Photographer: Kiyoshi Ota/Bloomberg

How Japanese Hedge Funds Are Aiming Small for Big Returns

  • Simplex fund returns 29% in first half by targeting small caps
  • Japan-focused funds are world’s third-best performers so far

Aiming small is helping some Japanese hedge funds deliver outsize returns.

Simplex Asset Management Co.’s Japan Lower Market Strategy fund, which scours the nation’s three regional exchanges for small-cap stocks, returned 29 percent in the first six months of the year. Eschewing big-name companies also helped Sparx Group Co.’s Value Impact Fund gain 19 percent in the first half, while Strategic Capital Inc.’s activist fund added 15 percent, according to the firms.

The gains stand out even against the backdrop of rising returns for Japan hedge funds, which were buoyed by a rebound in the nation’s stocks to rank as this year’s third-best performers behind Pan-Asian and Latin America-focused strategies. The Eurekahedge Japan Hedge Fund Index gained 4.9 percent in the first six months, rebounding from its worst performance in five years in 2016.

Gauges tracking small-company shares have trounced the broader Topix Index this year as investors have flocked to companies that are less vulnerable to a fluctuating yen than large global corporations. Smaller companies have also produced faster earnings growth than bigger counterparts, adding to their appeal.

Japanese small-cap stocks have outperformed because they are “rather immune to macro or geopolitical risks," said Motoyuki Sato, a Tokyo-based strategist at Man Group Japan Ltd., the world’s biggest publicly traded hedge-fund firm. “Global investors are diversifying their portfolio risks to include small to medium stocks.”

The Jasdaq Index of smaller shares, which has advanced 22 percent this year, reached an all-time high last month and the Topix’s Second Section Index of mostly medium-sized stocks surged to record levels Tuesday to bring its gain this year to 23 percent. The Mothers Index that tracks startup stocks has increased 19 percent, compared with the Topix’s 7.7 percent gain.

The Mothers index has produced median earnings per share growth of 28 percent over the past three years, compared with the Topix’s 10 percent increase. Even so, analyst coverage remains low for small-cap companies, with less than one-fifth of Mothers’ stocks followed by analysts, compared with more than half for Topix.

In addition, a government push for Japanese companies to focus on shareholder returns is starting to pay off. Smaller companies tend to enjoy bigger gains on positive news than large companies, said Simplex Asset Management Chief Executive Officer Hiromasa Mizushima.

Better Returns

Japan’s regional exchanges and other indexes contain 1,653 companies, with a combined market value of less than 4 percent of the Topix index, according to Simplex. That presents the opportunity to find stocks overlooked by investors and analysts, said Mizushima.

“It would be hard for companies like Toyota to double their growth,” he said. “Our focus is whether smaller companies have the ability to boost profit say by tenfold.”

Big Gainers

One strong performer in Simplex’s portfolio is Jasdaq-listed Optoelectronics Co. The maker of bar-code readers has gained 56 percent this year and forecasts profit will gain 18 percent in the fiscal year ending Nov. 30.

The Lower Market Strategy fund has about 10 billion yen ($91 million) in assets, and Mizushima is seeking to increase that to 30 billion yen by the end of the year before closing it to new investors.

Sparx’s Japan Value Impact Fund, which targets under-performing companies and pushes for change to boost share prices, has benefited from its campaign to get Teikoku Sen-I Co. to reduce its shareholding in Hulic Co., which accounts for about a third of its assets. Teikoku Sen-I shares have risen 26 percent since Sparx went public with its campaign.

Strategic Capital’s holdings include pump-maker Teikoku Electric Manufacturing Co., which has gained 15 percent this year, and Nittoc Construction Co., which is up 30 percent. The activist firm has urged Teikoku to return excess cash to shareholders, and is betting Nittoc will increase shareholder returns because of its family connection to Finance Minister Taro Aso, who has led the government’s push for improved corporate governance and shareholder returns.

— With assistance by Yuko Takeo, Tom Redmond, and Nao Sano

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