Japan: down but not out

Japanese institutional defined benefit pension funds have not been immune to the shocking fall in investment returns seen in 2008. Corporate pension funds saw double-digit losses in the Japanese financial year that ended on March 31. Funds have reacted in several different ways: some have terminated mandates with underperforming active equity managers in favour of passive strategies, others have terminated mandates and not reinvested the cash that resulted, and others have moved to de-risk their assets altogether by increasing their allocation to fixed income at the expense of equity allocations.

Some asset consultants report clients are looking to sophisticated strategies to minimise market beta, but other industry professionals worry that the majority of pension fund managers are planning to curtail liability risk with a continued shift away from higher risk/higher return strategies to the safety of lower-risk/lower return investments, like fixed income. But with Japanese 10-year government bonds only yielding 1.5% and the average pension fund seeking an annual return of 2.5% to 3%, industry professionals are deeply concerned that pension funds are making investment decisions that will result in long-term shortfalls that cannot be met unless plan sponsors contribute extra cash.

The average corporate pension fund lost 17.1% in the year ended March 31, according to research from Watson Wyatt. This figure is reflected by the observations of other asset consultants.

“Let me explain the status of our clients,” said Mercer Japan’s head of investment consulting Yoshinori Kouta. “Based on the asset allocation of our clients, the performance range was widely spread with a variance of over 20%. It really depends on the asset allocation. One or two of our clients didn’t have any equities in their portfolio, so they suffer from slightly negative numbers in their performance. The average was -17% to -18%.”

In response, pension funds have become defensive – either moving to rebalance in line with the pre-set asset allocation, or doing nothing at all, according to Tokio Marine Asset Management’s president Akiyoshi Oba.

“The reaction has been largely defensive in nature, rather than one that has sought solutions through innovation,” he said. “About 70% of plan sponsors are trying to keep the base asset allocation agreed before the economic upheaval. The remaining 30% think that this is a one in a 100-year occurence, and are being much more conservative. As such they are waiting to see how events unfold and are generally not taking any action just yet”

Asset allocation

Fixed income has come to represent a higher proportion of the overall asset allocation, but that can be as much a function of falling equity values relative to fixed income values as it is a choice by pension funds to sell equity assets and reinvest in fixed income.

“The proportion of fixed income and equities are completely different from the original starting point. Some Japanese sponsors didn’t change their allocation, but just didn’t rebalance their portfolio after the value of the equity portfolio declined,” said Kouta of Mercer. “Some sponsors have tried to reduce their equity portfolios based on the review of target return or contribution level related to their liabilities side. Of course, if you just look at the asset side, the result is the reduction of equity asset side. At the same time, plan sponsors talk carefully about how much they should contribute each year. The reduction of equity may come together with more contributions by sponsors and the attitude towards the risk of the portfolio.”

Some pension funds will allow market fluctuations to set the terms of their new asset allocation, said Nikko Asset Management’s head of institutional business division Kikuo Shirose.

“Increasing fixed income and cash is a current fixture of the corporate pension plans,” he said. “There has been no big change – it’s been done in a very passive manner. Some of our clients are doing those actions, but in two ways: one is just to keep their asset allocation through the market fluctuation, so over the past 18 months, the equity value has gone down, the fixed income value has stayed, which means that the fixed income asset allocation shifts. Where they have actively decreased the equity allocation, it’s been in the active equity management portion.”

Shirose emphasised that Nikko Asset Management, one of Japan’s largest independent asset managers, had not lost many mandates because they have performed better than their peers.

Short term solution

As pension funds have liquidated holdings in managers and hedge funds, they have not rolled it into new allocations as yet, creating what is believed to be a short-term overweight to cash. But BGI’s managing director and head of Japanese institutional business Masahiro Fukuhara believes this is only a temporary status.

“Clearly, clients are going to go defensive in tough times. At some point in time, they have to bring it back to equities or alternatives, or they can’t achieve their expected returns,” he said. “They are going to change their allocations within a few months. Some pension funds have shifted cash into hedge funds, for example.”

Pension funds that are looking to innovate within their stated asset allocations have been diversifying assets to non-Japanese investments and looking to consider downside risk at the total portfolio level.

“Clients have been focusing on downside risk, rather than just seeing an overall risk picture,” said Fukuhara. “They have started to talk more about risk of the total portfolio. To make this happen, some pension funds have started to change the bias for Japanese equities to global equities. They have previously used TOPIX as a benchmark, but are now interested in minimum variance portfolio, or a low risk portfolio. I think clearly the focus is on having expected returns. … In some corporate pension funds, exposure to the equities can be 40-60%. They’re keeping the exposure, but reducing exposure to Japanese equities, which can be 20% to 40% of the equity allocation. Some clients are down from 40% to 20%, or from 20% to 10%.”

Others are looking to products that will protect against downside risks through the use of derivatives and even leverage, said Russell Investments president and CEO in Japan Bruce Pflaum.

“It’s a new concept for many of these funds,” he said. “Many of these instruments have been on the market for years, but the packaging is new. There’s a lot of derivative use in these instruments and the funds need to get comfortable with derivative use. The conversations are going on, but it will take some time and I suspect it’s similar to what you see in the UK/Australia/US. The process will be the same.

“Trustees are coming to people like Russell and saying, you have to help us identify when markets are over/under valued. Trustees are bombarded with information about the markets, and we need a way to sift through this. If there is a point in the market cycle, where it’s appropriate for our fund to de-risk and take money off the table, we want to be able to at least consider that decision.”

Accounting changes to increase pressure

This trend of de-risking the asset allocation may be exacerbated by the projected integration of International Accounting Standard 19 in the 2011/2012 financial year. IAS19 requires corporations to recognise pension liabilities on the company’s annual balance sheet instead of using a longer term smoothing mechanism that makes pension liabilities appear smaller or more even. Although precise details on how this will happen in local accounting terms have not yet been set, this change is expected to prompt plan sponsors to demand that pension fund managers seek out low volatility assets with a lower return possibility. 

“[Pension funds sponsored by a big company or a group of big companies] prefer asset allocation with stable return to asset allocation with volatile return even though such an option may sacrifice high performance in longer term,” according to DIAM Co. “Due to the recent trend of IAS to introduce immediate recognition of pension liability to sponsors’ balance sheet, big companies are afraid that their accounting result can easily be damaged by financial market conditions. As they don’t want that to happen, they are increasing allocation for asset with lower and more stable expected return, i.e. fixed income by reducing allocation for equity and other volatile assets.”

In addition to the integration of IAS19, from the end of 2009, Japanese accounting standards will remove a smoothing mechanism that previously permitted pension funds to use the discount rate of Japanese government bonds as the default interest rate, according to Towers Perrin senior consulting actuary Yoichi Okamoto. 

“From the end of this fiscal year, Japanese accounting requires the use of current market interest rates, and an average smoothed rate cannot be used anymore,” Okamoto said. “Previously, we could use a five-year average of historical bond yields to set the discount rate. Under international accounting standards, such smoothing is not permitted. The previous method of setting the discount rate kept the liability from changing dramatically from year-to-year; i.e. it was more stable.” 

The road to government bonds

Some Japanese pension funds have allowed their asset allocation to be more heavily weighted towards Japanese bonds as equity markets have fallen. “[T]hey have taken short-term strategic decisions to not re-balance their portfolios. Overall, pension funds are adopting a wait and see approach,” Okamoto said. 

“They have changed their asset allocation more towards Japanese bonds,” he said. “But most pension funds are now just seeing, waiting, because Japanese companies’ pension liabilities are not usually too significant compared to their total asset size. Having said this, some pension funds are considering changes. Japan may adopt international accounting standards within a few years. If so, actuarial gains and losses will likely be required to be accounted for immediately. Currently, under Japanese accounting standards, gains and losses can be amortised over, say, 10 or 15 years. But such smoothing will likely be prohibited in the near future. Structurally, many pension funds will need to consider how they invest pension fund assets in this environment.”

This wait and see and discuss approach has been reported by other asset managers.

“IAS19 may force the pension funds to reduce the investment risk,” said Russell Investments director of consulting Konosuke Kita. “We are discussing with client groups that they have some options to introduce downside protection or equities. It really depends on the size of pension fund relative to the parent companies’ shareholder capital, as related to the financials of the parent company. If the liability is very small, then the pension fund isn’t really thinking about reducing the risk. But if they have a larger deficit, they have to think of another option.”

 

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Hedge fund allocations stay the same, favoured managers and strategy change

Japanese pension funds have typically held higher allocations in hedge funds than their international counterparts – as high as 15% of the total portfolio. At the moment, it does not appear that pension funds are reconsidering the percentage of their allocation to hedge funds, but are dropping fund of hedge fund and market neutral strategies for their poor returns and failure to perform as expected.

Some pension funds had used hedge fund allocations as an extension of fixed income portfolios – a way to achieve higher than benchmark returns for the same volatility of fixed income. As mentioned before, the 10 year Japanese government bond has a yield of 1.5% – far below pension funds’ target return.

“Domestic fixed income has so little yield and corporate pension funds might have a target return of 3% to 4%,” said Nomura Asset Management’s senior manager, institutional business planning department Junji Kawahara. “The majority of asset allocation to a fixed income strategy is not enough to keep the target. They have to use another, higher return asset class. Some people have interest in the alternatives, because they have the return and the volatility is lower than they expect. But there is only one way to invest in hedge funds – you have to be very careful of liquidity and transparency.”

Those pension funds that invested in hedge funds as an adjunct to the fixed income allocation are most likely to decrease hedge fund allocations, said Goldman Sachs Asset Management, managing director, head of instituional sales and institutional product planning and strategy Shunichi Yamada.

“Some market neutral or fund of hedge fund managers had predicted volatility of 5%, which is similar to fixed incomes,” said Yamada. “Last year, fund of hedge funds reported volatility of 20% and market neutral 10%. That is far bigger than the downside of fixed income. They are now seeing that a hedge fund is not an alternative to international fixed income, so they’re decreasing those types of allocations. For those that viewed alternative assets as an independent asset class and not a substitute to fixed income, in that case they are keeping hedge fund allocations.”

Market neutral investment

Some pension funds that had previously invested in market neutral strategies are casting their eye towards strategies like global tactical asset allocation (GTAA), long/short funds or even real estate or private equity to diversify away from the market neutral managers, said Kawahara of Nomura Asset Management.

“Pension plans investing into the market neutral with lower volatility, but last year, those funds have moved down simultaneously,” he said. “They now want to invest into another strategy like GTAA or something like that. Real estate, private equity, other things like that, such as long/short funds.”

Pension funds that have grown disillusioned with hedge funds are currently liquidating their holdings and sitting on the cash for the moment, said BGI’s managing director and head of Japanese institutional business Masahiro Fukuhara.

“Some clients have put their money in alternatives by taking it out of the investment of their domestic fixed income,” he explained. “Some clients had been up to 40% in Japanese fixed income exposure and had been moving some of that to hedge funds. The performance of hedge funds has been tough. If they take it out, they have been putting it into cash, and adding it to cash taken from equity mandates.”

 

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Currency overlay grows in popularity

As pension funds have diversified into non-Japanese assets, the need to hedge against currency fluctuations has also risen. Asset managers report that pension funds have been more interested both in overlay strategies as well as in products that build in hedging as part of the return.

“We have a currency management team in Tokyo as a part of the global management team,” said State Street Global Advisors (SSgA) Japan chief investment officer Hideki Takayama. “We have seen an increasing need in this area. This is to be interpreted in the context of the managers/plan sponsors needing  to control the beta. Actually, we have received some mandates for currency overlay.”

SSgA offers three products in the Japanese market – a currency hedge fund for alpha generation, an active overlay and a strategic hedge. Thus far, pension funds have given SSgA mandates for overlay, is “about” to sign agreements for mandates in strategic currency hedging and is seeing interest in the currency hedge fund, Takayama reported.

Others are reporting discussions with pension fund clients, but no actual commitments to managing currency exposures.

“Russell clients, as a group, tend to have a higher exposure to overseas investments. We have to deal with the currency question,” said Russell Investments’ president in Japan Bruce Pflaum. “Up until now, it’s mostly been passive hedging. We have a number of clients with active currency managers – but that’s for an investment vehicle. Currency management has been long-term strategic and passive. I do believe that in line with trustees becoming generally more active in looking at the risks in the portfolio, will get more active on the currency side. We haven’t seen that yet, but we think that’s the potential trend.”

Nomura Asset Management offers clients international fixed income products that are hedged to protect against currency fluctuations to replace domestic fixed income, said Junji Kawahara, senior manager, institutional business planning dept of Nomura Asset Management, Tokyo.

“Hedging currency risk is a function of the reporting assets to pension funds – they have to care about the currency risk,” Kawahara said. “When that portion of the foreign assets exceed about 30% within total assets, they have to care about the currency risk. Sometimes they hire a currency overlay to manage the hedge, but also we propose products which already are currency hedged within each asset class. This is especially popular in the fixed income area.”

Interest rates

Hedging currency risk in international fixed income holdings may be particularly attractive now because of the difference between Japanese interest rates and other countries’ interest rates and the relatively cheap cost of hedging out currency risk, said Goldman Sachs Asset Management, managing director, head of instituional sales and institutional product planning and strategy Shunichi Yamada.

“Basically, hedging costs are really low. Hedging costs done by interest rate differential between Japan and US/UK/EU,” he said. “The short-term rate of Japan is 0% and short-term of US/EU is almost the same. To hedge that, it costs 30 basis points or something like that. This is a good time to hedge all our currency risk. For fixed income in particular, global fixed income or global corporate bonds have an attractive yield of 4% or 5%. If you’re paying 30bp for hedge, pension funds can treat it like a domestic bond.”

GSAM offers two types of overlay products in Japan – one that merely controls risk and another that combines risk with an active alpha portion. Currently, overlays that just protect against downside risk are more popular, Yamada said.

“We have both products, but we think that the risk controlled type of produces meet clients interest,” he said. We are recommending a 100% hedge at this moment.”