Japan sets example in dealing with low bond, equity returns

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Japanese pension executives — who've struggled for decades to eke out returns from floundering stock and bond markets at home — are looking less like outliers on the global scene in a post-2008 environment of weak growth and rock-bottom interest rates.

In opening remarks Nov. 13 at Pensions & Investments and Nomura Securities' 6th annual global pension symposium in Tokyo, Hideyuki Takahashi, senior managing director and head of global research at Nomura, said the challenging global outlook has helped Japan morph from “cautionary tale” to a provider of useful lessons as pension executives overseas grapple with the prospect of low bond yields and modest equity returns for years to come.

Many issues that pension executives outside Japan are preparing now to tackle were front and center at the conference, from the need to lower annual investment return targets and the subsequent ripple effects on asset allocation to dealing with benefit payouts already well in excess of new contributions for many company pension funds.

The conference, under the banner “Seeking Investment Returns — While Managing Investment and Operational Risk in Pension Funds,” was held toward the end of a year that saw due diligence issues in Japan brought to the fore by a home-grown Ponzi scheme. In February, Japanese regulators shut down hedge fund firm AIJ Investment Advisors when its president, Kazuhiko Asakawa, admitted to falsifying performance reports following derivatives-related losses of more than $1 billion.

Regulatory issues likewise made their way to the conference agenda amid recent moves by Japanese regulators to abolish a long-standing arrangement in which corporate pension executives could oversee the public pension assets of a company's employees as well. Speaking at the conference, Kiyoshi Murase, the president of Japan's Pension Fund Association, said the abrupt decision, made before any consensus had been reached among the association's members, should be opposed.

Conference panels looked at the challenges presented by a variety of asset classes and segments – from bonds and distressed debt in a low interest-rate environment, to hedge funds at a moment when scarce leverage and a market dominated by political and regulatory issues have hindered performance, and to equities following a lost decade in most major markets.

A number of speakers — including David C. Saunders, CEO of K2 Advisors LLC and Shachi Shah, a managing director and head of funds and advisory at Barclays Capital — argued for strategic partnerships with money management firms that have the skill to execute dynamic approaches to asset allocation as a key to helping pension funds squeeze out needed returns from today's capital markets.

Such relationships remain rare in Japan for now, but some industry veterans predict the pressures facing Japanese pension executives could pave the way for growing interest in the future.

The increasing complexity of investment strategies and risk control could eventually convince pension executives to take a more serious look at strategic partnerships, said Yoshinori Kouta, a partner and head of investments, Japan, with Mercer Japan Ltd.

At the conference, pension executives reported a wide array of asset allocation approaches but agreed on one thing: the need to further diversify away from Japanese equities and bonds to meet annual investment return targets that have dropped in recent years to between 2% and 3%.

For many pension executives, that amounts to revisiting the issue after moving to reduce the level of portfolio risk following the 2008-2009 global financial crisis at the request of their sponsoring companies.

Speaking on a panel looking at distressed debt opportunities, Hiroyuki Tanaka, a managing director and director of investment at Kariya, Japan-based Denso Pension Fund, which oversees investments for Japanese auto parts maker Denso's 350 billion yen ($4.3 billion) defined benefit plan, said his company's desire to reduce portfolio risk led to lifting the pension fund's fixed-income allocation to 80% from 70%, and lowering its equity target to 20% from 30%.

Even then, the need to “generate a 2% return means we have to pursue other sources of return,” said Mr. Tanaka. Distressed debt and bank loan strategies, with their perch at the top of the capital structure and their ability to gain, rather than lose, when interest rates rise, makes them an attractive option and a candidate for his investment committee's consideration, he said.

Amid a general move away from equities, some pension executives said they remain committed to that asset class, even as they concede that investments in leading Japanese market-cap weighted indexes, such as TOPIX, have been a losing proposition over the past 20 years.

Norio Kanie, managing director and director of investment for the 482.6 billion yen ($5.9 billion) Toyota Motor Pension Fund, Toyota-City, noted that his portfolio's 49% target allocation for equities is roughly 15 percentage points above the Pension Fund Association's 34% median figure for Japanese pension funds. That seven-point decline from Toyota's peak equity allocation of 56% in 1999, a fraction of the more than 20-point decline for the typical Japanese pension fund, reflects the fact that “we continue to believe in the (equity) risk premium,” Mr. Kanie said in a panel discussion.

Even so, over the past two years Toyota has favored the risk premium offered by international and emerging markets equities, dropping its target allocation for Japanese equities to 22% from 32%, while boosting allocations benchmarked against the MSCI World index to 24% from 19% and adding a 3% emerging markets allocation, he said. (The remaining 2% was newly allocated to infrastructure investments.)

This year, Toyota has moved to get better returns from its domestic equity allocations, shifting 10 billion yen in May away from the long-suffering TOPIX index to a concentrated portfolio where investment skill in finding strong Japanese companies can help the portfolio achieve its 3.3% annual return target, he said. In addition, Mr. Kanie said he's studying alternatives now to market-cap-weighted indexes, such as fundamental and low-volatility indexes, as well as high-dividend-paying equity strategies.

Some pension fund executives have already moved sharply away from Japanese bonds and equities over the past few years.

Yoshisuke Kiguchi, a former Russell Investments consultant who became chief investment officer of the 40 billion yen Okayama Metal & Machinery Pension Fund, Okayama, said alternatives strategies now account for 72% of his portfolio, up sharply from 15% five years ago. Private equity has a 25% allocation while hedge funds take 23%, with insurance-related and multiasset-class strategies accounting for much of the remainder.

Speaking at the conference, Yoshihiko Sato, fund manager of the 46 billion yen pension fund for information technology systems provider NEC Fielding Ltd., said his fund's allocation to Japanese equities has dropped to less than 1% of the portfolio today — as part of a 10% investment in global equities — from 20% just before the crisis.

The fund's fixed-income allocation is entirely invested in corporate bonds, with 29% in domestic and 22% in international. Under a risk-based asset allocation framework, another 4% is invested in emerging markets debt, 3% in emerging market equities and 2% in high-yield debt, said Mr. Sato.

Alternative investments account for the bulk of the remainder, with a 20% allocation to hedge funds, 4% to private equity and another 4% for a strategic partnership with BlackRock (BLK) Inc. (BLK), Mr. Sato said. A 2% cash allocation rounds out the portfolio.