No Surprise! Japanese Pensions Still Want Hedge Funds

"The best leaders are apt to be found among those executives who have a strong component of unorthodoxy in their characters. Instead of resisting innovation, they symbolize it - and companies cannot grow without innovation."

David Ogilvy, b.1911
founder, Ogilvy and Mather

A recent Greenwich survey of361 Japan pension funds turned out to be one big yawn. Released with apparent fanfare (courtesy of the F.T.) it was notable in what it didn't say to the world regarding the status of hedge funds and the whole plethora of alternative investments.

If only so-called experts would clarify what exactly they are talking about!

First, we are apparently blinded by meaningless data related to financial institutions. The last time I looked, pension plans did not fall into that universe. We are informed that F.I.s have raised their overall allocations to alternatives from 63% in 2006 to 70% in 2007. We are informed that hedge fund allocations have decreased from an average of just under 5% in 2006 to 3.1% (of total assets) in 2007.

Sadly, it should be pretty plain to the international community (unless you have been living in a hole the last 3 years) that Japanese financial institutions, and specifically bank and bank-like institutions, have been subject to more stringent BIS regulations that have impacted negatively their willingness to take on more hedge fund product due to their higher capital requirements.

Another reality and side-effect of this was that many of these same institutions were the same ones that piled into high-yielding CDOs and sub-prime related structures as a way to goose their returns. We are now finding how deep they were involved in this mess.

The same cannot be said for Japan's pension funds which do not have short time horizons and certainly are not so concerned with mark-to-market valuations.

Back to Japan's pension funds. The US$1.068 trillion assets that the 6,000 pension funds manage in Japan have actually been bulking up on HFoF and single managers over the last 3 years - and in big amounts. This has taken place at the same time as a shake-out in FoHF "brand name" market shares (losers being Ivy and FRM) due to disappointing performance. On the traditional side their collective portfolios have been taken a whack from continued depression in the domestic stock market in addition to a declining US $ hitting U.S. denominated assets namely equities and U.S. Treasuries.

Today, hedge funds have penetrated into about 75% of Japan's pension market versus 65% in 2006. That makes it about 4,500 pension plans. The types of investment and the scale of their investments is better understood if one examines the alternative survey that was put together by Daiwa Pension Consulting not too long ago (and covered in a previous blog here).

Interestingly, this had already flagged the fact that pensions had been aggressive buyers of CDO and other structured products (yikes) in addition to being big buyers of private equity whether in "fast" economies like India or China or even in the U.S. It also pointed out that continued demand for private equity remains quite strong.

The Greenwich survey should have focused on how distribution channels have become far more competititive in the way product is sent into the pension market. It is no longer only the sole "property" of consultants and trust companies but now includes banking intermediaries too who are trying to loosen up the market offering white-label managed accounts and other vehicles that address the institutional demand for transparency. The other side of this is that many of the investors are still very interested in high octane products be they macro, commodity, managed-futures related or focusing on the "fast growth economies".

This author believes that the amount of Japan pension fund exposure to hedge fund products is likely to be understated in the Greenwich figures. First, their survey is skewed to the biggest pension plan in Japan. However, as a Columbia University study in this area 2 years ago stated, unlike in the U.S. and Europe, in Japan the smaller the pension plan the higher their allocations to hedge funds. The reverse is true in the U.S.

Second, as long ago as 2004/05 many pension had portfolio exposure running at around 8-11% of total AUM with some of the most "advanced" having up to 30% of their AUM in hedge fund assets. Admittedly there was a lot of "catch-up" that went on simply to make up for their overall portfolio poor performance that had been a feature of pension investing over the last 5 years.

Perhaps the biggest take-away in the Greenwich findings is something that has been apparent in the U.S. - that institutional investors are making decisions now regarding their "core" equity holdings. Like in the U.S. there is the clear problem in Japan among pension plans that their U.S. equities and U.S. fixed income has lagged in performance terms relative to international.

In Japan the issue is more marked as the Nikkei 225 Index or other equity index benchmark have pretty much sucked wind or been negative over the last few years. Meanwhile, the JGB market have remained at extremely low yielding levels for almost a generation! As a result, Japanese institutional investors have abandoned their own equity markets putting more moeny abroad and into the JGB market. This posture is evident in Tokyo Stock Exchange data that points to a dwindling % of market capitalization since 2003 of domestic institutions including banks, trust companies and lifers.

So the real question should be "what is the methodology that a pension plan should adopt to deploy assets related to their "core" equity allocation?" Also, what is the role of active absolute return strategies. THIS is the REAL challenge and opportunity facing hedge funds, fund of hedge funds and the investment community at large. It is not simply selling their products into a channel in Japan. Getting that figured out will be the real surprise for pension funds as well as hedge fund marketers. Mahalo.