If hedge funds and Japan dated, it might be called an on-again, off-again relationship.
Investors famously shorted Japanese government bonds, or JGBs, a few years ago but got burned; the bearish trade was dubbed the "widow-maker."
The next big play was a bullish one on local stocks rising and the yen falling, which made tons of money in 2013. But many of the same hedge funds got burned early this year when that "reflation" trade reversed.
Despite those ups and downs, hedge funds are now more in love with Japan than at any time in the last decade. Managers surveyed by Bank of America Merrill Lynch from Nov. 7 through Nov. 13 found that they had the most positive outlook on Japan since 2005 and the country is the most-favored investment region for the coming year.
"Japan is the flavor of the month," said V-Nee Yeh, an investor in hedge funds through Hong Kong-based Cheetah Investment Management.
The most common investment thesis is relatively simple: Don't fight Abenomics.
"Abenomics" refers to the aggressive economic stimulus policy instituted by Japanese Prime Minister Shinzo Abe. Like U.S. Federal Reserve moves after the financial crisis, the mantra among managers is not to go against a central bank's attempt to reinflate the markets (hence the term "don't fight the Fed").
The Bank of Japan recently announced it would pump even more cash into the system by purchasing additional government bonds, as Japan unexpectedly fell into a recession in the last two fiscal quarters.
Hedge funds also point to the coming rotation of Japan's $1.1 trillion public pension fund out of government bonds and into stocks, a likely boost to the equity markets. Retail investors are also starting to invest more of their cash—about $7.6 trillion—into stocks.
"These numbers of mind-numbingly large," Tomas Jelf, chief economist at hedge fund Prologue Capital, said in a letter to clients on how the such rotations would hurt the yen and boost stocks.
For hedge funds, that mostly means going long the stock index or specific equities in it and shorting the yen. Hedge funds are especially interested in betting on the export sector, such as technology, industrial and automobile companies, which would likely benefit from a weaker currency.
Such a "reflation" trade is common among so-called macro hedge funds that bet on broad economic trends.
Examples include longtime Japan bull Eric Mindich and his Eton Park Capital Management; Hugh Hendry's London-based Eclectica Asset Management; and the Fortress Investment Group hedge fund managed by Jeff Feig and Michael Novogratz, according to people familiar with the positioning. David Einhorn's Greenlight Capital is also short the yen, a long-term trade, according to a person with knowledge of the portfolio.
"We believe that the Abe/Kuroda (BOJ Gov. Haruhiko Kuroda) regime will undoubtedly be successful in reflating the Japanese economy," wrote Feig and Novogratz in a November letter to investors in their Fortress Macro Fund. "The (yen) is likely to be materially weaker and the equities significantly higher over the next six to 12 months."
The Fortress Macro Fund is down 6.58 percent for the year through October, according to a regulatory filing. A spokesman for Fortress did not respond to a request for comment. Spokesmen for Eton Park, Greenlight and Eclectica declined to comment.
"You can say long Nikkei and short the yen is a consensus trade," Tak Aoyama, CIO of $630 million fund of hedge funds AIFAM, said of macro investors.
Just because hedge funds have a bullish trade on doesn't mean they are in it for the long term.
"I started the year hugely bullish on Japan. Hugely bullish, let me say, not qualitatively. I'm not an advocate of the three arrows and the resuscitation to the great heights of whatever Japan represented in the 1980s," Hendry said in a recent interview with MoneyWeek. "I am saying that I can see persistent failure to achieve such honorable ambitions, which leaves no recourse but to intervene again and again and again. Therefore I see the yen being a weak currency ... the other side of that, the stock market, being higher and higher and higher."
Eclectica, which manages $250 million overall, has gained modestly this year in its flagship fund: 2.6 percent through October.
Morgan Creek Capital Management, a Chapel Hill, North Carolina-based investment advisor and allocator to hedge funds, is highly bullish on Japan.
"The events of the last few weeks point to an increasing likelihood that the Japan bull market has far to run before it rests," the firm's CEO, Mark Yusko, said in a recent letter to clients.
Yusko also notes that the government of Japan will continue its stimulus programs because it wants "to show the world that the work of Abenomics is far from complete."
Morgan Creek uses hedge funds like the Indus Japan Fund to express the bullish view. The Japan reflation thesis represents 7.8 percent of its Morgan Creek Global Equity Long/Short Fund, according to investor materials.
Some hedge fund allocators think the best days of the trade may be over.
"The Japanese equity markets have already moved 100 percent off of the lows—the easy money has probably been made," said Michael Oliver Weinberg, chief investment strategist at Protégé Partners.
Weinberg, who also teaches at Columbia Business School, said he prefers to play Japan through small, Asia-based fund managers who can go long and short.
Aoyama of AIFAM agrees. "We've likely seen most of the effects of Abenomics on Japanese equities and there's not much upside left to the Nikkei," he said.
Aoyama said he isn't giving money to Japan-based hedge funds or others that trade Japanese assets as their returns are too correlated to the market. That includes macro managers who think they can "trade Japan for a quick buck."
One contrarian on Japan is Hayman Capital Management.
The investment manager, led by Kyle Bass, has been critical of the Japanese government and has a dedicated fund to express the negative views. The Japan vehicle uses a combination of short positions on the yen and options on interest rates; it does not directly short government bonds.
Performance of the fund was unclear. A Hayman staffer declined to comment.
The old trade of shorting Japanese government bonds doesn't appear popular.
"There hasn't been JGB shorting this time around, and hedge funds are probably wary of going back in a trade they have historically been squeezed out of," Aoyama said.
Many hedge funds focused on the region have lost money despite the Nikkei rising more than 6 percent and the yen (relative to the U.S. dollar) falling nearly 11 percent this year. The average Japanese stock-focused fund is down 5.13 percent for the year through October, according to hedge fund tracker Simplify based on reporting from 378 funds. The average performance for all hedge fund strategies is 2.83 percent, per an early performance estimate on the same period.
Many macro funds have also lost money in 2014 in part because of bullish Japan bets. Firms burned by investments in Japan earlier this year include Balestra Capital (down 12.7 percent through October); Caxton Associates (down 5.46 percent through Nov. 10); and Brevan Howard Asset Management (down 1.58 percent through October), according to performance data obtained by CNBC.com.
Current positioning for those funds was unclear and spokesmen did not respond to requests for comment or declined.