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Hedge funds playing with fire shorting the Nikkei

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Hedge funds are playing with fire as they turn short on Nikkei futures for the first time in two years, according to one analyst, noting Japan's public pension fund is ready to buy the dip.

"Shorting the Nikkei can be risky because the government pension fund and the Bank of Japan (BOJ) are effectively providing a floor to prices," said BNP Paribas Chief Japan Equity Strategist Shun Maruyama. "It's a very dangerous strategy for the hedge funds."

Hedge funds had been long Nikkei futures for two years and helped fuel a near 60 percent rally, but that changed in January. "Doubts about the huge Bank of Japan injections led hedge funds to turn net short," Societe Generale equity strategist Arthur van Slooten said in a note last week.

The Nikkei rallied 13 percent in November, boosted by two events in late October: additional monetary easing by the BOJ and an announcement by the Government Pension Investment Fund of Japan (GPIF) – the world's largest public pension fund – that it would double its Japanese stock holdings.

The rally stalled, however, with the Nikkei currently down 1.6 percent from its most recent peak on December 8. Foreign investors sold 897 billion yen ($7.6 billion) worth of stocks in January alone, Ministry of Finance figures show.

Shorting against the GPIF

The public pension fund, which held assets of 126.6 trillion yen ($1.07 trillion) at the end of fiscal 2013, said on October 31 it would boost its stock holding from 12 percent to 25 percent.

In theory, GPIF needs to buy around 1 trillion yen worth of stocks every month for thirteen months to achieve its new allocation target.

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But the fund prefers to bargain hunt and tends to buy when stocks dip, said Maruyama, noting this will likely provide a Nikkei floor of 17,000. The index closed at 17,652 on Tuesday.

BOJ taking a break

Fading expectations that the BOJ will undertake further stimulus measures could underlie the shift in hedge funds' positions, analysts say.

Positioning has ebbed and flowed along with speculation about and actual changes in monetary policy, said Mizuho Securities senior economist Tomochika Kitaoka. He pointed to a 3 trillion yen spike in yen short/Nikkei long positions just after the BOJ's October 31 easing.

Now, funds are unwinding these positions, which likely reflects changing expectations for another round of easing, he said.

Hedge funds are also trying to free up cash to protect themselves against overseas risks, "in particular, the expected rate hike in the U.S. as well as the Greece crisis," said BNP Paribas' Maruyama.

Others believe the reversal in positioning is a sign that hedge fund investors are pessimistic on Prime Minister Shinzo Abe's ability to deliver economic growth.

"[It's] the end of the honeymoon for Abenomics," said Societe Generale Asia Equity Strategist Vivek Misra in a note published on Tuesday.