Japan funds’ private markets diversification proceeds slowly

Japan's top public pension funds — led by the ¥186.2 trillion ($1.7 trillion) Government Pension Investment Fund — continued adding private equity, infrastructure and real estate assets to their portfolios last year but with little to show for it in terms of lessening their reliance on equity market beta.

Masataka Miyazono, GPIF's president, in a July 2 briefing on GPIF's results for the fiscal year ended March 31, said the value of the fund's private markets holdings for the year jumped ¥397.5 billion to ¥1.34 trillion, less than half of the fund's roughly ¥3 trillion in outstanding commitments to alternatives managers.

But with last year's huge stock market rebound from pandemic lows accounting for 94% of GPIF's record ¥37.8 trillion gains for the year, that more than $3.5 billion increase in alternatives — focused on infrastructure and real estate assets — only lifted the fund's combined private markets exposures by 9 basis points to 70 basis points of its portfolio, well below the government's 5%, or $85 billion, ceiling for alternatives allocations.

That modest exposure to private markets has left GPIF's gains or losses almost entirely dependent on the ups and downs of its equity holdings since late 2014, when then-Prime Minister Shinzo Abe's government engineered a dramatic shift into stocks from domestic bonds as part of its signature "Abenomics" economic revitalization program.

Equity allocation targets for GPIF and other public funds more than doubled to 25% each for domestic and overseas stocks from 12% each, with an offsetting 25-percentage-point plunge in domestic bond allocations to 35%.

Since that time, GPIF's performance — for better or worse, but mostly for better — has been largely dependent on the gyrations of global equity markets.

The story has been similar at Japan's second-biggest public fund, the ¥23 trillion Pension Fund Association for Local Government Officials, or Chikyoren, despite differences in the two funds' approaches to private markets investments.

For example, Chikyoren over the past five years has focused on allocating money directly to managers of private equity, real estate, infrastructure and bank loans, awarding more than 35 mandates. GPIF, by contrast, has relied almost entirely on funds-of-funds managers.

But in terms of total private markets exposures, there's little sunlight between the two. For the past year, Chikyoren reported a ¥51 billion increase in alternatives holdings to ¥180.9 billion, or 79 basis points of its portfolio, up from 70 basis points the year before.

The two leading funds' continued embrace of equity market beta has produced the occasional stress test. By way of example, when the pandemic crushed global equity markets early last year, GPIF's stock holdings accounted for more than 99% of the ¥17.7 trillion in losses the fund reported for the first quarter of 2020.

Even so, to date going slow on private markets exposures hasn't been an issue.

The shift into equities seven years ago has led to "huge returns," and the market outlook remains pretty robust for the coming year or so, said Takatoshi Ito, the Columbia University professor who chaired the government advisory panel that drove GPIF's big move into risk assets in 2014.

Still, if boosting equity allocations at the expense of domestic bond allocations was "the main story" of the panel's push to raise the level of sophistication of portfolio management for public pension funds in Japan, adding exposure to alternatives was also on the agenda, Mr. Ito said in a recent interview.

On that front, Mr. Ito said progress in expanding those funds' private markets programs has been slower than he anticipated. Putting a solid alternatives investment program in place takes years but Japan's big public funds have had six or seven years to lay that groundwork and the growth being seen now "is not what I personally expected," he said.

And continued reliance on equity market beta hasn't proved problematic yet against a backdrop of consistently attractive returns from holding stocks.

Tokyo-based executives with global managers running private markets mandates for GPIF or Chikyoren cited the ongoing bull run by global equity markets as either a direct or indirect cause for the slow growth of those funds' private markets programs.

The Tokyo-based head of one global firm's Japan business, who declined to be named, said persistently strong gains for stocks have left those big asset owners facing less pressure to accelerate private market programs capable of cushioning returns in a bear market — especially in light of the career risk those pension executives would face if one of their private markets investments were to blow up for any reason.

The head of institutional sales for another global manager, who likewise declined to be named, said to some extent that slow growth is a matter of appearances: "Public funds are making steady efforts ... to build up exposures (to) private markets/alternative assets but the results haven't looked very impressive because of (the) global equity market's rally," he said.

Columbia University's Mr. Ito noted that the economic and market backdrop could change. If the U.S. Federal Reserve starts raising interest rates in 2023, "it will be an interesting moment" and maintaining large equity holdings could become less comfortable in that environment, he said.

Mr. Miyazono, in his July 2 news briefing, gave no indication that GPIF is feeling pressure to accelerate its push into private markets. While reiterating that such investments offer both diversification benefits and a liquidity premium, he said GPIF will continue to pursue high-quality assets "deliberately."

By contrast, other big institutional investors in the region say they are moving now to expand private markets programs that already dwarf those of GPIF and Chikyoren. Sue Brake, the chief investment officer of Australia's A$178.6 billion ($130.9 billion) Future Fund, Melbourne, recently said that low expectations for "bulk beta" in coming years is driving a buildup of the sovereign wealth fund's investment team in part to expand holdings of private equity, debt, infrastructure and property that already account for roughly 35% of its portfolio. South Korea's 882.5 trillion won ($765.8 billion) National Pension Service, Jeonju, meanwhile, is targeting a 15% alternatives weighting for its portfolio by 2025 from a target of 13.2% by the end of 2021.

Meanwhile, analysts contend that Japan's 5% ceiling on alternatives allocations remains a considerable hurdle to making private markets a meaningful component of public pension fund portfolios.

At that level, "it's really a toe in the water towards a longer-term meaningful exposure," said John Ross, senior vice president, risk management with Farmington, Conn.-based investment consultant Segal Marco Advisors.

For example, shifting 5% of a portfolio to a private markets allocation that may get 9% from fixed income yielding 3% to 4% can contribute directionally to a fund's returns but making a meaningful difference in portfolio returns and asset growth would require greater exposures, he said.

It's fair to say that "even at 5% the ability to have an impact is small," unless it involves allocations targeting aggressive returns of 20% or more, said Michael Sofer, principal consultant and head of strategy and business solutions with Melbourne-based investment consultant Frontier Advisors Pty. Ltd.

Frontier is moving now to leverage the experience the consulting firm has gained advising Australian clients on making infrastructure and real estate investments on behalf of other institutional clients in the Asia-Pacific region, including in Japan, Mr. Sofer said.

While conceding the big Japanese funds are moving slowly, Mr. Sofer said he has some sympathy for the challenges those investors face, both in terms of moving up the learning curve in a complicated segment of the market as well as dealing with an environment now where a flood of institutional money is inflating asset prices.

Cameron Systermans, senior portfolio manager and head of mainstream investments, Japan, with Mercer Investments (Japan) Ltd., said while client type, regulations and geographic location could factor into the details, for a "best-ideas portfolio," Mercer would "probably recommend that clients put something like 20% in private markets."

Mr. Ito said he saw that 5% ceiling in 2014 as "a good testing ground. It wouldn't be too risky and (it) shouldn't be too difficult to get there" — even if it's taking longer to reach that goal than he anticipated.

Even back in 2013 and 2014, he said his advisory panel was looking at pension funds in Canada and Europe, especially the Dutch, for good models to study — institutional investors with large allocations to private markets back then and even larger allocations now.

If his committee were brought together again today, it would likely be studying pension funds with more than 50% of their portfolios in alternatives, he said.