Japanese Institutional Investors

Institutions dominate the investor landscape in Japan. By far the largest investors in hedge funds have been the insurance companies. The banks represent the next largest investor group with a growing number of corporations starting to make allocations. Corporate pension funds, which until several years ago shunned hedge funds altogether, have discovered the asset class and are now the fastest growing investor group. Although still small in total value, the rate of growth and sheer size of total assets could quickly move pension funds to a leading position in terms of total investments.

Insurance Companies

Although some of the insurance companies were already investing in hedge funds in the early 90’s, the large shift towards alternatives came near the end of the decade when low interest rates and a weak equity market increased the attractiveness of absolute returns available in hedge funds. Premium income and cash were invested in low yielding government bonds and the domestic equity market. The negative spread between the low investment returns and the higher yield payout guaranteed to policy-holders attributed to a loss of Yen 1.5 trillion in 2001 alone. In financial year 2002-3, the average guaranteed rate of return paid by the 10 largest Japanese insurers was 3.31% compared to the 2.41% they earned on investments. Even with the advent of variable rate policies with an extremely low guaranteed floor of 1.5%, insurers were often unable to meet their targeted rate of return. As a result a few insurance companies started to make large allocations to hedge funds and soon most of the others followed suit. Collectively the allocation was substantial with investment into both fund of hedge funds and direct investment into single funds.

Yet, despite the sheer volume of investment, even the largest investor, who at their peak had nearly four billion dollars allocated to hedge funds had at that time not even 2% of their total assets in the asset class. This was not nearly enough to make a difference to their overall portfolio returns. Whilst insurers in general have been steadily increasing their investments in hedge funds, some of the largest allocators have significantly reduced the size of their hedge fund portfolio. Despite this kind of short-term tactical change in exposure to the asset class, any decision to make meaningful allocations to hedge funds will result in a massive flow of investment capital into hedge funds.

Initial allocations to hedge funds were via fund of hedge funds with only two insurance companies investing exclusively in single managers. Now that most insurers have core positions built up in fund of hedge funds, they are actively investing in singe managers. The preference has generally been in equity long/short, market neutral, fixed income arbitrage, and other low volatility strategies. Although global macro and CTA funds were avoided after the LTCM debacle, recently they have begun to be looked at again as possible strategies to invest in.

Life Insurance Companies ­ Investments in Hedge Fund (March 31st 2003)
	2002 March	% Of Assets	2003 March (est.)	% Change
Nippon Life	1,300	0.3	1,300	0.0
Daichi Life	1,100	0.4	1,300	18.2
Sumitomo Life	3,700	1.7	3,700	0.0
Meiji Life*	750	0.5	900	20.0
Asahi Life	500	0.6	500	0.0
Yasuda Life*	1,700	1.8	3,500	105.9
Mitsui Life**	250	0.3	300	20.0
Total	9,300	0.7 (average)	11,500	23.7

Source: Nikkei Kinyu: July 1st 2003

*Yasuda Life & Meiji Life merged in January 2004.

**Mitsui Life has demutualised and is planning a stock market listing.

Amounts are in units of one hundred million Yen.

This table only shows the investments by the top seven life insurance companies, there are numerous other life companies as well as casualty companies that are actively investing in hedge funds.

Banks

Banks began increasing their investments in earnest in the late 1990’s. They too were looking for alternatives to cash, Japanese Government Bonds and domestic equities. Commercial banks such as the Sumitomo Bank (now Mitsui Sumitomo) as well as quasi government banks like the Norinchukin Bank were quite active from the early days. Some have grown their portfolios to levels that rival the allocations made by large insurance companies. Like the insurance companies the banks initially focused predominantly on fund of hedge funds. However, more recently they have begun to focus on investments in single managers.

Particularly interesting was the entry of the regional banks into the market. Regional banks were looking for any kind of absolute return strategy that could potentially balance the losses in their equity portfolios and the lower yields of their JGB holdings. Two important factors that regional banks require when selecting funds are liquidity and the payout of returns on a regular basis. Low volatility, high Sharpe ratio, a high level of assets under management and a lengthy track record are also important elements in the selection equation.

The trust banks mainly invest in hedge funds on behalf of their pension fund clients. As of May 2003, it was reported that Sumitomo Trust Bank had invested some Yen 180 billion in alternative investments, primarily into hedge funds on behalf of pension funds. Recently however Trust Banks have begun to invest on their own account as their balance sheets have begun to recover.

In addition to investing for their own account, many banks have started to adopt hedge fund products for sale to their retail client base. Since 1999 when banks were allowed to enter the investment trust and fund distribution business their share of mutual fund sales has risen from zero to 40% of the market. Although hedge fund product sales are in their infancy, we expect that banks will become a major distribution force over time.

Pension Funds

In 2003, according to data from the Japan Securities Investment Advisors Association, total pension assets under management were Yen 341.505 trillion. 61% of this was in public pension funds with the remainder being private pension funds.

Recent surveys by pension consultants and money management groups all point to an increase in the number of Japanese institutional investors allocating assets to hedge fund with commensurate increases expected in the future. The preferred strategy remains equity market-neutral and equity long/short, although based on the performance of these strategies over the last two years we believe that Japanese investors are considering other single strategies with interest.

Until recently amongst the major institutional investors, pension funds have only made up a small percentage of institutions investing in alternative investments. A recent joint survey conducted by Frank Russell Co. and Goldman Sachs Group Inc showed that Japanese pension funds are expanding their investments in hedge funds. In 2003 an average of 7.1% of their assets were invested in these vehicles. With interest rates at such low levels pension funds were using hedge funds as an alternative to Japanese bonds. The survey predicted that Japanese pension funds will invest an average of 8.5% in their assets in hedge funds in 2005. The survey included responses from 49 pension funds.

A survey released in September 2003 by Greenwich Associates found that 18% of pension funds had invested in hedge funds while 17% intended to start.

Pension funds, such as the East Japan Stationery Sales Pension Fund, which manages 55 billion yen, are increasing their weightings in alternative investments. The fund plans to raise the weighting of alternative investments in its portfolio from the current 16% level to 25% in fiscal 2004. The rationale behind this move was that investments in alternative products had been effective in smoothing the volatility in its portfolio and reducing downside risks in the stock market.

Public Pension Funds

Pension Welfare Service Public Corporation (Nenpuku). Up until fiscal 2000, Nenpuku was the active government arm managing public pension funds. They managed JPY 27 trillion that was “lent” to them from the Trust Fund Bureau at an interest rate of 5%+. Part of this (JPY 3.5 trillion) was managed in-house with the remainder entrusted to private investment institutions. However, the low interest rate environment combined with the high interest charge from the TFB and weak performance of funds caused massive bleeding and sparked an overhaul of the system.

In 2001 Nenpuku was abolished and in it’s place the Government Pension Investment Fund (GPIF) was established. The GPIF inherited the massive loan Nenpuku had with the FLF however plans to pay it all off by 2010 by returning around JPY 3 trillion each year. On the other hand, the FLF is returning, each year, some of the JPY 130 trillion yen they manage, to the Special Pension Account of the Ministry of Health, Labour and Welfare. This will be completed in 2008. As the funds come into the Special Pension Account, they are entrusted to the GPIF for management. Thus, over the next 5 years it is expected that the AUM of the GPIF will grow to over JPY 130 trillion.

When the GPIF was formed, the head of the Pension Fund Association, Mr. Noboru Terada, was appointed as its head. According to the Financial Times (FT) (December 18th, 2003) the GPIF which currently manages USD300 billion plus is in discussions to allow it to invest in hedge fund and other alternative investments. The FT claimed that the move which would represent an official stamp of approval from the Japanese government would clear the way for a potentially huge transfer of funds into alternatives once other public pension funds followed suit. If the GPIF were to match current U.S. average pension fund weighting of 7.5% that would translate into potential investments of USD 22.5 billion. The FT believes that the GPIF is considering an initial allocation of 1% (USD 3 billion) alternative investments. It was interesting to note that within 24 hours of Mr. Terada’s comments that the GPIF was considering an investment into alternatives being reported, Nomura Securities Investment Mgt Co., Ltd and a whole host of other asset management firms had announced plans for domestically registered long short hedge funds. The explosion in the number of Japan domiciled domestic hedge funds (Teneo Partners estimates there are more than 100 of these vehicles) mostly unknown to foreign observers, acted as a catalyst for investments by pension funds.

Private Pension Funds

Two groups, the Pension Fund Association (PFA) and the 1,623 member, Corporate Pension Funds (Kosei Nenkin Kikin), manage private pension funds. The PFA is the “home” for pensions that are no longer managed by the corporations either through early retirement of an employee or for companies that don’t have their own funds. It is also the governing body for corporate pension funds. AUM of the PFA is Yen 7.1trillion, which has grown over the past several years due to the weak economy (many early retirement packages). The current investment breakdown is 37% domestic bonds, 30.7% domestic equities, 8.3% foreign bonds, 22.5% foreign equities and 1.4% other. 26.9% is managed by trust banks, 50.5% managed by investment management companies, and 22.5% managed in-house. To date there has been no investment in hedge funds although the PFA did begin investing a small portion of their funds into corporate rehabilitation funds from 2002.

The Corporate Pension Funds manage an aggregate JPY 52 trillion. Scattered throughout the country, they are typically company specific, for larger corporations and cooperatives or union related for smaller companies that can’t afford their own pension fund. The breakdown by type is as follows: 477 independently established (specific corporate), 601 cooperative (sogo) and 545 union (rengo) funds. The company specific pension funds have been allowed to invest the portion of pension funds collected that normally must go directly to the government (called daiko). A guaranteed rate of 5.5% was set on those funds. The company was allowed to keep returns over and beyond the hurdle rate of 5.5%. This was an attractive option when interest rates were high and the equity market was booming. However, recently it has created liabilities on corporate balance sheets due to underperformance of the funds. The guaranteed rate was reduced to 2% but this was still seen as too high in the prevailing environment. As a result many corporations have opted to return the funds to the government (the much publicized “daiko henjyo”). As of Sept 1 2003 there were 161 pensions holding daiko funds, a dramatic reduction compared to one year earlier in 2002.

In addition to these funds, just over JPY 20 trillion is managed by trust banks in Tax-Qualified Pension Plans. These are being phased out and will eventually change to Defined Contribution Plans.

Please note a Discretionary Investment Management license (DIM) or a Trust Bank license is necessary to manage money for Japanese pension accounts.