Over the next five years, Japanese public and corporate pension funds are expected to alter their strategic investment approach in search of better risk-adjusted returns. The change may be gradual, but the long term implications of this move for the asset management industry will be massive.
Roughly speaking, pension funds in Japan have an average equity exposure of 50%, and while home country bias is gradually declining, the biggest change in structure is that responsibility for core assets will increasingly be devolved from the quant/passive managers. Yoshi Kiguchi, a director at Russell in Tokyo observes that, “Pension fund managers are slowly realising they should mix passive investments with more active and direct investments. So the quant bias will decrease as people become more comfortable with alternative sources of return. Current we see the greatest demand is for portable alpha products. Another trend is for managers to have discretion to alter the Japanese portion, so rather than have international equity ex-Japan, corporate pensions are now willing to include Japan in the global equity portion.”
Japanese pension funds have assets of over US$3 trillion. Of this, public pension funds (National pension, Employees Pension Insurance and Mutual Aid Associations) account for over $2 trillion. Seventy per cent of that belongs to the EPI scheme. Since 2001, the Government Pension Investment Fund (GPIF) has been investing EPI assets together with the National pension assets.
In the October-December 2007 quarter, the GPIF incurred around 1.5 trillion yen in losses, spurring calls for the fund’s investment strategy to be overhauled. In fact, a major review of the fund’s investment policy was already under way and in the past few weeks, the GPIF has embarked on a new long term policy mix. GPIF’s asset allocation up to now has seen domestic bonds account for slightly over 50% of market invested assets, with domestic equities at around 20% and foreign securities the remainder.
Given the enormity of the GPIF’s AUM, some 80% of its assets have been passively managed. Management fees are legendarily low, at an average 0.03%, and that includes active mandates. “The GPIF’s move will have a big impact the Japanese asset management market in the next five years”, says Sadayuki Horie of the Nomura Research Institute in Tokyo. The picture may not alter dramatically in the short term, although the fund has already made a significant shift out of Japanese corporate bonds while increasing its allocation to JGBs.
On the equities side, the big winners in the past were the passive managers such as BGI and SSGA. The table below shows the Top 10 investment advisers to Japan’s public and corporate pension funds.
Investment Advisers to Japanese institutions - the top 10
Barclays Global Investors
State Street Global Advisers
Nomura Asset Management
Morgan Stanley Asset Management
Tokio Marine Asset Management
J.P. Morgan Asset Management
As the GPIF and others move away from the largely passive approach of the past, its initial allocations are not that radical, apart from a new 5% allocation to hedge fund strategies. The Japanese bond portion has increased from 58% to 67%, Japanese equities have reduced from 18% to 11%, and foreign equities are down from 13% to 9%.
Hedge fund investment is a mature market in Japan. There are, for example, a higher proportion of Japanese corporate pension plans investing in hedge funds than there are in the US; 4.2% compared with 1.3%. Japanese investors are using hedge funds as a substitute for fixed income, investing in funds of funds, low-risk portfolios.
However, while US pension funds have an average of 4.6% invested in real estate, their Japanese counterparts have less than 1% invested. US funds have 3.2% on average in private equity, but Japanese corporate pensions have only 0.3%. Horie explains: “Institutions have a bad attitude towards real estate - many of them still remember and indeed suffer from the experiences of the bubble years of the late 1980s.”
Corporate pension assets total around $1 trillion. The number of Employees’ Pension Funds, the most prevalent type of corporate pension fund in the 1990s, has decreased substantially as a result of fund dissolutions and the return of the so-called ‘substitutional portion’ of EPF assets to the Government (known as Daiko-Henjo). In place of the dissolved EPFs, defined benefit corporate pension plans have grown significantly, partly due to the growth of DB plans converted from tax-qualified pension plans. The tax-qualified plans are due to be phased out by the end of fiscal 2011.
Kiguchi says, “Investment allocations haven’t changed much. Returns were very good in the period 2003-2006, so most funds have enough surplus to smooth over the deficit in fiscal 2007. However some corporate pensions have turned to deficit and may change investment allocations, moving to more conservative assets.
DB pension plans’ asset allocations to domestic and foreign equities has been increasing, with a corresponding drop in short term money market holdings. Since 2003, corporate pension plans have generated quite high, but volatile, returns, leading to major improvement in pension funding levels. This volatility has led a few of the more forward thinking corporate pension sponsors, to consider changes to their investment approach; in particular a reduction in their equity weightings.
Sony Corporation’s Director of Asset Management, Eiji Takita explains the background to these changes: “A strong bias to equities is being addressed by many Japanese corporate pensions. The weightings are a throw-back to the days when required return targets were set at a net 5.5%. At that point, the average fund had a 50-60% Japanese equity component; Sony had 70%.
“Until 1997-98, this was OK, but then we had the market turmoil that reached its nadir in 2002. That period was so bad, the Nikkei had fallen to 7600 in the first quarter of 2003. We had experienced three consecutive years of downdraft and people began to doubt the theoretical concepts of long term investment.
“In 2003 people started to look into alternative investments and hedge funds came into the picture. People then realised that trying to make 6% when interest rates are 0.5% was not realistic. That is when they tried to do make changes at the scheme level, on the liability side, and that is where the cash balance plan idea emerged.”
At the same time, funds lowered their equity allocation in the move to liability profiling. Toshiba, Toyota and Hitachi all drastically lowered their equity portion. Some of them lost a lot of money in the process, losse that were covered by sponsors’ special contributions. In January 2005, rather belatedly Sony cut its equity allocation by half. On the basis of the new cash balance plan, the return target declined from 5.5% to 3% - “and even that is challenging, when the JGB rate is 0.4%” says Takita.
Sony moved a lot of asset to JGBs, but needed equities to provide the extra 2.5%. “We realised we needed to diversify, so we invested between 7% and 12% of the fund into hedge funds via UBS, private equity using Harbourvest and managed futures using Man Group, commodities via Goldman Sachs, global REITs managed by Morgan Stanley and direct real estate managed by Nomura.
Sony’s asset allocation is now 60% bonds and 30% equities, with 10% in alternatives. They now have a 3.6% target return. Their 30% equity exposure is low compared to other Japanese corporates. The passive element is managed by BGI, Japanese equities by BGI and Daiwa.
In spite of the relatively conservative weightings, Takita is conscious of the concerns of the plan sponsor with regard to overall levels of risk. “If you calculate the risk of your asset allocation using Barra, you can see there is more than an 80% risk allocation. With the recent volatility of markets, it is closer to 90%. Which means your potential return is determined entirely by your equity exposure.
“Looking at it from a pension fund perspective, you can assess it as a long term buy and hold approach. But from a sponsor’s point of view, the dependence on return being 90% based on equity holdings is something they need to discuss, which may mean we need to lower the equity allocation.
“The pension fund manager is more concerned with providing the participants with the 3.6% return. We can take the long view on volatility, but in a year like we have had (to March 31), the sponsor is getting nervous. It’s like trying to solve a mathematical puzzle with two variables. It becomes a question of where you put your bias within your ALM.”
Ultimately, the resulting allocation will be negotiated between the sponsor and the pension fund manager. Takita says, “We cannot disregard the sponsors’ interest, so now we are starting to formulate a global policy. The conviction is that a pension policy is a matter of taking a long view, but an environment of having to report results over the short term (Sony is listed in NY, requiring quarterly reporting), is forcing a change in attitude. The alternative is we give up on DB altogether. We may yet have to conclude that DB is not sustainable in this environment.” Sony’s US subsidiary has already closed its DB scheme to new members.
The big concern for the sponsor is to lower the equity risk component and the fund’s managers are discussing with Watson Wyatt how to re-allocate. Nissan and Sony are probably the only companies taking this global approach.
Takita says, “Diversification of beta is an option we are looking at. Recently we thought that emerging markets gave us diversification, but that theory about how markets are de-coupling is a myth. These countries are all still highly correlated. What we need is a totally different form of beta. For example, private equity, forestry, infrastructure.
“For traditional asset classes, you can manage the risk using Barra, but for assets like timber, you don’t have that ability. Private equity is not marked to market, so you don’t have the risk management model there. These are the issues we are getting to grips with. If we want to move towards stability of returns and to manage the risk, we have to reduce the equity portion and perhaps move to an LDI type approach.
“Your total commitment to risk management is increased if you decide to go down this road. In traditional assets, we follow more of a core and satellite approach. The core is passive and small cap/deep growth managers are used as satellite holdings. That element of the portfolio takes a lot of cost and effort to monitor. Once we move to a 20% equity allocation, the amounts become smaller, so we wonder whether it’s worth it, whether we shouldn’t just move it all to passive exposure.
Sony has $2bn invested in foreign assets, which brings with it a need to manage foreign currency exposure. Takita says, “For Sony, having $2bn unhedged is not acceptable, so currently 60% is dynamically hedged”, (ie, hedging the risk of a stronger Yen. A currency alpha program is another option being considered.
April 2009 is the start date for the new asset allocation strategy. The portfolio book was closed at the end of March 2008. By September Watson Wyatt will begin working on an ALM, which should take three months. Beauty parades will be held in January and come March next year, the fund will be in transition. “And in April, we take a holiday,” says Takita.