you are incredibly lucky; have a narrow, cap-weighted portfolio; or are incredibly lucky AND have a cap-weighted narrow portfolio. There is almost nothing credible in between. This is highlighted by the implausibly low percentage (less than 25% as of 2nd week of April) of stocks outperforming either the Nikkei or TOPIX First Section on a rolling 12 month basis.

While good news for disciples of the MSCI Japan Index, and even better news for those prescient enough to make the TOPIX Large 70 their index of choice, this is decidedly BAD news for broader indexers, slaves to more inclusive benchmarks, as well as those with purely small and mid-cap mandates. Now, my data is reasonably good and extensive, going back to the early 1980s, and such widespread under-performance is historically unprecedented. Unprecedented BOTH in absolute percentage terms (less 25%) and for the duration of time (> 2-1/4 years) that the percentage has been deteriorating enroute to its current depths.

Now this may be as it should. Many of Japan's largest enterprises happen also have global, rather than purely domestic, markets, and benefit from the labour supply shocks boosting transnational enterprise profitability. Sales growth on one side coupled with cost relief on the other is, it must be said, virtuous for investors, in comparison to the obverse.

But before ye lucky ones start patting each other on the backs and spending one's accrued, but uncrystallized performance fees, I must be point out that this Golden Era Of The Large Cap, of the Most Deserved Enterprises In Japan, also happens to coincide with the period in which East Asian Surplus Capital - both Japanese and Chinese and others, has been flowing uphill to ostensibly finance the Americaland in its rather errrr unsustainable consumptive binge. And as a "Cassandra", I will give fair warning that the last time "The Deserving Few" shone so brightly, so too did they violently and terrorizingly under-perform for not less than a full Calendar year.

Despite however despicable some might find the YEN, (and make no mistake, there are no shortage of reasons) the Yen WILL become untethered from USD in spectacular fashion, and in the process crucify those with implied short yen bet buried within their "Market Cap Bet". I cannot say "when", but everyone has been warned and the prescient should - at the very least - take the opportunity to hedge hedge hedge.


Anonymous said...

"...then you are incredibly lucky; have a narrow, cap-weighted portfolio, or ..."

i know for a fact this is not true. i know a very diversified (ca. 60 names) portfolio immunized for size and and sector imbalances vs the index and it doing what you write is impossible. and this is fully including the slippage/transaction costs of monthly rebalancing.

generally i have really enjoyed reading your blog, however, more and more it is sounding like sour grapes.

yes its hard to make money now. and yes the state of the market (in particular small caps vs large caps) just doesnt make sense. ive lost money over the last month on that one too. but this context is reality too. just as much as any other has been or the next will be. best to learn to make money here too.

"Cassandra" said...

Thanks anon, for the comment, though sadly I've seemingly [unintentionally] offended your sensibility. I would point out that I don't believe I said "impossible", and even then only implied "improbable" which means perhaps only a few out of 20 would be so fortunate. Those that have been are likely to have a portfolio (and 60 remains reasonably "narrow" IMHO) heavily skewed in favor of the few
factor(s)-drivers outside of m-cap that have found favor amongst the foreigners dictating the prevailing style.

Let me clarify, first, that my observations are patently NOT sour grapes. If they are anything discernible other than objective observation of real phenomena followed by prognostication (which is my intention), it is commiseration with what (according to observed performance numbers of Japanese long v. short managers) must be hard times for all but the most fortunate and prescient.

Market-wise, I've nothing to be sour about. Following a cracker 2006, I will admit that I've found CY07 meagre in absolute terms, + 1.7% to-date net of costs but gross of fees, unlevered. But I am more than satisfied with this for a zero-beta neutral (to cap , industry etc., domestic/foreign exposure etc.) long v. short portfolio in the current environment.

I will (proudly) say that I was pounding the table for both large caps, and export-oriented tilts beginning Q1 2005 to those who make their living from assuming such exposures, expressing them on the margins in my own cauldron. And while this was perhaps 12 months early, it was certainly in the region of the local minima for large cap relative performance following the "Daiko Henjo" dislocation. And looking backwards, the relative outperformance of Large over the past two years DOES make wonderful sense, given the USD/Yen, and extreme undervaluation of the trade-weighted YEN, continued funding of US imbalances by most comers, and the superior revision ratio and growth rates of say the parochial TOPIX 70 or broader MSCI Japan vs. the broader TOPIX, the 2nd section, or heaven forbid the JASDAQ or MOTHRS.

That said, the purpose of the post was NOT to moan, but to highlight the fat-tail risk of riding this market-cap, exporter train too long, in the face of deteriorating conditions in the US, for it is the same fat-tail risk that exists in USD/YEN, which I reckon may soon come untethered.