Insight - Japan: land of the rising funds
This insight is by Brett Cooper, Senior Trade Commissioner, Tokyo
For more than half a century, Japan has maintained a reputation as one of the world’s leading exporters of the highest quality manufactured products.
But it also maintains a strong competitive advantage in another sector: capital.
Japan holds enormous amounts of capital but historically much of its savings have been recycled internally, with banks, life companies and pension funds investing primarily in domestic government bonds. However the returns on such secure investments have historically been very low.
Now Japanese funds and companies have started to turn more attention offshore, to markets such as Australia, to diversify and bolster returns.
Structural reform and Japan’s underlying economic challenges are beginning to drive a new approach from Japanese pension funds including significant changes to asset allocations, which have the potential to benefit Australian asset managers.
Japan has one of the largest pools of institutional investment assets in the world and the Japanese Government Pension Investment Fund (GPIF) is known as the world’s single largest public pension fund.
The asset allocation of Japan’s public pensions have historically been overly weighted in Japanese Government Bonds (JGB) and domestic equities, however the prolonged setting of extremely low interest rates is now encouraging Japanese institutional investors to seek higher yields from various alternatives, such as infrastructure, real estate and private equities.
These changes in turn are generating higher demand for foreign alternative asset managers and significant opportunities are emerging for well-prepared Australian firms.
Japan continues to face enormous structural challenges such as a high debt-to-GDP ratio (over 230 per cent), a declining population and a rapidly ageing society. Since taking office in 2012, Prime Minister Shinzo Abe’s government has taken measures to stimulate economic growth and address these issues through “Abenomics”, which comprises the three so-called “arrows” of monetary easing, fiscal stimulus and structural reform. One consequence has been historically low, even negative, interest rates.
Many financial institutions believe negative interest rates have hurt profitability and are now actively exploring opportunities to invest in higher-yield products. This pressure is generating a significant increase in M&A activity in Japan and overseas by Japanese firms. It is also creating higher demand for some foreign asset management products.
Changes to asset allocation
Historically, the asset allocation of Japan’s public pension funds has been heavily weighted to Japanese Government Bonds (JGB). More than 60 per cent of Japan’s assets under management were allocated to very low yield JGBs in 2012. However, recent reforms and market pressure are already impacting asset allocations in Japan.
The country’s largest fund, GPIF, announced a major change to its asset allocation mix in October 2014 in response to perennially low interest rates, decreasing its exposure to domestic fixed-income assets from 60 per cent to 35 per cent; increasing its share of domestic equities from 12 per cent to 25 per cent; increasing its foreign fixed-income from 11 per cent to 15 per cent; and increasing foreign equities from 12 per cent to 25 per cent.
The announcement of negative interest rates in January 2016 by the BOJ has further encouraged the GPIF and other investors to explore various alternatives to JGBs in search of higher yields.
As of March 2016, the allocation was 37.55 per cent in domestic bonds, 21.75 per cent in domestic equities, 13.47 per cent in international bonds, 22.09 per cent in international equities, and 5.14 per cent in short-term assets. For the GPIF, alternative investments will be made within a maximum 5 per cent of the total portfolio, in infrastructure, private equities and real estate.
This change in asset allocation by GPIF is a direct reflection of Japan’s recent pension reform and the central bank’s economic policy. It has laid the groundwork for a new investment direction for Japanese public pension funds given the significant influence of the GPIF.
The Japanese financial market is one of the largest in the world and the size of investable wealth held by Japanese investors is estimated to be approximately A$21.5 trillion, of which Japanese household assets account for roughly A$18 trillion. Japanese pensions account for A$3.5trillion. Of this, public pensions represent approximately A$2.3 trillion (over 60 per cent of total pension assets), with the rest held in corporate pensions.
The four major public pension funds are:
- Japanese Government Pension Investment Fund (GPIF), known as the world’s single largest pension fund with Assets Under Management (AUM) of over A$1.6 trillion
- Pension Fund Association for Local Government Officials (PAL), the second largest Japanese public pension fund with AUM of A$238 billion
- Pension Fund Association (PFA), with AUM of A$133 billion
- Federation of National Public Service Personnel Mutual Aid Association (KKR), the 5th largest public pension with AUM of A$77.5 billion.
The cornerstone of the public pension fund system, the GPIF, was established in 2006 with a mandate to manage a passive investment portfolio over the long term to deliver sustainable pensions to the Japanese public.
Japan Post Bank is another major player, with over JPY 200 trillion in assets and an increasingly global investment outlook.
Recent GPIF reforms
A number of recent reforms to the GPIF have been undertaken to respond to the size and speed of demographic changes, the introduction of more sophisticated investment options in the market, and the impact of Japanese government economic policies.
These reforms have encouraged recent developments with the GPIF, including:
- Changes to its basic investment asset allocation portfolio
- Increasing sophistication of its investment methods, including the launch of an alternative investment program in partnership with the Development Bank of Japan (DBJ) and the Canadian pension fund (OMERS), investment in new indices such as the JPX Nikkei Index 400, and the purchase of inflation-indexed JGBs
- Implementing Japan’s Stewardship Code (launched by the Financial Services Agency in 2014), which aims to promote the sustainable growth of investee companies through deeper dialogue and engagement with investors
- Signing the United Nations Principles for Responsible Investment.
Other market developments
The Pension Fund Association (PFA) moved relatively early by participating in one of the world’s largest infrastructure investment alliances, the Global Strategic Investment Alliance (GSIA) in 2012. The PFA now invests up to $2.5 billion in large-scale infrastructure assets together with other Japanese financial institutions. Led by Canada’s leading pension plan, the Ontario Municipal Employees Retirement System (OMERS), the GSIA was designed to attract sophisticated like-minded investors to directly invest in infrastructure assets. This alliance was the first of its kind in Japan.
In November 2014, GPIF also entered into a co-investment agreement with the Development Bank of Japan (DBJ) and OMERS in order to jointly invest in infrastructure assets.
The Pension Fund Association for Local Government Officials (PAL) has responded to this trend, by issuing Requests For Proposals (RFP) from overseas and domestic real estate and infrastructure investment managers in 2015.
The Federation of National Public Service Personnel Mutual Aid Association (KKR) issued a RFP in 2015 for global and domestic real estate investments, and started an asset manager entry program for their alternative investments.
In April 2016, GPIF announced an RFP for non-Japanese equities followed by an RFP for alternative investment consultants. These RFPs establish clear guidelines that have the potential to open up mandate opportunities for overseas asset managers including from Australia.
The qualification criteria for a RFP entry is similar across all 3 public pension funds. Applicants are required to meet all of six conditions spanning certification; governance; scale; track record; regulatory hygiene; and control of third party managers.
Foreign fund managers need to outsource to Japanese local fund managers or trust banks, unless they are registered as Investment Management Business and Type II Financial Instruments Business in Japan.
The Japanese pension funds have tended to demonstrate a preference for using large established players for mandates, which can make it challenging for new entrants to break into the market. Numerous non-Japanese asset management companies already active. Large US and European managers have established Japanese subsidiaries to demonstrate their commitment to this market. These players include Prudential Investment Management, Pimco, Manulife Asset Management, JP Morgan, BlackRock, State Street Global, Goldman Sachs Asset Management, Morgan Stanley Asset Management, Alliance Bernstein, and Northern Trust Global Advisors.
Local competition for domestic funds from domestic infrastructure opportunities is also strengthening, with some Japanese asset management companies aiming to launch domestic infrastructure funds. The Tokyo Stock Exchange has also established an “Infrastructure Fund Market" for listing of renewable energy assets.
Since the Global Financial Crisis, Japanese investment management businesses including public pension funds have also been under increasing pressure to reduce costs. Ongoing consolidation and restructuring combined with low investment returns and low yields continue to impact fees for asset managers.
Implications for Australian asset managers
A number of Australian investment management companies have already established in Japan including AMP Capital, First State Investment, IFM Investors and Macquarie Asset Management. Australia is well regarded in Japan as an investment destination because of its high-quality regulatory environment, political stability and strong track record of economic growth. Major pension managers in Japan also have a good understanding of Australian capabilities in infrastructure financing, project pipelines and investment management expertise.
Despite strong interest in Australian infrastructure, the majority of Japanese pension funds have very limited capacity for direct investment. These limitations are partially regulatory, but are also driven by limited numbers of professionals who can directly manage investments. As infrastructure is a relatively new asset class in Japan, a lack of investment professionals in this sector may also be a constraint on future growth. However, this gap may present opportunities for Australian firms that have products and services to meet market needs, although patience and a long-term commitment are essential for success.
Distribution channels also need to be considered by Australian entrants. One of the most important gatekeepers for foreign fund managers looking to distribute their investment schemes in Japan are trust banks. Trust banks in Japan have a broader function than many global markets and often operate as intermediaries and trusted advisors. They are positioned to explain investment strategies to their institutional clients through broad networks and relationships with the public pension funds. Other key gatekeepers to major pension funds in Japan include prime brokers, domestic asset management companies, and securities brokers.
Australian funds looking to raise funds in Japan need to carefully understand the web of regulations under the Financial Instruments and Exchange Act (FIEA). Funds management companies who wish to offer funds management, investment advisory and fund distribution services are required to register in Japan. Close consultation with experienced legal advisors is essential to ensure compliance. A track record of at least three years, liquidity, transparency and brand recognition are also considered particularly important by major institutional investors in Japan.
Japan’s participation in the Asia Region Funds Passport in 2015 - the first mutual recognition scheme for funds established in Japan – will also assist Australian asset managers in entering Japan’s market from 1 July 2017 after the first Collective Investment Vehicle under the fund is introduced.
Challenges aside, this is a propitious moment for the Australian funds management industry in Japan. Macro-economic and fiscal pressures on the nation, and Japan’s monetary policy response, are unlikely to change quickly. Japanese capital is seeking higher returns. They must come from offshore – and increasingly via offshore entities.
 In this report, exchange rate of A$1=JPY 86.34 as of 25 Jan 2017 is used.
 Source: Nomura Research Institute, Japan’s asset management business 2016-2017
 As of 31 Mar 2016