HONG KONG/TOKYO (Reuters) - Hedge funds are turning attention to Japan once again and are set to attract more capital on expectations a pick-up in corporate activities there like M&A and share buy-backs would yield strong returns.
The resurgent interest in Japan could mark a turn in the fortunes of the country's hedge funds industry, which has seen a sharp drop in assets and the number of funds since 2006 as the market peaked.
Hedge funds are betting the current environment is ideal for strategies such as event-driven and long/short, given that many companies are trading at low valuations and funding is cheap -- conditions ideal for M&As.
A stronger yen has prompted domestic firms to buy new production plants abroad and go in for deals. In a symbolic move, Japan's two major steel makers, Nippon Steel Corp (5401.T) and Sumitomo Metal Industries 5405.T have announced merger plans..
Other factors favouring a relook at Japan are the recent shift in capital flows in favour of developed markets, strong corporate profitability -- which has left companies with about a record $2.5 trillion in cash -- a rebound in exports driven by robust demand in fast-growing Asia and hope that the economy is heading towards a moderate recovery.
A vast liquid market and return of flows into Japanese stock mutual funds are also seen as positive.
"The feedback from our Japanese prime brokerage client base as to the opportunity set and expected returns for 2011 has been more positive than previous years," said Marlin Naidoo, hedge fund capital group head in Asia-Pac for Deutsche Bank (DBKGn.DE).
"Additionally we are also seeing pan-Asian managers materially increasing their exposure to the Japanese market."
While large inflows are not coming yet, money will start pouring in the next two to three months as investors were conducting final due diligence, several prime brokers said.
Many hedge funds have given up on Japan, with collective assets under strategy plunging more than 50 percent from 2006 to about $20 billion now, data from fund tracker AsiaHedge shows.
Their number has dropped by about a fourth to nearly 200 during the period, according to data from Eurekahedge.
Still, there are signs of gradual improvement and many of those who have survived are increasing assets. Eurekahedge sees assets of hedge funds it tracks rising by two-thirds in 2011.
Hedge funds such as Instinct Capital and Symphony Financial Partners earned 33 percent and 20 percent, respectively, in 2010 when the benchmark Nikkei index .N225 was down about 3 percent, indicating it was possible to make big returns in Japan.
In the latest vote of confidence, Tiger Management, founded by hedge fund industry pioneer Julian Robertson, last month seeded Hong Kong-based Nezu Asia with $50 million, part of which went to Japan focused equity strategy Nezu Kuma Fund.
Funds such as Instinct Capital, GCI Japan Hybrids and Martin Currie ARF-Japan increased assets multiple times last year, while the Japanese strategy saw launches such as Simplex J Flag Fund and FuNNeX KPI, data from Thomson Reuters Lipper shows.
"I think that contraction has stopped and if anything we are seeing a gradual turnaround," said Futoshi Ago, Japan prime brokerage arm head at Bank of America Merrill Lynch. "We have seen launches and we will be seeing more launches in the near future."
The increasing interest, however, may not add more fuel to the rally that has taken the Nikkei to near a nine-and-a-half-month highs.
Japanese shares have shown a tendency to sprint and then give up. In the last twelve years, they have outperformed those in the rest of the world in eight periods and each have lasted an average six months, according to money manager T. Rowe Price.
Masaru Hamasaki, senior strategist at Toyota Asset Management, said the current rally should last another six months as investors stick to safe assets.
Optimists cite 54 percent of Japanese firms trading below book value and the MSCI Japan Index at a 22 percent discount to 10-year median forward price-to-earnings ratio as reasons to invest.
But Japan is still fighting high unemployment, long-term structural debt, overregulation, and political risk and hedge funds' primary bet is not one of growth or cheap valuations.
"Alerting investors to the fact that Japanese companies are trading at a discount to book encourages a polite yawn. You have to have a plan to close the gap," David Baran, founder of Japan-focused hedge fund Symphony Financial Partners, said.
Baran, whose event-driven hedge fund has acquired, reorganised and sold a listed company in Japan and made money, said he saw promising new potential opportunities in the market currently, more than seen in recent memory.
"Any positive catalyst there could set that market off, the most likely being if the yen were to weaken meaningfully or global consumption were to continue to strengthen," said Kirby Daley, senior strategist of Newedge's prime brokerage unit.
"It could be like lighting a match on timber. It might burn quickly but there would be money to be made there," Daley said.
Editing by Muralikumar Anantharaman