Japanese hedge funds, which had the industry’s only gains of all regions in June, are braced for more volatility and eyeing short-selling opportunities, as the country heads into upper house elections on Sunday.

“It has been an exciting market,” says Makoto Takahashi, chairman of Tokyo-based United Managers Japan (UMJ). The firm takes the view that the market's big correction occurred in late May and will be followed by increased volatility for much of the rest of the year.

The Nikkei 225 fell -22% from May 23 to June 13, on the back of slowing growth in China and hints of an end to quantitative easing in the US – they are Japan's two most important export markets.

According to preliminary Eurekahedge figures, Japan was the only region to turn in hedge fund gains last month, with relatively flat returns of 0.1%. That compares to June falls on benchmark indices the Nikkei 225 (-0.71%) and Topix (-0.17%). Year-to-date gains by Japan managers are the strongest of all regions, at 17.3%.

Takahashi foresees more volatility in the coming months, as market watchers await the outcome of the elections for the upper house of the Diet at the weekend, which polls predict will result in Prime Minister Shinzo Abe’s ruling Liberal Democratic Party and coalition partner New Komeito gaining a majority.

The widely expected market reaction is a yen sell-off, as Abe would be better placed to push through further monetary easing.

“We don’t think that the bear market is over,” UMJ fund manager Tsukasa Shimoda tells AsianInvestor. “We are very cautious on the market for the time being.”

UMJ runs the Japan-focused Kotoshiro and Galleyla hedge funds, with the latter having opened to external capital in April. Galleyla, run by Shimoda, was up 2.07% last month and 10.58% in the second quarter.

Galleyla had greater gains from its short portfolio than its long positions in June, says Shimoda, noting that short positions in biotechnology and real estate-related stocks were contributors to performance.

While many investors had large positions in those sectors, “we could see some signs from overheating, some small bubbles in those areas”, says Shimoda.  

Other industry players are also taking a walk on the short side in Japan, with Tokyo Stock Exchange data showing that shorting activity is most active among stocks in sectors that include electrical appliances, retail, foods, banks and chemicals.

Shimoda specialises in small-cap Japanese stocks, although his portfolio also includes mid- and large-cap securities.  His strategy, which started off as a managed account running private money, returned 90%, net of fees from February 2010 through January 2013.

Galleyla opened to external investors in April with $11 million, including capital from an Asian fund of hedge funds that UMJ declined to name. It has a capacity of $200 million, which the firm expects to reach by late next year.

Interest in UMJ’s two funds has picked up steam in the last three to four months, says Takahashi, as strong performance by Japanese fund managers has caught investor attention.

The firm is fielding enquires from investors in Hong Kong, Singapore and elsewhere in Asia, in addition to the US. “We are also in talks with European investors, including a Swiss family office, high-net-worth individuals and private banks,” adds Takahashi.

“Many European investors feel they should have some exposure to Japan,” he notes. “Equity long/short is probably one of the preferred routes. The long/short managers more or less performed well in spite of the gyrations of the market.”

While investors are generally optimistic on Japan’s outlook, they too have a cautious eye on the results of the weekend elections and will make allocations decisions in accordance with the outcome, he adds.

“Trading volumes are getting lower [compared to April and early May] and there are obviously a lot of concerns surrounding the US, Europe and China too,” says Takahashi.