Unlock Value in Japanese Equities Using Micro Nikkei Futures
If you cannot beat them, join them. Activist funds are astute investors. Considering their investment strategies to position one’s portfolio can often lead to credible positive returns. But mind the risk as with any other investing strategies.
Activist funds are circling around specific Japanese stocks that have significant potential to unlock value from undervalued real estate.
Simply put, some listed Japanese firms have real estate whose book value is lower relative to its current market price. Activist investors are building stakes in these companies to nudge the management of these firms to unlock value. In theory, this must result in substantial gain in share price.
The gap between book value and market value of real estate is massive. By some estimates, the gap is as large as 22 trillion JPY (~USD 146 billion) reports Bloomberg.
THE BIG PICTURE LOOKS BRIGHT AND POSITIVE.
Japanese equities have been making headlines for much of this year. Recovering from three lost decades, the Nikkei 225 index is trading at near 35-year highs.
Mint Finance covered opportunities in Japanese equities early this year. We also articulated the nuanced behaviour of Nikkei 225 to the strength of the Japanese Yen. The Nikkei and the Yen are inversely correlated.
Japanese equities remain bullish, but headwinds are lurking on the horizon. More on risk as we read on.
THE SUMMARY DEEP DIVE.
Let’s shift our lens from macro into the micro.
Activist hedge funds have turned their sights on Japanese firms. Key among these have been Elliott Management Corp., Strategic Capital Inc., 3D Investment Partners, Palliser Capital, and Murakami Fund (co-founded by Yoshiaki Murakami).
Sectors with large unrealised real estate gains in Japan include land transportation (37%), construction (10%), telecoms (7%), retail (7%), utilities (6%), and warehousing (5%), as per Goldman Sachs estimate. The rest is held across various sectors.
Top five firms with large unrealised property gains (excluding real estate & transport firms) as per Goldman Sachs (reported by Bloomberg) are:
SPOTTING THE TARGETS.
This paper illustrates the mechanism of securing a risk hedged exposure to these stocks while minimising beta risk.
Beta risk is the volatility that stems from broader equity market movements. It is the risk that the stock might lose in value because of a fall in the broader market.
TradingView provides rich data including a forecast of stock prices and a summary of analyst ratings. For four of the five stocks shortlisted above, the 12-month price target and analyst ratings are summarised below.
Based on analyst ratings, this paper suggests that we drop Aeon (8267) as it has a sell rating from the illustrative hypothetical portfolio while including the other four stocks.
MIND THE RISK.
Pursuit of returns is noble. But mind the risk. Recent elections in Japan resulted in the erstwhile ruling political party – the LDP – losing the majority seats in the lower house after 15 years. Political instability can create idiosyncratic risks impacting equity markets. Compounding political risk is the change in monetary policy stance. A hawkish Bank of Japan (BoJ) can send the Yen soaring which can adversely impact stocks.
Recent BoJ’s rate hike (in July) by 25 basis points strengthened the yen by 12.4% from 10th July to 5th Aug. It unravelled the carry trade leading to a crushing 24.7% drop in the Nikkei 225 - the worst since Black Monday in 1987. The Nikkei volatility index surged from 17.8 in early July to 70.7 by early August.
Shrewd investors recognise the importance of prudent risk management. In investing, setbacks are common. Withstanding and navigating risks by honing a resilient portfolio is essential to being successful over the long term.
Risk avoidance is return avoidance using the wise words of Howard Marks of Oaktree Capital. Sustainable long-term returns can be generated by bearing risk intelligently.
HYPOTHETICAL TRADE SETUP
To that end, generating positive investment gains from Japanese firms that are holding onto undervalued real estate requires stripping away beta risk. Constructing a portfolio of stocks with beta risk eliminated requires deployment of financial instruments such as futures.
Why eliminate beta risk? Stocks can and do get impacted by the broader market moves despite the significant upside potential that it might present as evident from the chart below.
Portfolio beta hedging requires computing the beta of the portfolio and then establishing a corresponding hedging using an appropriate derivatives instrument to neutralise the beta effect. The residual portfolio returns post beta-hedging corresponds to pure alpha.
To illustrate portfolio beta hedging, we assume that a certain fund manager plans to allocate JPY 800,000 per stock for each of the four stocks.
TradingView publishes beta for each of the stocks. Beta adjusted portfolio value is as computed below.
The beta published by TradingView is relative to the Topix index. The chart below shows that the CME JPY denominated Nikkei futures are tightly correlated to the Topix index. A 60-day rolling correlation hovers at near +1 most of the times with occasional break (in Jun & Jul this year) and currently stands at +0.88.
The CME Group recently launched Micro Nikkei 225 Futures which has witnessed strong participation with both volumes and open interest rising sharply. This newly launched Micro Nikkei Futures achieved a cumulative volume of 150,000 contracts in one month since the launch on 28th Oct 2024. Bid/Ask spread is very tight, 1-2 ticks for Micro Nikkei (JPY) and 2-3 ticks for Micro Nikkei (USD).
To beta hedge the above stock portfolio of four Japanese stocks, the fund manager will need to short one lot of CME Micro Nikkei (JPY) Futures expiring (later this month) which translates into a notional value of JPY 1,914,750 (based on the closing price as of 29th Nov 2024 of 38,295). Take note that the contract multiplier for the Micro Nikkei (JPY) contract is JPY 50 and hence the notional value of JPY 1,914,750 (38,295 x JPY 50).
Before expiry, the fund manager will need to roll this short position into the next expiry which is in March 2025. The roll will involve buying back the Dec contract month while simultaneously selling the March 2025 contract.
The outcome of this hypothetical portfolio can be visualised in the following possible scenarios as illustrated below.
The illustration does not consider transaction costs & the cost of capital associated with (a) margins for the short futures position and (b) the capital for holding stocks. Also, take note that the six scenarios above are not exhaustive.
Alpha from this trade setup is realised when stocks outperform the index. This is illustrated in scenarios 1 and 2 above. In Scenario 1, both stocks and index rise but stocks rise more than the index. The pay-off is a positive returns outcome.
In Scenario 2, it is assumed that the correlation between the index and stocks break. The scenario imagines that stocks fall by 5% while the index plunges by 10%. The beta hedge negates the loss from stocks and delivers positive portfolio returns.
Scenario 3 & 4 shows the outcome where the alpha fails to be realised. The stocks underperform the index, and this results in a loss in both the scenarios.
Scenarios 5 & 6 illustrate a case where the stocks move in tandem with the index as per their trailing twelve months beta values. In theory, a perfect beta hedge will result in zero P&L. As the notional size of the futures and stock portfolio are not exactly equal to begin with, these outcomes result in a small positive P&L.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Activist funds are circling around specific Japanese stocks that have significant potential to unlock value from undervalued real estate.
Simply put, some listed Japanese firms have real estate whose book value is lower relative to its current market price. Activist investors are building stakes in these companies to nudge the management of these firms to unlock value. In theory, this must result in substantial gain in share price.
The gap between book value and market value of real estate is massive. By some estimates, the gap is as large as 22 trillion JPY (~USD 146 billion) reports Bloomberg.
THE BIG PICTURE LOOKS BRIGHT AND POSITIVE.
Japanese equities have been making headlines for much of this year. Recovering from three lost decades, the Nikkei 225 index is trading at near 35-year highs.
Mint Finance covered opportunities in Japanese equities early this year. We also articulated the nuanced behaviour of Nikkei 225 to the strength of the Japanese Yen. The Nikkei and the Yen are inversely correlated.
Japanese equities remain bullish, but headwinds are lurking on the horizon. More on risk as we read on.
THE SUMMARY DEEP DIVE.
Let’s shift our lens from macro into the micro.
Activist hedge funds have turned their sights on Japanese firms. Key among these have been Elliott Management Corp., Strategic Capital Inc., 3D Investment Partners, Palliser Capital, and Murakami Fund (co-founded by Yoshiaki Murakami).
Sectors with large unrealised real estate gains in Japan include land transportation (37%), construction (10%), telecoms (7%), retail (7%), utilities (6%), and warehousing (5%), as per Goldman Sachs estimate. The rest is held across various sectors.
Top five firms with large unrealised property gains (excluding real estate & transport firms) as per Goldman Sachs (reported by Bloomberg) are:
SPOTTING THE TARGETS.
This paper illustrates the mechanism of securing a risk hedged exposure to these stocks while minimising beta risk.
Beta risk is the volatility that stems from broader equity market movements. It is the risk that the stock might lose in value because of a fall in the broader market.
TradingView provides rich data including a forecast of stock prices and a summary of analyst ratings. For four of the five stocks shortlisted above, the 12-month price target and analyst ratings are summarised below.
Based on analyst ratings, this paper suggests that we drop Aeon (8267) as it has a sell rating from the illustrative hypothetical portfolio while including the other four stocks.
MIND THE RISK.
Pursuit of returns is noble. But mind the risk. Recent elections in Japan resulted in the erstwhile ruling political party – the LDP – losing the majority seats in the lower house after 15 years. Political instability can create idiosyncratic risks impacting equity markets. Compounding political risk is the change in monetary policy stance. A hawkish Bank of Japan (BoJ) can send the Yen soaring which can adversely impact stocks.
Recent BoJ’s rate hike (in July) by 25 basis points strengthened the yen by 12.4% from 10th July to 5th Aug. It unravelled the carry trade leading to a crushing 24.7% drop in the Nikkei 225 - the worst since Black Monday in 1987. The Nikkei volatility index surged from 17.8 in early July to 70.7 by early August.
Shrewd investors recognise the importance of prudent risk management. In investing, setbacks are common. Withstanding and navigating risks by honing a resilient portfolio is essential to being successful over the long term.
Risk avoidance is return avoidance using the wise words of Howard Marks of Oaktree Capital. Sustainable long-term returns can be generated by bearing risk intelligently.
HYPOTHETICAL TRADE SETUP
To that end, generating positive investment gains from Japanese firms that are holding onto undervalued real estate requires stripping away beta risk. Constructing a portfolio of stocks with beta risk eliminated requires deployment of financial instruments such as futures.
Why eliminate beta risk? Stocks can and do get impacted by the broader market moves despite the significant upside potential that it might present as evident from the chart below.
Portfolio beta hedging requires computing the beta of the portfolio and then establishing a corresponding hedging using an appropriate derivatives instrument to neutralise the beta effect. The residual portfolio returns post beta-hedging corresponds to pure alpha.
To illustrate portfolio beta hedging, we assume that a certain fund manager plans to allocate JPY 800,000 per stock for each of the four stocks.
TradingView publishes beta for each of the stocks. Beta adjusted portfolio value is as computed below.
The beta published by TradingView is relative to the Topix index. The chart below shows that the CME JPY denominated Nikkei futures are tightly correlated to the Topix index. A 60-day rolling correlation hovers at near +1 most of the times with occasional break (in Jun & Jul this year) and currently stands at +0.88.
The CME Group recently launched Micro Nikkei 225 Futures which has witnessed strong participation with both volumes and open interest rising sharply. This newly launched Micro Nikkei Futures achieved a cumulative volume of 150,000 contracts in one month since the launch on 28th Oct 2024. Bid/Ask spread is very tight, 1-2 ticks for Micro Nikkei (JPY) and 2-3 ticks for Micro Nikkei (USD).
To beta hedge the above stock portfolio of four Japanese stocks, the fund manager will need to short one lot of CME Micro Nikkei (JPY) Futures expiring (later this month) which translates into a notional value of JPY 1,914,750 (based on the closing price as of 29th Nov 2024 of 38,295). Take note that the contract multiplier for the Micro Nikkei (JPY) contract is JPY 50 and hence the notional value of JPY 1,914,750 (38,295 x JPY 50).
Before expiry, the fund manager will need to roll this short position into the next expiry which is in March 2025. The roll will involve buying back the Dec contract month while simultaneously selling the March 2025 contract.
The outcome of this hypothetical portfolio can be visualised in the following possible scenarios as illustrated below.
The illustration does not consider transaction costs & the cost of capital associated with (a) margins for the short futures position and (b) the capital for holding stocks. Also, take note that the six scenarios above are not exhaustive.
Alpha from this trade setup is realised when stocks outperform the index. This is illustrated in scenarios 1 and 2 above. In Scenario 1, both stocks and index rise but stocks rise more than the index. The pay-off is a positive returns outcome.
In Scenario 2, it is assumed that the correlation between the index and stocks break. The scenario imagines that stocks fall by 5% while the index plunges by 10%. The beta hedge negates the loss from stocks and delivers positive portfolio returns.
Scenario 3 & 4 shows the outcome where the alpha fails to be realised. The stocks underperform the index, and this results in a loss in both the scenarios.
Scenarios 5 & 6 illustrate a case where the stocks move in tandem with the index as per their trailing twelve months beta values. In theory, a perfect beta hedge will result in zero P&L. As the notional size of the futures and stock portfolio are not exactly equal to begin with, these outcomes result in a small positive P&L.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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