Abstract
On February 24, 2012, Japan’s Financial Service Agency suspended an investment advisory license of AIJ, a little known Japanese hedge fund manager founded in 2000 by a Nomura’s legendary salesman. The public later learned that nearly 90% of $2.4 billion managed by AIJ is gone because of trading losses. AIJ’s investors, mostly small and medium corporate pension funds, didn’t know about the losses. How was it possible to hide such massive losses over 10 years?
Case Profile
Background
Mr. Kazuhiko Asakawa (“Asakawa”), a legendary salesman at Nomura, established AIJ Investment Advisors Co. (“AIJ”)[1] in 2000 and launched AIM Global Fund (“Global Fund”), a Cayman-based hedge fund, in 2002. However, AIM Asset Management did not have a license to provide discretionary investment advice and Asakawa feared it might be a violation of a securities law to manage the newly launched fund. Asakawa learned that Signa International Investment Advisors (“Signa”), a discretionary investment adviser and subsidiary of a large US-based insurance company, was considering closing the business in Japan. AIJ negotiated if Signa can became an investment manager of Global Fund. Signa agreed the arrangement and eventually merged with AIJ in July 2004.
Asakawa was a visionary salesman. He clearly saw desperate demand for “yields” among smaller size institutional investors. Among all, corporate pension funds provided alluring opportunities as they were struggling to fill the gap between decreasing asset values and increasing liabilities. On average, Japan’s pension funds only generated 2.98% p.a. from 1996 to 2002, far short of the actuarial target of 5.5%. By 2010, most of small and medium sized pension funds were significantly underfunded. In order to reduce the target return to 2.5%, those pension funds must receive additional capital of JPY 5.7 trillion (approx. $70 billion), or 30% of current pension assets, according to the research conducted by Ms. Tsutomu Okubo, DPJ member of the House of Councilors. Large corporate pension funds successfully lowered the target as their sponsors injected additional capital; small corporate pension funds never had such luxury.
Asakawa teamed up with Mr. Shinpei Matsuki (“Matsuki”), a long-time buddy and former head of Nomura’s powerful equity department, and marketed Global Fund as an absolute return strategy with very low volatility. Asakawa told his investors that Global Fund would generate attractive returns through various option strategies, including collecting premium by selling put options on Topix. Asakawa’s smooth talk touched heartstrings of many pension managers and the money started flowing into the fund. As Global Fund continued performing well through the financial crisis, the firm’s AUM ballooned to over $2 billion.
Exhibit 1: AIM Global Fund track record since its inception
Source: Diamond Magazine, Bloomberg
Exhibit 2: AIM Global Fund AUM, Reported By AIJ (100 million Yen)
Source: SESC
Problems
AIJ’s investment strategy should have generated the promised returns if Japan’s stock markets either had risen or been flat. Unfortunately, Mr. Markets weren’t kind to AIJ: Topix fell more than 30% for the first 9 months and over 60% from March 2006 to March 2009. As the strategy kept struggling, Asakawa, who feared massive redemptions, decided to hide the losses from investors, hoping he can recoup in the future.
Through 2012, however, Global Fund continued its losing streak and the total amount of losses from derivative trading surpassed JPY 109 billion. The fund’s custodian could only confirm the existence of JPY 25 billion; it means that the fund accumulated phony profits of JPY 293 billion.
Exhibit 3: Accumulation of Phony Profits
Source: SESC, the author’s calculation
Asakawas created a complex web of structure to hide the losses from the public. First, he created a BVI-based administrator called AIA. AIJ was a 100% owner of the company and Asakawa became a director. He also established ITM Securities Co., Ltd. (“ITM”), a Japanese brokerage firm, with Mr. Hideaki Nishimura, and ITM became a placement agent of AIJ’s Global Fund. AIJ controlled over 80% of ITM’s ownership through two controlled companies.
Exhibit 4: AIJ’s Key Subsidiaries
Source: Created by the author using the SESC document
AIA was assigned be a fund administrator for Global Fund and reported NAVs to investors and trust banks through ITM Securities. According to the media source, the relationship between AIJ and AIA was never disclosed to investors and this scheme helped AIJ to hide its massive losses over ten years. AIJ also set up two private funds in Japan, Venture Investment Alpha I and Venture Investment Alpha II. At the later stage of this scheme, Global Fund transferred majority of new subscriptions to those two funds and used them to pay redemptions. A valuation policy of the funds is not disclosed, but it probably helped Global Fund and AIA to conceal the size of losses and helped to manage cash flow. Lastly, AIJ and Global Fund did not have any prime brokerage relationship as they probably wanted to avoid unnecessary attention to their failing business.
Exhibit 5: Valuation Scheme
Source: Created by the author using the SESC document
On Feb 24, 2012, AIJ’s operations were suspended by FSA. All redemption requests were upheld as the regulator continued investigation. On Mar 27, Asakawa appeared for the first time in public after the scandal when he was summoned by the House of Representative’s finance committee. He admitted the fraud and apologized for his misconduct.
Recommendations
Check the legitimacy of an administrator and relationship with an investment manager
Offshore administrators must be recognized by local authorities to provide administrative services to regulated mutual funds (including hedge funds) and the list of licensed/regulated administrators is available online.
AIA was established in the British Virgin Islands, but it is not recognized by the BVI Financial Services Commission as a “Sub Cat. B - Admin of Investments Mutual Funds”. See the online search screenshot below.
Exhibit 6: Admin Search Result
Confirm how an investment manager could execute trades without a prime brokerage relationship.
It is important to understand how an investment manager executes complex trades efficiently without any interruption. Prime brokers usually provide the best trading services and executions for hedge fund managers.
The fact that AIJ didn’t have any prime brokerage relationship is a concern. The firm disclosed the total trading volume of $713 billion (Exhibit 7). It is nearly impossible to execute this amount of transactions without legitimate prime brokerage services.
Exhibit 7: AIJ Trading Volume (2010)
Source: AIJ’s 2010 Annual Report
Investigate the history of an investment manager
AIJ began its operation in 2002 as a non-discretionary investment advisor and was not allowed to manage a fund by itself. Without the permission, AIJ launched a Cayman-based fund in 2002 and lent a name of Signa, which had a discretionary advisory license, to serve as an investment advisor of the fund, until their merger in 2004. This is potentially a violation of the securities law in Japan. Investors should have known this fact after reading its offering documents carefully and have sought advice from a legal professional.
Check employees’ past record
Matsuki’s criminal record shows that he was arrested in 1997, when he was Nomura’s head of equity division, and sentenced 8 years (with suspension of 3 years) for his involvement with an infamous payoff scandal. This was widely publicized incident and potential investors should know why Asakawa decided to hire him.
Check an affiliation of a placement agent
ITM Securities were the Global Fund’s placement agent in Japan and directly owned by AIJ (80%).
This fact by itself is a problem, but investors should know there is a potential conflict of interest between the placement agent and the investors.
Resources
Pension Fund Association, “Performance Update of Pension Funds”, http://www.pfa.or.jp/jigyo/tokei/shisanunyo/shisanunyo01.html (Japanese)
AIJ, “2010 Annual Report”, http://www.aim-ij.com/20120224-22rep.pdf (Japanese)
SESC, “Supplemental Information” for AIJ, March 23, 2012, http://www.fsa.go.jp/sesc/news/c_2012/2012/20120323/01.pdf (Japanese)
[1] AIJ changed the name twice; it was set up as AIM Asset Management in 2000, then became AIM Investment Japan in 2001. The company finally became AIJ in October 2003.