Hedge funds were the biggest sellers in the exodus from emerging market debt this summer, after expected Japanese investor flows into the asset class never materialised, according to EM-focused fund house Ashmore.

Having put highly leveraged short-term bets on EM debt, hedge funds were left high and dry when banks recalled financing after the US Federal Reserve hinted that it would start ‘tapering’ quantitative easing, says Jan Dehn, Ashmore’s co-head of research.

Global flows poured into EM debt in the first quarter, following strong performance in 2012. The money mostly came from large institutional investors, which arrived in droves, says Dehn. UK-based Ashmore’s AUM increased by 10% in the first quarter this year, he notes.

In his view, the key to the subsequent carnage lay in the Nikkei 225 Index rallying, and specifically, what US hedge funds thought this signalled.

A combination of quantitative easing in Japan, which started in November, and significant government spending from the start of 2013, led to huge gains in the Nikkei. Between mid-November and the end of March, it rose 43%.

As Japanese institutions moved out of safe-haven Japanese government bonds (JGBs), EM bond yields rose sharply. As such, hedge funds figured local pensions and insurers would shift from JGBs into EM debt.

“You had all of the Wall Street investment banks telling hedge funds to get in there before the Japanese money,” Dehn says.

But this great migration never happened, because Japanese investors were rotating out of bonds and into their domestic stock market.

“In April, we were actually seeing redemptions from our Japanese investors from EM debt,” says Dehn. “They were charging into the Nikkei index, which was the fastest money in the world at the time.” The Nikkei was up 15% in April and by May 20 had gained another 13%.

Japanese investors stayed clear of EM debt, argues Dehn, because it was starting to look overbought – the Emerging Markets Bond Index rose 4% in April.

In the absence of the expected surge of Japanese money, hedge funds suddenly found themselves in an asset class that looked increasingly expensive and risky,  following rapid first-quarter inflows, a big portion of which were highly leveraged.

Then came Fed chairman Ben Bernanke’s comments on May 21, when he gave the first indications that the Fed would ease off QE in the US.

The resultant spike in US Treasury yields to nearly 3% from 1.96% the day before the comments, sent the Nikkei into freefall. The index fell 17% in just over two weeks, sparking a rush by Japanese investors back into JGBs.

The thought of buying EM debt couldn’t have been further from their minds, Dehn says. “Suddenly the whole premise of that speculative trade – to front-run Japanese real money – had disappeared,” he adds.

The Fed’s comments ultimately triggered a sell-off in EM debt. Dehn notes that hedge funds were forced to sell into falling market because the Fed’s comments had scared the banks providing the leverage to finance the positions.

Prime brokers received calls from their risk control desks, saying they didn’t understand where US monetary policy was going and it was time to pull out. “They did what investment banks always do in bear markets, and shut down,” says Dehn.

As a result, a number of EM hedge funds recorded losses in June. Brevan Howard Asset Management’s flagship master fund, with $29 billion in AUM, recorded its largest monthly loss since 2008, dropping -2.9%.