GPIF Reveals its New Fee Structure

Michael Katz of Chief Investment Officer reports that Japan's GPIF just revealed its new fee structure:

Japan’s $1.48 trillion Government Pension Investment Fund (GPIF) has created a new performance-based fee structure that it says “drastically” reduces the basic fee rate for its asset managers.

The fund said that under the old fixed-fee structure and partial performance-based fee structure, asset managers were “paid considerable sums regardless of their investment performance, and therefore have little incentive to set target excess return rates appropriately.”

While approximately 20% of the fund’s assets are actively managed by the asset managers, only a small number of funds achieved the target excess return rate from 2014 to 2016, according to GPIF.

“For this reason, we revised the current fixed fee structure and partial performance-based fee structure,” said the fund.

In a move that the GPIF believes will align the interests of the fund and its asset managers, it lowered its base fee rate to the rate of a passive fund, and eliminated the maximum fee rate. However, a carryover mechanism has been included to even out the amounts of fees paid, and a portion of the fees will be held back to ensure that the amount of fees is linked with medium- to long-term investment performance.

And to enable asset managers to achieve target excess returns over the medium- to long-term, the fund said the introduction of the performance-based fee structure will normally involve the termination of multi-year contracts with asset managers.

The performance-based fees are based on “the precise measurement of the monetary contribution of investment performance,” said the fund. This, it said, is reached by multiplying the excess return rate on the portion in excess of the basic fee rate by the share of alpha and the average daily balance. Additionally, there is no cap on the fee rate; the share of alpha is computed based on the target excess return rate, and the fee rate paid when the target excess return rate under the current contract is reached.

The GPIF also said the full amount of the performance-based fees calculated each year will not be paid. Instead, 45% of the cumulative amount will be paid to the asset manager, with the remaining 55% to be deferred to the following year as a carryover.

“We hope that introducing this new performance-based fee structure will lead to further evolution of active management institutions,” said the fund.

When you're the world's largest pension fund managing over $1.4 trillion in assets, you have a lot of clout in terms of fees you dole out to external managers. GPIF has been putting the squeeze on fees in recent years and rightfully so.

Roughly 20% of its assets are actively managed, which is almost $300 billion, no small chunk of change. So they're right to get better alignment of interests by lowering the base fee rate and introducing a performance fee structure that rewards medium to long-term investment performance.

On LinkedIn, Warren Peng, Senior Principal at OTPP's Strategy & Risk Group, stated this:

This is an interesting fee structure, almost treating the external managers as internal managers, i.e., you will get a fixed salary and a fixed portion of bonus and another trunk of bonus is pending on performance. Moreover, the performance based bonus is not paid outright away and is paid over the long term aligning the long term interests between the fund and the managers. Very interesting and make perfect sense. I personally would like to see a clawback clause, that is, if the manager is losing money in a particular year, the performance based bonus is cut back. Not sure how wide this fee structure will be accepted by the industry. Let's wait and see.

I completely agree with Warren, it's an interesting fee structure and GPIF should add a clawback clause.

On Friday, GPIF saw its assets grow by another $2.4 billion for the recent quarter ending June 30. It announced 0.16% returns for the recent period, getting most of its gains from foreign stocks, which returned a mere 1.29%.

The gain was paltry compared to the prior-year period’s 1.68%. Japanese stocks suffered the most, losing 2.31% due to concerns of poor earnings reports for the island nation’s businesses and a potential sales tax increase in October, according to Bloomberg.

Foreign assets helped the plan recoup some of the 14.8 trillion yen lost in 2018’s final quarter but given the recent rout in stocks, I doubt GPIF's Q3 performance will be good, especially if the selloff continues this quarter.

In July, I wrote a comment on how too much beta is dragging down Japan and Norway's giant funds, stating this:

I've already covered Norway's giant beta problem and GPIF is in the same boat and worse because its allocation to alternatives is much lower. Norway has started investing in real estate all over the world but it recently lowered its target for real estate in its portfolio to 3 to 5% from 7% on concerns the global boom is nearing an end (a wise decision, especially now that real estate vulture funds are building up their fire power).

The swings in Japan are making people very nervous and some are saying it will cost GPIF's CIO his job. I wouldn't be so quick to blame Hiromichi Mizuno, it's not his fault the fund's returns swing hard with equity markets. He's steering a giant ship which moves at a snail's pace.

But both Mizuno and Slyngstad need to ramp up their allocations to private markets and to do this properly, they really need to think outside the box. Given their giant size, it won't be easy to scale up private markets, something they're both very aware of.

Why ramp up privates and why is the strategy so important? Because the volatility of these giant funds is quite frankly, unacceptable even if they invest over the long run, and they need to to reduce it by partnering up with the right partners, getting the most bang for their buck while reducing overall fees.

To be blunt, they are both late to the private markets game but if they have the right partners and strategy, that doesn't matter.

Having the right partners in private and public markets is essential. Unfortunately, it's been a very tough slug for active managers in public markets, the Fed and other central banks have killed them with their quantitative easing which is why passive investing has been garnering all the attention.

Of course, when everyone is doing the same thing, indexing, it exposes the stock market to other risks because when they all run for the exits, all stocks get slammed and that creates great opportunities for solid active managers (if you can find the good ones).

Lastly, Bloomberg reports that GPIF  is adding currency hedges just as the country’s most well-known exponents of the strategy cut back:

The world’s largest pension fund, which oversees the equivalent of $1.46 trillion, revealed in its annual report last month it was buying overseas bonds with hedges against possible yen fluctuations for the first time. Earnings reports from Japanese life insurers show they cut the proportion of the portfolio they hedge to 55% in March, from as high as 63% in September 2016.

Whether or not to hedge is a tricky equation for many Japanese firms that hold overseas assets. While adopting protection can safeguard their foreign-currency denominated assets from losing value if the yen strengthens, purchasing hedges comes with a price. The cost of hedging for dollar assets has become particularly expensive due to interest-rate differentials and rising demand for the U.S. currency.

“It’s hard to imagine Japanese investors being in a rush to boost yen hedging,” said Yukio Ishizuki, senior currency strategist at Daiwa Securities Co. in Tokyo. “The investment environment is really dire, and hedging inevitably erodes returns.”

GPIF’s latest annual report showed it held a total 588.2 billion yen ($5.4 billion) of assets tracking an FTSE Russell Index of U.S. government bonds that incorporates currency hedging, along with 668.6 billion yen of hedged European sovereign debt. While that equates to only about 4.6% of its total overseas bond portfolio, this is the first time the fund is buying bonds with hedges in place, according to its annual reports. The fund will release its quarterly performance results on Friday.

Nine of the largest life insurers held a combined 31.5 trillion yen of bullish wagers on Japan’s currency using forwards as of March 31, compared with a total 57.2 trillion yen of overseas assets. Their hedging proportion for dollar assets is 47% and for euro ones is 78%, a Bloomberg analysis of their reports shows.

Hedging euro-denominated assets by yen-based investors pays a premium of 0.22%, meaning it contributes to the total profit that can be earned. In contrast, hedging of dollar assets costs an annualized rate of about 2.6%, which means even holders of U.S. 30-year Treasuries would not earn enough yield to cover the expense.

The Bank of Japan at a policy meeting Tuesday reaffirmed its commitment to keeping interest rates low. Given yields are negative for all Japanese government bonds up to 10 years left to maturity, the country’s investors are set to keep sending money abroad in search of higher returns, which means whether or not to hedge will remain a key question.

Right now, trade war fears are bullish for the yen. Most Asian currencies tumbled on Monday, led lower by a fall in China’s renminbi, as elevated trade tensions prompted investors to seek safety in havens including the Japanese yen.

All this to say, depending on how bad things get, hedging foreign currency risk might prove to be a very wise move for GPIF and other large Japanese institutional investors.

Below, Kyle Bass, founder and chief investment officer of Hayman Capital Management, told CNBC China didn't try to weaken yuan, they just stopped supporting it. A very interesting interview, listen closely to what he says as the repercussions for global markets and risk assets are huge.

As I warned on Friday when I discussed how trade wars are slamming stocks and boosting US long bonds, if something blows up in China sending another global deflationary tsunami our way, the yield on the US 10-year note will slice below 1% and hit a new secular low.