Japanese pension funds' tilt to risk likely a manager boon

An unprecedented move into risk assets by Japan's large public funds will present money managers with challenges but even bigger opportunities in coming years, industry executives say.

Roughly $400 billion in public pension fund money could flow to domestic and international equities from Japanese government bonds within a few years, “a huge opportunity for fund managers around the world,” Takumi Shibata, CEO of Nikko Asset Management, Tokyo, said in an e-mail.

That opportunity will not come easily, however.

The concentration of assets in a small number of hands, led by the ¥137 trillion ($1.14 trillion) Government Pension Investment Fund, Tokyo, is poised to magnify the importance of their choices in Japan's money manager marketplace.

In Asia's biggest institutional marketplace, managers could find themselves with “very few at-bats,” in comparison with a big, fragmented pension market such as the U.S., said Daniel Celeghin, Hong Kong-based partner and head of Asia-Pacific for Casey, Quirk & Associates LLC, a strategic consultant to the money management industry. If the biggest public funds turn negative on a particular manager, opportunities for that firm could quickly evaporate, he said.

In the market environment developing in Japan, winning business from big public funds has to be a cornerstone of any manager's institutional business plan, said Alex Sato, CEO of Invesco Japan, Tokyo. And the bar for taking advantage of those opportunities is rising, with top-quartile performance needed to come to the table, he said.

Other ripple effects from the concentration of public money in Japan could include further fee compression and greater allocations to passive or systematic “smart beta” offerings, as opposed to actively managed strategies, analysts predict.

But Nikko's Mr. Shibata predicted any negatives will be outweighed by the positives.

In an ideal world, a wide spectrum of asset owners and asset managers would be the foundation for a healthy pension industry, but “Japan does not live in an ideal world,” he said. He cited such structural problems as a large number of small pension funds struggling to meet their defined benefit plan obligations.

Among those funds are the country's multiemployer plans, with more than ¥15 trillion in combined assets. They are slated to be absorbed into the GPIF over the next five years, after struggling to recover from sharp declines in funding levels during the global financial crisis.

Because these funds have an industry-high allocation to alternatives of 17% and are relatively willing to extend allocations to startup managers and boutiques, their dissolution will be a matter of regret for the money management industry, noted Invesco's Mr. Sato.

However, the current “large-scale reallocation of assets” toward a level of diversification more in line with global best practices should prove beneficial, said Mr. Shibata.

The GPIF's Oct. 31 decision to more than double its targets for domestic and international equity allocations to 25% apiece from 12%, while slashing Japanese government bonds to 35% from 60%, has dominated the spotlight, but other public funds have since followed suit.

Last month, three sizable Tokyo-based public funds — the ¥18.9 trillion Pension Fund Association for Local Government Officials, the ¥7.6 trillion Federation of National Public Service Personnel Mutual Aid Associations and the ¥3.8 trillion Promotion and Mutual Aid Corporation for Private Schools of Japan — announced the same equity and foreign bond targets as the GPIF.

Nikko's Mr. Shibata said six other funds are considering similar shifts. Taken together, the 10 funds' plans would spell a “massive shift” of up to ¥23.6 trillion into domestic equity and an equal amount into international equities, he said.

Like Mr. Shibata, Sadayuki Horie, a senior fellow at Nomura Research Institute Ltd. , Tokyo, and deputy chairman of the GPIF's investment committee, said he's “quite optimistic” about the opportunities for money managers now, in part because of a “drastic” change underway in the willingness of public funds to pay for performance.

With Japan's aging demographic profile weighing on the country's corporate pension fund assets, money managers are likely to see public pension funds eclipse corporate funds as a source of revenue in the coming five years, predicted Mr. Horie.

Foreign money managers are especially well-placed to benefit, industry executives say. There should be “very good opportunities,” particularly for firms with skill sets in international equities and bonds, said Taeko Sumiyoshi, managing director of financial industry consulting firm Greenwich Associates LLC's Tokyo office.

Japanese managers will benefit as well, but the pressure they'll face to upgrade their capabilities could be more intense.

For locals, “it's more of a double-edged sword,” said Casey Quirk's Mr. Celeghin. With the GPIF's focus on a higher-risk, higher-reward tradeoff, the days of a big Japanese manager going to the pension giant with a “plain vanilla” strategy are over, he said. There'll be growing pressure to add value, he added.

Industry veterans pointed to the GPIF's shakeup of its domestic equity manager lineup a year ago — in which overseas managers outnumbered Japanese managers for the first time, 10 to 4 — as evidence of that higher hurdle for local firms.

Corporate pension funds remain an important part of Japan's institutional landscape, but in recent years the typical allocation from that market segment has fallen to $20 million or $30 million, noted Mr. Sato. Five or 10 years ago, $100 million allocations were more common. That trend makes the hefty allocations big public funds can offer stand out further in any ranking of business opportunities, he said.

An executive with one foreign manager, who declined to be named, said for capacity-constrained strategies, the trade-off of big allocations for low fees won't work. For such strategies, “everyone wants to be on the GPIF's manager list ... but only as one of their smaller managers,” he said.

But Nikko's Mr. Shibata predicted managers of capacity-constrained equity strategies — such as the concentrated portfolios with 30 to 40 holdings on which Nikko Asset Management has focused — will find ample opportunities in the current environment. “The asset owners realize that capacity constraints exist, so they're prepared to hire as many managers as necessary as long as they can deliver true alpha,” he said.

Meanwhile, a number of managers said the GPIF's investment team has become less willing to suffer through periods of underperformance, and quicker to terminate managers. “Their horizon is getting narrower ... it used to be five years, now it's down to three years,” said another money management executive, who also declined to be identified.

And some market watchers predict talk of breaking up the GPIF into smaller pieces could surface again, perhaps when the GPIF moves to invest in capacity-constrained areas such as private equity or hedge funds.

However, Yasuhiro Yonezawa, chairman of the GPIF's investment committee, said that topic isn't on the committee's agenda.