Average returns for Japanese hedge funds in 2007 were 1.98%. Not bad compared to the 11% fall in the Nikkei, but laughable in comparison to the 23.4% return of non-Japan Asia hedge funds.

Phalanx Japan Asia Multistrategy Fund, managed by Chris McGuire and Neal Brauweiler, won AsianInvestor magazineÆs æBest New Hedge Fund' award in 2006. The fund runs statistical, convertible and capital structure arbitrage, volatility and event-driven strategies.

Taxonomically, Phalanx falls into the sub-category of æmulti-strategyÆ, but it accomplishes its strategies by concentrating almost exclusively on Japanese asset classes. We spoke to Chris McGuire about the state of play for Japanese hedge funds.

2007: a good year or bad year for Japanese hedge funds?

McGuire: I would think most Japanese hedge funds would like to forget 2007. The dismal underperformance of the equity market relative to global indices and certainly its Asian neighbours has given many reasons to take their eyes off Japan. But, if hedge funds were truly ôhedgingö and being market neutral, instead of leveraged equity funds they may have been pleased with the volatility and mispricings in securities.

How about your fund?

Personally, 2007 was difficult for us to make money in Japan. We were able to grab some wonderful opportunities in Asia which helped propel our returns up above 50% for the year (our final figures will be out within a week). But after a horribly quiet end to 2006 and first quarter 2007, volatility in Japan came back with a vengeance and our portfolio of convertibles and options performed extraordinarily well.

Others didnÆt fare so well though.

To be fair, many friends and colleagues (and often ourselves) in the market had a difficult time making money in Japan last year. The market seemed to trade on a negative bias to the rest of the world. That is, if the world rallied, Japan did not go down. But if the world markets fell, Japan fell twice as much. Sentiment in the market has been quite poor since the end of the stellar rally in 2005.

Which localised macro factors does Japan have to overcome?

Politically, people fear that the bureaucratic regime running the country will fail to adapt and improve conditions for making companies more profitable. People have felt Japan may be a ôvalue trapö as valuations have begun to look quite attractive as cash rich and profitable companies continue to abound within the market. That being said, the concern is that they will not grow and the profits will be lost in stagnancy.

Are hedge fund managers and investors tempted by higher absolute returns available elsewhere?

There have been so many managers throwing in the towel and abandoning Japan for richer pastures in China, Asia, India, and other growth markets. Given the growth in the hedge fund universe perhaps we are having a healthy shakeout of those who adeptly followed the bull market of 2005, made some money, and were shaken out when times got tough.

Might investors lose hope on opportunities in Japan?

Throughout my career I have felt that the best opportunities arise when people take their eye off the game and become complacent. I believe that is what may be occurring in Japan. Managers have given up, are moving away, and making the space less-crowded for those of us that are grinding it out and looking for long term benefits.

We believe that very good things are on the horizon. Japan is a very cautious market now and is opening up to be vulnerable for big moves and potentially extraordinary volatility. It will not be the market for the faint of heart but will be the market for a volatility fund such as Phalanx.

What philosophical conclusions should we draw?

I have found that one must look at Japan quite differently than the rest of the world. It is a market where patience is the ultimate virtue. Good performance may not exist continually throughout the year but Japan is one where 80% of oneÆs profits come 20% of the time, or perhaps even 90% come 10% of the time. But, if you are not there for that 10%-20% you miss out on unbelievable gains. That was the case in 2007. We are sure not to be left out when payouts come in 2008.