Seeking alternatives in Japan

Newly empowered pension managers are experimenting with foreign hedge funds, private equity and real estate trusts for the first time - anything to avoid the Nikkei 225. Can they make a go of it?

By Charles Smith
July 2001
Institutional Investor Magazine

Isao Ishiyama doesn't have the résumé of a radical. The soft-spoken 64-year-old executive at the East Japan Stationery Sales Pension Fund joined the Ministry of Health and Welfare out of high school and ultimately became a manager at the giant bureaucracy's Nagoya office. He left in 1990 to become an inspector for the national health insurance system. In 1996 he moved into his current post, managing a pooled

investment fund for 650 mostly small and midsize stationery shops and wholesalers. During his spare time, Ishiyama likes to photograph flowers.

So it came as a surprise to some of his pension fund peers when Ishiyama opted to put a hefty 13 percent of his pension fund's ¥60 billion ($488 million) into hedge funds, mostly U.S.- and European-run outfits like the asset management arms of Merrill Lynch & Co. and UBS Warburg, that invest in overseas equity markets. By pension standards in Japan - where a hedge fund investment is still unusual, and even progressive funds rarely chance more than 5 percent of their funds on the asset class - that's a huge bet. To Ishiyama, though, it's also a sensible one. "We must keep up returns when the [domestic stock] market underperforms, and, to do that, we need risk dispersal," he says.

Ishiyama's interest in hedge funds and the entire universe of alternative investments is shared by practical-minded pension managers at Sony Corp., telecommunications giant KDDI Corp., computer systems developer CSK Corp. and security systems provider Secom Co. as they begin to flex their muscles in a newly deregulated investment world. Some of these funds are building sizable real estate trust portfolios (considered an alternative investment in Japan). Others are making initial commitments to U.S. or European private equity funds to diversify their holdings or, like Ishiyama, employing fund-of-funds managers to oversee long-short and market-neutral equity strategies to protect themselves from the poorly performing Nikkei 225 index. More-adventurous pension managers are eyeing high-yield bonds and merger arbitrage funds. Barring a major problem or subpar returns for some of the pioneers, more sponsors are expected to follow. And if Japanese versions of these products aren't available, the pension funds, which invariably refer to their new activities by the English term "alternative investments" rather than the Japanese daitai toshi, seem perfectly happy to expand their new relationships with foreign firms.

Toshimichi Sagawa, a consultant at Watson Wyatt K.K., one of a handful of Tokyo-based firms offering advice on these new areas, says that 60 or 70 big funds on his client list expect to double or triple their allocations to alternative assets this year. It's just the start: Sagawa predicts that, within five to ten years, up to 15 percent of the ¥71 trillion worth of

assets controlled by the two main classes of corporate pension funds will go to alternatives, bringing Japan close to parity with current U.S. allocations. As recently as five years ago, the notion that Japanese sponsors of employee or tax-qualified pension funds would devote a significant portion of their money to a relatively new, mostly foreign-dominated asset class would have been laughable.

"Alternatives are a drastic departure for Japanese pension funds," says Takeshi Kadota, president and CEO of Mitsubishi Corp. Capital, an investment advisory firm owned by trading company Mitsubishi Corp. "To appreciate the pace at which things are changing, you have to realize that, until recently, corporate funds weren't even heavily into equities."

At least among a small group of Japanese pension funds, much is changing. Consider Ishiyama's decision-making process for his hedge fund investments. He spent portions of the past two years studying the area and brought in 21 asset management firms, 17 of them foreign, to make detailed presentations on their style, strategies and holdings. On April 1 of this year, his 11-member investment committee, mostly presidents of stationery retailers in the Tokyo area, approved his recommendations. Shortly thereafter, six winners were named. Only one, SG Yamaichi Asset Management Co., an affiliate of France's Société Générale, had ever worked for the stationers before. New relationships were struck up not only with Merrill Lynch and UBS Warburg but also with Gartmore Asset Management and two Japanese firms - newcomer Sparx Asset Management Co. and Nissho Iwai Asset Management, a three-year-old subsidiary of one of Japan's major general trading companies - that run domestic hedge funds.

Though alternative investing is standard practice elsewhere in the world, Ishiyama's review and subsequent action plan hint at how different the new environment is. When he joined the stationers, their pension fund was allocated entirely to general accounts at Japanese life insurers or commingled funds run by trust banks. The life insurers guaranteed a 2.5 percent return each year but didn't reveal more than the barest of details about their strategy or holdings. These funds were invested in Japanese and overseas stocks and bonds, although little was known about their specific deployment at any time. The trust banks similarly provided few clues about their investment practices. Mandates from corporate plan sponsors were often awarded based on the insurer's or bank's relationship to senior management rather than performance or ability to create a long-term investment strategy. Frequently, the insurer would be an affiliate of the company's main lender.

Ishiyama finds the changed atmosphere, particularly the inclusion of foreign managers, refreshing. "Japanese [investment] companies are no good. They just chase the Topix," he says, referring to the tendency to try to match the returns of the Tokyo Stock Exchange's broadest index. He prefers working with a more diverse group of managers pursuing a variety of strategies.

The differences aren't mere window dressing. In contrast to the dominant role they once played, the trust companies now get just 15 percent of the stationers' money, and the life insurers 13 percent. The remainder is spread among investment advisory companies that specialize in a given sector. Among these are such foreign firms Pictet & Cie., W.P. Stewart & Co., ING Barings and United Asset Management, as well as domestic institutions such as Dai-Ichi Kangyo Asset Management Co., Nippon Trust Bank and Kogin Dai-ichi Asset Management Co.

There are some very good reasons

for managers like Ishiyama to search for new approaches such as alternative assets. Few markets in the world have disappointed investors the way the Tokyo Stock Exchange's Nikkei 225 has over the past decade or so. Since 1989, Japan's main stock index has lost two thirds of its value, limiting pension returns to low single digits in most years or, as in fiscal year 2000 (ended March 2001), eliminating them completely. Although figures won't be finalized until August, it's informally calculated that Japanese pension funds lost 10 to 12 percent of their assets in the latest fiscal year, mainly because of falling stock prices.

Until two years ago, however, collapsing Tokyo stock prices weren't that much of a problem for pension funds. (Indeed, Japanese plan sponsors probably lost more on their equity portfolios when the Nikkei dived in 1990-'91 than they lost in fiscal 2000, says Mitsubishi's Kadota.) Why? Until 1999, equities were listed in pension accounts at book value, so losses or gains were incurred only if a stock was sold. Since then, funds have had to mark equity holdings to market, which means that a falling stock market directly hits fund asset values and returns. For example, Nissei Sangyo Co., a Hitachi affiliate, lost 11 percent of its ¥25 billion in assets in the year to January 31 because of the plunging value of its equity holdings, according to Ken Sakamoto, a former investment manager at Yamaichi Securities Co. who manages the pension fund.

Unfortunately, fund managers like Sakamoto can no longer look to fixed-income securities to soften the blow. In September 1990, when the Nikkei index was in free fall, the benchmark rate on a ten-year Japanese government bond was 8.22 percent. In late April 2001 it was 1.335 percent - one of the lowest bond rates ever offered. The more rigorous accounting, coupled with a plummeting stock market and a low-yielding bond market, very likely made fiscal 2000 "the worst the pensions industry has ever experienced," says Kadota.

This poor performance couldn't have come at a worse time. Although estimates vary widely, everyone agrees that Japan's corporate pension plans are sorely underfunded - by about ¥70 trillion or ¥80 trillion, according to the consensus figures. At the same time, Japan's population is aging faster than that of any other major developed country; 25 percent of the population will be over age 65 by 2015. The underfunding continues despite repeated attempts to curtail benefits. In fiscal 2000, 177 companies, including such giants as Toyota Motor Corp. and Fuji Electric Co., cut their pension benefits for newly enrolled members.

Aside from punishing markets, Japanese pension funds are considering alternative assets seriously for the first time because they can. Until the mid-1990s the industry operated within a straitjacket known as the 5-3-3-2 principle, imposed jointly by the country's Ministry of Health and Welfare and Ministry of Finance. This rule required that at least 50 percent of assets (the 5 in 5-3-3-2) be invested in fixed-income securities (usually Japanese government bonds) and not more than 30 percent each in equities and foreign assets. The concluding 2 in the 5-3-3-2 formula represented the 20 percent cap on the fund's assets that could be invested in real estate.

In addition to these stifling asset allocation guidelines, as late as 1990 the MoF prohibited investment advisory companies from accepting pension fund mandates, and it gave them full access to the market only in March 1999, when pension funds were permitted to invest all of their money with advisers. Previously, portions of the funds had to be directed to trust companies and insurers, greatly limiting the selection process.

The broader range of possible investments has changed the whole job description for an investment manager like Ishiyama. "With the end of 5-3-3-2, running a pension fund has become a job for professionals instead of for generalists serving out the last five years of their corporate careers," says Hiroyuki Aikawa, 33, pension fund manager for KDDI. But Aikawa, who has gotten hands-on experience in his six years at the company, stresses that investing is still a learning process for the managers.

And not all of the experiences are positive. Even at Sony, which boasts one of Japan's biggest and best-organized funds, managers have learned that success isn't simply a matter of switching mandates from life companies to skilled professional asset managers and waiting for the money to roll in. "When we reorganized the fund in 1996," recalls Masakazu Arikawa, general manager of Sony's financial division, "we opted for what we thought was a classic allocation pattern." Arikawa moved 33 percent of the fund's ¥300 billion of assets into domestic equities, 35 percent to domestic bonds and 23 percent and 9 percent, respectively, into foreign equities and bonds. Although he still believes the initial strategy was sound, Arikawa concedes that the hostile global markets have limited his returns. Beyond that he declines to specify Sony's performance.

More recently, Arikawa has moved into hedge funds in the hope that their supposedly low correlation to stock market fluctuation will help cushion performance. About 18 months ago he began to put 4 percent of the fund's assets into market-neutral and hedge funds-of-funds. He plans to add private equity and high-yield corporate bonds before long.

Despite the enthusiasm of Arikawa and Ishiyama, other plan sponsors will have to step more carefully into alternative investments. For newcomers, asset classes with long payback periods - such as private equity - present problems. Sony, a relatively young company with a net inflow of funds into its pension plan, can afford to invest in a partnership that won't begin to realize its gains for seven years or more. However, older companies with a high proportion of pensioners may have to remain more liquid. "We won't reach the point where we have to start stressing liquidity over long-term yields for at least another 20 years," says Arikawa. Others are not so lucky.

There is also some concern over the depth of knowledge at many pension plans. A Watson Wyatt survey conducted in late 2000 turned up a disturbingly large number of small to medium-size funds managing between ¥10 billion and ¥20 billion of assets that had shifted money into funds-of-funds "with a very weak understanding" of what they were doing. Consultant Sagawa thinks a wave of investment seminars offered by U.S. and European investment banks last year "swept some pension managers off their feet."

The sheer number of funds is perplexing even to those who are knowledgeable. There are more than 300 hedge fund-of-funds managers in the world investing in an average of 25 individual funds each, says Nobuki Yasuda, a hedge fund specialist at Sumitomo Life Insurance Co. (see box). Even the most reliable gatekeeper is hard-pressed, he says, to keep track of all the opportunities - and potential risks.

Once a sponsor has narrowed his search, the evaluation can still be tricky. "Fund-of-funds performance can't be judged against conventional market benchmarks because the whole idea of alternatives is that they are supposed to perform independently of markets," stresses Tetsuo Tanimura, president of Tower Investment Management Co., or Timco, one of a handful of Tokyo-based hedge funds investing in Japanese stocks. "To evaluate them you need to look at the careers of managers and examine the consistency - or otherwise - of investment policy."

The Japanese pension fund manager's job is further complicated by the fact that most of these funds are located thousands of miles away, and few operate representative offices in Tokyo. Since top-performing hedge and private equity funds close to new investment quickly, they rarely need to market their services as far away as Japan. As a result, KDDI's Aikawa and Shunzo Tamai, executive director of Secom's pension fund, tend to be suspicious of firms that market heavily: It could mean the fund has a problem they are unaware of.

What has evolved in Tokyo to deal with some of these obstacles is an informal information network among pension fund managers. Aikawa says he relies heavily on personal contacts at other big corporate pensions funds to spot the best U.S. fund-of-funds managers. "One of the good points about this business," he notes, "is that we're not directly competing with each other, so we can pool information." He's proud of identifying one San Francisco-based venture capital fund-of-funds investment opportunity, which he declines to name, shortly before it closed to investment.

Others have developed their own rules of thumb for alternative investing. Tamai says he won't buy any fund that doesn't allow him to exit in less than two weeks. Tamai also buys small stakes initially, permitting him to get comfortable with the fund's operating style and performance - without undue risk. "Buying alternative assets is much like sampling the free cheese niblets in a department store," says Tamai, who, with three years of experience, is an alternative-investing veteran by Japanese standards. "You try a little bit and then buy some more if it tastes okay." To date, Secom, which aims to keep 5 percent of its assets in alternatives, has made more than a dozen investments in foreign and Japanese bond, stock and currency hedge funds, generally using Tokyo-Mitsubishi Securities Co. as gatekeeper.

The paucity of local alternative-investment vehicles is, in part, a result of Japan's recent economic history. Venture capital and other forms of private equity have only lately come to the fore in Japan because entrepreneurialism didn't develop the way it has in places like the U.S. Japan, after all, owes most of its postwar success to the emergence of huge companies working closely with the government, the banks and one another. Until the late '90s, workers had virtual guarantees of lifetime employment in big companies and, therefore, few incentives to start their own enterprises. As a result, an IPO market generating growth capital for business builders and an exit vehicle for financiers has come to life only in the past couple of years with the creation of Nasdaq Japan and the Tokyo Stock Exchange's Mothers marketplace. Although Japan's recent restructuring, together with a host of successful new high-tech start-ups and a booming IPO market, is putting more emphasis on small companies, private equity is still in its infancy.

Because of Japanese managers' inexperience in these areas, some plan sponsors are skeptical of homegrown product. At computer systems maker CSK, pension fund manager Hiromi Sugiyama believes that Japanese asset managers are still too bureaucratic and "committee-bound" to move in and out of fast-moving markets as quickly as traders in others parts of the world do. Their skill levels, at least in overseas markets, haven't advanced far enough to merit serious commitments of cash, in his opinion. "Their approach," he says, "is too simple."

In the interim, Japanese hedge funds, for instance, have borrowed what U.S. expertise they can. Timco president Tanimura, a U.S.-educated ex-Nomura Securities Co. manager who once worked for Credit Suisse First Boston's Osaka branch, says his firm has looked for managers with New York experience. Timco's chief investment officer, Tatsuro Kiyohara, once handled short transactions for one of the legends of U.S. hedge funds, Tiger Management. Sparx Asset Management founder and CEO Shuhei Abe worked as a consultant on Japanese equities to U.S. hedge fund pioneer George Soros for three years in the 1980s.

If the managers can provide credible products, there are at least some signs they can succeed. Timco, which is running a yen-denominated long-short fund, has already garnered more than ¥200 billion from institutional investors, including pension funds, well on its way to its ¥360 billion to ¥420 billion goal. Sparx is overseeing ¥260 billion, including a ¥30 billion long-short fund that is mostly invested in Japanese stocks; and Nissho Iwai Asset Management is managing a much smaller ¥4.9 billion in a long-short fund.

Whether Japanese asset managers can gain the requisite skills fast enough to stave off foreign competition is a bigger question. "There's a clear need for yen-denominated hedge funds in Tokyo," says a former equity strategist for a European investment bank who now runs his own Tokyo-based asset management company. "If Japanese nationals don't meet it, foreigners may." Even Sparx's Abe doesn't think many Japanese firms will succeed. With more than a bit of bravado, Abe says: "There are no creative investors in Japan, except us. Japanese asset management companies are geared to selling their services. When it comes to picking stocks, they follow the crowd."

That may be an overstatement, but it is true that Japanese investors lack certain skills, owing in part to previous regulatory restrictions. Japan retains residual legal restraints on stock borrowing, a key facet of operating a hedge fund, so it's not commonly used in the investment process. The practice was legalized in principle 40 years ago, but borrowed stocks still have to be returned to lenders at the end of each half-year business term. An arbitrary due date presents a major complication for a short-seller who's holding borrowed stock and doesn't want to liquidate his position.

The lack of local experience in some of these areas has helped make real estate, which the land-starved Japanese know very well, the leading homegrown alternative investment, with an estimated ¥3 trillion. Real estate investment trusts that securitize office buildings in prime downtown areas of Tokyo and Osaka and sell investment units as senior debt or asset-backed securities have proved popular. Although he has steered clear of other alternatives, CSK's Sugiyama has invested 4 percent of his ¥25 billion fund in a real estate trust run by Sumitomo Trust.

Even within the real estate sector, investors are getting more adventurous, says Motofumi Shimizu, manager of Sumitomo Trust's real estate planning department. In recent months, he says, investors have been shifting away from the more predictable senior debt portions of deals and into the higher-yielding, equitylike tranches. Shimizu says that Sumitomo's internal figures show that about 70 percent of new pension fund money flowing into securitized real estate in the past year has gone into the riskier portions of the trusts, against just 20 percent in 1999.

Despite their comfort with real estate investing, the bigger pension funds haven't jumped into the securitized real estate sector with both feet, notes Shimizu. For that to happen, he says, Japan's Pension Fund Association, an industry lobbying group that also manages a ¥4.7 trillion fund of its own, will have to give an official "blessing" to real estate funds. To date, it hasn't done that.

Will Japan fulfill the bullish predictions that as much as 15 percent of its pension money will be in alternative investments near the end of this decade? Most practitioners insist that it will. Mitsubishi's Kadota likens the situation to that in the U.S. two decades ago, when pension funds were first starting to win broader investment powers and dabble in new areas. Because their pension needs are so great, and the path to alternative investments has been smoothed by U.S. and European efforts, the Japanese should be able to travel the same distance in less than half the time, he says. If he's right, the world's second-largest economy will soon also house the globe's second-biggest alternative-investment market.

Due diligence at Sumitomo

A pension fund manager seeking to start investing in hedge funds will find his head spinning pretty quickly. After all, there are several hundred so-called funds-of-funds that channel money into thousands of hedge funds. Even longtime observers of the industry find it difficult to keep track of the players and the nuances of their strategies. For Japanese plan sponsors, the problem is far worse (story). With virtually no native hedge fund business to use as a reference point, they are forced to learn about an unfamiliar product operating in a distant country, where portfolio managers and marketers speak a different language. Under these conditions, the risk of making a costly mistake rises immeasurably.

What to do? For Sumitomo Life Insurance Co., probably Japan's leading hedge fund investor, the answer has been to work very hard. In December the country's third-largest insurer, which had begun to make a few investments earlier in the year, assembled a six-person team to research hedge funds full-time. The team leader, alternative-

investment manager Nobuki Yasuda, 44, says he's taken just two days - January 1 and 2 - off. The rest of the time, including Saturdays and Sundays, Yasuda is either in the office evaluating fund performance and strategy or on the road interviewing fund and fund-of-funds managers.

The hard work of Yasuda and his five colleagues is starting to show results. Sumitomo has invested ¥488 billion ($4 billion) in 25 funds-of-funds that in turn may hold stakes in as many as 600 hedge funds at any point in time. His team has researched an additional 70 to 80 fund-of-funds candidates that Sumitomo is considering for investment. Factoring out overlapping positions, Yasuda estimates that Sumitomo is now exposed to about 300 individual funds, making it, in his judgment, one of "the world's most diversified" hedge fund investors.

Since Sumitomo made its first investment in early 2000, its hedge fund positions have easily outperformed the insurer's other holdings, Yasuda says, declining to specify exact returns. Japanese stocks have nosedived during this period, and government bonds typically yield between 1.2 and 1.3 percent. That falls far below the average of 3.5 percent that Sumitomo has to pay out on its "general account," a ¥22 trillion pool of money that guarantees a set rate of return to institutional investors.

Sumitomo may not be one of the most popular hedge fund investors, because of the "notoriously rigid" guidelines it gives to fund-of-funds managers, says Yasuda. Those include at least a two-year track record and a limit on losses in any given month. Yasuda also demands liquidity: He won't invest in any fund that won't allow him to redeem 70 percent of his money within three months and 100 percent within five months.

Because Yasuda thinks they're too risky, Sumitomo has avoided many of the well-known names that make macro bets on foreign exchange rate movements. Instead, he's sought out specialists that try to profit from anomalies in the U.S. bond and equity markets. The biggest manager (he won't name names) has about $7 billion in assets. Yasuda estimates that about 2 percent of Sumitomo's general account is now in alternatives.

Yasuda's labors are expected to pay another dividend. Sumitomo plans to start offering its hard-won expertise to other institutions seeking information on these alternative assets. "When we start to guide pension funds around the U.S. hedge fund market," says Yasuda, "you can be sure that we will make them pay for it."