Japanese Pensions Remain Positive on Hedge Funds

"The person who is devoted to paperwork has lost the initiative. He is dealing with things that are brought to his notice, having ceased to notice anything for himself. He has been essentially defeated in his job."

Professor C. Northcote Parkinson (1909-1993) author of "Parkinson's Law"

The pension consulting arm of a prominent Japanese broker speculated that as of 2006, Japanese institutional investors held approx. US$50 billion in hedge fund product (single managers, fund of hedge funds and structures). That is an ambitious number considering that an estimated US$7-10 billion of hedge fund product may have been redeemed over 2005 by financial institutions in Japan due to worries surrounding BIS (Bank for International Settlements) treatment of the equity exposure in hedge fund products and the impact that would have on their balance sheets.

The survey examined attitudes to alternative investments and the results pointed to a big difference among Japanese financial institutions and pension plans. The former are typically invested in REITS, private equity and CDOs and CLOs, while the latter prefer hedge funds.

The real eye opener was in terms of Japan's pension fund exposure to hedge fund product. Over 36% of pension plans have between 5-10% of their total assets in hedge funds while 27% of them have over 10%. This compares with a relatively low 1-2% exposure by US pension plans. Even the early adopter public pension plan CalPERs has only 2% in hedge fund product to date!

What does this mean? Clearly if we assume that 500 pension plans currently have exposure to hedge funds and the total universe size is 4,000 ( in reality is is 6,500) then there is still a great wave of pent-up demand in the pension fund market waiting for scalable products to invest in; especially if the average fund has somewhere between 8-14% of their assets in hedge fund products with the bulk of the single manager investments falling into equity market neutral strategies followed by long short equity strategy and less than 10% in other types of strategy.

Equally important, the survey pointed to the fact that many pension plans consider hedge funds as a substitute asset class to JGBs or domestic fixed income. Over 60% of pension respondents expect a return of 5% from their hedge fund investments. These facts suggest that Japanese investors are still relatively keen on stable, modest returns on their hedge fund investments as they have always been, and so hedge fund managers and promoters of product would be wise to remember that. On the other hand, financial institutions have a slightly different view, including higher return expectations - with over 50% of them expecting returns from hedge funds in the 5-10% range and 12% in the 10-20% range.

In reality, Japan's pension market probably soaks up over US$20 billion in product so far but the growth potential is phenomenal- not only for HFoF but single managers too. Until recently, a problem has been the relatively low level of research, education and conflicts facing distribution channels to that market. Many trust banks have legacy relationships, more often than not exclusive with US and European based product providers, which can lead to a feast or famine type of situation that Sumitomo Trust and Banking experienced following their fateful adherence to FRM products. In the beginning the products flew of the shelf, and when performance headed south redemptions hit them in waves. The consultants are now setting up to sell and market products. The interesting thing will be to see which approach they take, one that is indpendent or one that is married to particular hedge fund products?

Building trust is not an easy thing when fee paying relationships are involved. Just ask the CIO of any Japanese pension fund. Mahalo.