Wednesday, November 20, 2013

Overhauling Japan's Pension Fund?

Chikafumi Hodo and Noriyuki Hirata of Reuters report, Reforms to shift Japan's huge pension fund towards riskier investments:
The world's biggest pension fund is preparing its most ambitious overhaul since its creation more than a decade ago, a process that will eventually see more of Japan's $2 trillion in public funds invested in stocks and other riskier assets and relatively less cash parked in government bonds.

An advisory panel to the government of Prime Minister Shinzo Abe, in a highly anticipated report on Wednesday, will propose far-reaching reforms to the Government Pension Investment Fund (GPIF), encompassing fundamental change to its governance and investment strategy.

The scope of the proposals suggests Abe is serious about making public funds more independent and equipped to generate returns from Japan's enormous pool of public savings to support its rapidly ageing society, rather than simply seeking to boost the stock market.

But the complex nature of the reforms may mean that the 121 trillion yen ($1.21 trillion) GPIF - and the other funds that typically follow it - are slower to shift their investments than some investors were expecting.

People familiar with the process say the final report will likely add details and a clearer direction to a preliminary September report that recommended GPIF shift away from very low-yielding Japanese government bonds (JGBs) and benchmark passive equity investments to a new index based on investment returns.

It will also propose setting up "baby funds" that could take on more exposure to riskier assets in pursuit of higher returns and will likely add a recommendation to invest in inflation-linked bonds, the sources said.

The recommendations mark a major step in Abe's hopes to reform Japan's conservatively managed public funds to help pull the world's third-biggest economy out of 15 years of deflation and weak growth.

He wants the massive pools of money to have the resources and expertise to generate higher returns as the country's working population ages and payouts to retirees increase.

Similar recommendations in 2008 were ignored. But the Ministry of Health, Labour and Welfare, which oversees GPIF, has been involved in this round of deliberations, meaning the proposals were likely to be implemented, the sources said.


Investors who have focused on the fund's shift from bonds to equities may still be disappointed, as Wednesday's report was not expected to specify recommended asset allocations, the sources said. Those changes are not scheduled to come into force until 2015, although it is possible they could come sooner.

The reference to the new JPX-Nikkei Index 400, which targets return on equity (ROE), could help shares in that index.

The report is likely to spell out which proposals can be implemented more quickly, such as the new ROE benchmark for passive equity investments, and which will take longer, such as setting up a new regulatory framework for the funds, the sources said.

"If the panel can actually draw up a clear roadmap, then the market will take this positively," said Kenji Shiomura, a senior strategist at Daiwa Securities. "With the Health Ministry in the discussion, the level of government commitment to implementing reform measures looks high."

The final report could change at Wednesday's panel meeting. It is to be released around 5:30 p.m. (0830 GMT), when the head of the panel, Tokyo University professor Takatoshi Ito, holds a news conference on the recommendations.

Anticipation that the report would recommend that GPIF track the new stock index - which focuses on ROE and corporate governance - for its passive equity investments has already helped some of the 14 stocks that are in the JPX-Nikkei Index 400, but not in the benchmark Nikkei 225 average .N225 or the broader Topix .TOPX.

Seria Co Ltd (2782.T), operator of a 100 yen-shop chain, has jumped 13 percent in the week since the index was announced, while fast-growing, e-commerce giant Rakuten Inc (4755.T) has risen more than 9 percent, outpacing the 2.7 percent rise in the Topix over the same period.

GPIF may not begin reviewing its asset allocations and investment strategy until the government completes a pension actuarial revaluation in March.

The fund reviews its medium-term strategy every five years based on these revaluations, with next year marking the review for implementation in the financial year from March 2015.

But it may not wait for this process to play out. In June, after a relatively brief eight months, GPIF made the biggest changes to its asset allocations since the fund was formed in 2001. It raised the weighting of Japanese stocks in its core portfolio to 12 percent from 11 percent and cut JGBs to 60 percent from 67 percent.

"It looks clear that the panel, the Health Ministry and GPIF all think that GPIF should alter its current heavy emphasis on JGBs as the result the money will flow into Japanese stocks and elsewhere," said Daiwa's Shiomura.


The report is expected to recommend that public funds start baby funds that would be managed separately from the core fund to allow them to take more exposure to riskier assets. These could put money in investments beyond conventional assets such as domestic and foreign stocks and bonds.

Overhauling GPIF's structure, which is important to its ability to make sophisticated investments, will likely take more time. The panel is expected to call for increasing the budgets of Japan's thinly staffed public funds to hire experts and acquire the resources to improve returns.

GPIF is an independent administrative agency, which has to operate under a tight budget and has severe staff limitations compared with large private-sector financial institutions. The fund has fewer than 80 people managing its trillions of yen. Converting it into a government-authorized corporation, like the Bank of Japan, would provide more flexibility, but such a change would require time and political debate over legislation.

The sources said the panel wants GPIF to consider diversifying into liquid asset classes, such as real estate investment trusts, when it reviews it portfolio from April. But investment in illiquid asset classes such as private equity, infrastructure and property would have to await the organization's overhaul.

This could mean a setback for GPIF after it made its initial moves towards investing in private equity in October, when it hired a veteran portfolio manager and moved several staff to focus on the asset class.
I discussed some of the proposed reforms in my last comment on GPIF not being ready for Abenomics. GPIF is a supertanker which needs to make an 180 degree turn. These reforms will take time to implement.

But I'm glad to see the panel is waiting before jumping into illiquid asset classes as signs of a private equity, infrastructure and real estate bubble abound. This is why Mark Wiseman and Leo de Bever are warning investors that deals are getting too pricey, prompting them to slow down their private market dealmaking activity.

My advice to the panel is to break GPIF into a few "baby funds" which will still be monsters on the global stage, and introduce proper governance. This means adopting Canadian-style independent investment boards and getting the compensation right to attract competent pension fund managers who know how to invest in public, private and hedge fund investments.

To be sure, the Blackstones, Carlyles and KKRs of this world will swoon all over GPIF, trying to get a piece of their lucrative alternatives business. There is no harm talking to them but the Japanese need to have a solid strategy to effectively diversify their holdings away from JGBs without causing major market disruptions:
The fund needs to reduce the risk of losses on its bond holdings should interest rates start to rise as Japan’s economy improves, Ito said in an Oct. 4 interview. Takahiro Mitani, GPIF’s president, has expressed doubt that the Bank of Japan can achieve its 2 percent inflation goal, saying in June that the fund plans to hold 60 percent of its assets in local bonds until at least 2015. The nation’s sovereign debt due in 10 years yielded 0.62 percent yesterday, the lowest rate in the world.

The fund should study the possibility of spinning off part of its assets into so-called baby funds, or specialized investment pools, according to the report.

“It’s a good idea to invest a small portion in REITs and alternative assets, but if they invest on a large scale, they’ll end up pushing up the prices of the assets they’re looking to buy,” Ayako Sera, a Tokyo-based market strategist at Sumitomo Mitsui Trust Bank Ltd., said by phone today. “They are a big whale. The market is very small, and if a big whale jumps in, it’s going to overflow.”

The baby funds will be small and won’t disrupt the market much, Ito said in a press briefing today. They should be set up within a year, he said.
The irony is that now may be the time for GPIF to stay put and keep its high allocation to JGBs. Why? Because as central banks keep pumping trillions into the financial system, the big risk is they are inflating several asset bubbles all at once in public and private markets, and instead of stoking inflation, they will create a major deflationary crisis.

I know the thinking is that banks flush with cash will start lending again and inflation is the end game in all this, killing bond markets all around the world. Maybe but thus far the evidence doesn't support this theory. In fact, inflation continues to be a no-show this year, and Treasury Inflation-Protected Securities continue to get no love from much of the investment community.

You should all read the recent comments Brian Romanchuk, a former senior fixed income analyst at the Caisse, is posting on his blog, Bond Economics.  Brian discusses why the OECD is delusional on Japan (again), why Abenomics is more of a faceplant than lift-off, and why there will always be new  JGB bears crying havoc and they'll get crushed just like so many others before them.

Below, Davide Serra, founder & CEO at Algebris, discusses the impact of what he sees as the Euro’s high valuation, where Europe is seeing deflation and explains why Europe will not be the new Japan. He speaks on Bloomberg Television’s “On The Move.”