Institutional investors in Japan are continuing to invest heavily in alternatives, which now make up more than a fifth of their portfolios, a comprehensive new survey shows.

The 12th annual study by JP Morgan Asset Management surveyed more than 100 Japanese corporate defined-benefit pension providers. It shows them still lapping up alternatives as they cast a wider net in a late-cycle environment in search of higher, risk-adjusted returns.

The 2019 survey, which reflects current investment strategies as well as their future plans, shows Japanese pension funds now allocate a record 21.3% of their portfolios on average to alternative investments such as property, infrastructure, private equity or private debt.

In 2015 it was just 12.8% and in 2009 just 5.4%.

Average allocation development Source: JP Morgan AM

What's more, seven of the funds surveyed already allocate 40% or more of their overall portfolios to alternatives.

One extreme example is Okayama Metal & Machinery Pension Fund and West Japan Metal & Machinery Pension Fund. Here, the strategy means that around 90% of their combined $1.2 billion in assets under management are invested in alternatives.

But how high can the share of alternatives on average go?

According to Akira Kunikyo, an investment specialist at JP Morgan Asset Management, it would be hard to define a one-size-fits-all percentage cap for alternatives as this limit will vary from pension fund to pension fund for a number of reasons.

Akira Kunikyo

“The maximum share is a function of risk appetite, degree of maturity [in form of] ratio of benefit and premium as well as market outlook, especially expected return,” Kunikyo told AsianInvestor.

Konosuke Kita, director of consulting at Russell Investments, singled out the maturity of the individual pension funds as the key factor when deciding on an alternatives cap, namely the varying member compositions of still-active contributors and retired beneficiaries.

“Young pension funds can increase allocations of illiquid asset but matured funds have to care about cash outflow,” Kita told AsianInvestor. “When they do ALM [asset-liability management] studies, they can check future allocations of illiquid asset in their portfolio.”

For more mature funds with larger and growing cash outflows it is important to ensure that the allocation of illiquid assets in a portfolio doesn't get too high, he said.

The JP Morgan AM survey was conducted among 113 defined-benefit pension funds and three mutual aid pension funds between March and May of 2019.

FEWER SHARES, BONDS

The flip side to the Japanese surge in alternatives investing is a decrease in two other asset-type allocations. First, domestic government bonds because zero-interest rates in Japan have made them less appealing. And, second, equities because stock markets have become more volatile at this late stage of the cycle.

In July, AsianInvestor talked to Aisin Employees’ Pension Fund about the benefits of strategically switching to alternatives from equities.

As the share of equities in portfolios has decreased, so the expected returns have continued to inch downwards, with the average target return for the next 10-15 years now 2.28%, according to the JP Morgan AM survey.

The same survey five years ago showed the target return was 2.55%.

The survey also showed that the average DB pension fund now allocates into at least three to four different sub-strategies within alternatives. While real assets like real estate and infrastructure are gaining in popularity, the core of Japanese alternatives investments is still funds of hedge funds and single hedge funds, Kita said.

There has been some fine-tuning of late nonetheless. 

“Single hedge fund [investments] have been growing while fund of hedge funds has been decreasing”, Kita said. “As a recent trend, private real estate investment trusts, private debt, infrastructure, multi asset and bank loan have all been increasing. Insurance-linked securities have been popular but many investors quit them during the last two years.”

RISK TRADE-OFF

Alternatives are seen benefitting from an illiquidity premium, but the trade off is that they are also more susceptible to liquidity risks, as AIA's group CIO Mark Konyn recently highlighted and by recent fund-house problems.  

If there is too big a share of investments that are not marked to market, for example, that can become a major problem if they are liquidated at a loss at the end of their investment terms.

Masaharu Takenaka

So although the increase in alternatives investments makes sense from a diversification and returns perspective, Japanese corporate pension funds should heed the lessons of the 2008 financial crisis and balance those risks, said Masaharu Takenaka, a professor of economics at Ryukoku University in Kyoto.

“The problem of less liquidity is sometimes very fragile and the situation gets very tough,” he told AsianInvestor. “Once we entered a less liquid market in 2008 and prices started to decline, it became a free fall.” 

“In a stable economy liquidity is not a problem, but in a critical phase liquidity can become a very serious problem. Such a thing could happen again in the next recession,” he added. 

However, in Japan the share of illiquid assets for "an investment term of around five to 10 years" is at 9.8% of the total portfolio on average, according to the JP Morgan AM survey. And that's manageable, Kunikyo said.

In that respect, he also noted that core assets – where the returns are created through income cashflows rather appreciation gains for liquidating assets – are the preferred target for Japanese corporate pension funds.

Given the average target return for the pension funds has now dropped to 2.28%, a typical risk/return profile of approximately 3% or above would be attractive. After foreign exchange hedging and other costs, the 2.28% target would still be achievable, Kunikyo said.