New GPIF program puts focus on fees

Managers of active strategies for the world's biggest pension fund are going to have to start singing for their suppers.

Japan's ¥162.8 trillion ($1.6 trillion) Government Pension Investment Fund was to roll out performance fees on April 1 that reward active managers in proportion to the alpha they produce, while paying only passive fees for those who come up empty-handed, confirmed Naori Honda, a Tokyo-based spokeswoman for the fund.

Ms. Honda declined to detail how a manager's fees will rise as the alpha it delivers increases.

Executives with the fund's managers, who declined to be named, said negotiations between GPIF and individual firms over the fee arrangements continued in the days leading up to the launch of the new regime. Each firm is being asked to set a target for the alpha it believes it can deliver, as well as delineating the market cycle over which it should be judged.

Some managers said they expect the new fee arrangements hammered out to be fairly uniform for firms in the same asset class; others expect a much wider dispersion. For GPIF, this is "very much an experiment," to see what works and what doesn't, said one ​ executive with an overseas bond manager who declined to be named.

Under GPIF's current fee structure, managers have been able to choose between a fixed fee and a base fee/performance fee combination. The performance fee has been capped at a maximum rate that made it a less-than-compelling option, some managers contended.

Tough new rules

Executives with some of the GPIF's more than 50 active managers described the new structure as tough, even if the removal of the cap on performance fees provides more potential upside. For example, the new arrangements include high-water marks, obligating managers to make up for any underperformance along the way to meeting their alpha goals over a market cycle. Trailing the benchmark would count as a "debit," and "unless you pay your debt, you won't get credit," said the overseas bond manager.

An executive with one GPIF manager, who declined to be identified, said as Japan's marquee client, the GPIF can set its own rules — but his firm would have preferred to continue enjoying the certainty fixed fees provide.

GPIF Chief Investment Officer Hiromichi Mizuno, in a November interview, was less than sympathetic, saying managers must stand ready to revise their business models to achieve better alignment with clients.

The "most common reaction we receive is 'that will make our revenue very volatile,' " said Mr. Mizuno. "My answer to that is: How would you react if your portfolio companies' executives (were to) say that to you?"

Income is volatile in every industry, and executives have to deal with that, he said, noting that the money management industry has been "too well paid" and too slow to adapt.

GPIF's fee initiative suggests Mr. Mizuno​ — who has said the $1.6 trillion behemoth should focus on improving beta by leading in areas like environment, social and governance matters — is looking to make progress in alpha as well. Roughly one-fifth of the fund's portfolio is actively managed.

It's an area in which the fund has enjoyed little if any success over the past decade. For example, the latest annual report shows GPIF's overseas equities managers as a group underperforming their benchmarks by 58 basis points and 48 basis points for the respective five- and 10-year periods ended March 31, 2017.

Active domestic equity managers, meanwhile, added an annualized 23 basis points over the past five years but trailed by four basis points for the 10-year period.

Mr. Mizuno attributed that performance, in part, to the fund's managers taking a more cautious approach than the GPIF would want. "Very few asset managers ever use the risk budget we agreed with them," he said, even though "we keep telling them we are conservative enough as a whole."

Some managers said they believe GPIF's previous capped performance fee structure could have discouraged risk taking. Under that system, it was easy to conclude "if we don't get (rewarded), why take unnecessary risk," said one.

Carrots and sticks

The new system, by contrast, provides carrots as well as sticks to entice managers out along the risk spectrum — with modest passive fees for those who fail to beat their benchmarks and potentially handsome revenues for managers who hit the ball out of the park.

An executive with one active manager not now in the GPIF lineup speculated the new fee structure should be a lot easier to embrace for "new guys like us," trying to win GPIF as a client, than for managers whose stable, fixed-fee arrangements are being replaced by a much tougher system. Some might even resign because the fixed fee is so low, he predicted.

GPIF executives insist their goal in introducing the new fee structure isn't to lower the fund's total fee payments. They've said they're willing to pay more, if they can get value for their money.

For the fiscal year ended March 31, 2017, actively managed stocks and bonds, both at home and overseas, accounted for 22.65% of GPIF's portfolio, up from 20.72% the year before.

For the fiscal year, actively managed bonds as a proportion of total bond holdings rose, while actively managed stocks declined.

In the interview, Mr. Mizuno said achieving a better alignment of interests with managers was a prerequisite to boosting mandates to active equity managers.