Asia’s pension funds are growing. But there is a real concern that they're not doing so fast enough.

In North Asia in particular, aging societies mean pension funds need to ensure a steady level of annual returns, to meet mounting future needs. But this is proving to be difficult. As Willis Towers Watson revealed in its annual global pension survey in September, Asia Pacific pension fund assets rose by 2.8% over the course of 2016, less than that of Europe (3.1%) or the US (6.7%). 

A large part of the problem is that contributions to regional funds simply isn’t extensive enough yet. But there is another problem too: at a time when many government bonds are offering miniscule (or negative) yields, the funds are struggling to ensure their annual returns keep up with their respective nations’ long term retirement needs.

The OECD’s most recent pension report, released in September 2017, reveals net rates of return that underline the problem. Hong Kong’s pension system returned a net -0.3% between 2015 and 2016. Thailand’s pensions did better, with a 3.4% return, but this was not all that high given that the country is Southeast Asia’s fastest-aging, and its relatively small funds will soon be needed.

More advanced countries were not that impressive either; Japan’s pension funds returned 2.3%; Australia’s superannuation funds returned just 1.9%. Both were under the OECD average of 2.4%.

In fairness, figures in all of these countries will be much better for 2017, in large part because global equity markets rebounded. But the whole point of pension providers is that they can take a longer term view and diversify their assets, to minimise poor rates of return in leaner years.

Some funds are doing this already. Korea’s pension funds, for example, have become aggressive buyers of alternative and offshore assets, in order to make up for the paltry rates of return offered by domestic fixed income assets.

But there is another area that pension funds would be wise to consider: small and medium enterprise (SME) investing, be it through public stocks or venture capital.

Investing in the future

A report by Bloomberg Businessweek on Tuesday (January 15) advocated that Korea’s National Pension Service plough more of its $510 billion in assets into the country’s Kosdaq, its junior bourse for smaller companies, which does not include the nation’s often scandal-ridden chaebols.

As that report noted, NPS has 70% of its stock portfolio invested into large cap companies, versus just 9.2% in small caps. Investing more into smaller companies would help it diversify its investments.

It would also offer a fillip to these smaller companies, and could help them to break the stranglehold that the country’s conglomerates have held over many of Korea’s industrial sectors for decades—a position that has encouraged them into the sort of bad governance and outright criminality that has hurt NPS, among others.

The suggestion makes sense for other countries apart from Korea too. While small and medium-sized enterprise stocks typically underperform during times of economic difficulty, they are often turbo-charged during better environments. 

Take Japan. The MSCI Japan Small Cap Index boasted returns of 31.68% in 2017, 7.91% in 2016 and 15.65% in 2015; that compared to the mainstream Nikkei 225, which returned 19.1%, 0.42% and 9.07% for these three years.

Given that Japan’s Government Pension Investment Fund, the world’s largest pension fund, only reported an overall return on its domestic equity portfolio of 0.2% for the 2016/2017 fiscal year (ending March 31, 2017), it seems evident that it was much more exposed to large cap companies than small cap ones. It could also benefit from taking a more assertive investment line on the nation’s smaller businesses.

In fairness, this is not always true. MSCI’s China Small Cap Index returned 24.62% last year, but it fell 5.95% in 2016 and returned just 3.48% in 2015. Meanwhile in the index provider’s Hong Kong small cap index may have risen 15.69% return in 2017, but this followed falls of 7.93% and 13.3% the two preceding years. Small cap investments are risky.

Yet they are also very lucrative when conducted at the appropriate time. And by investing in them, the pension pots of North Asia can meet two goals: potentially raising their longer term returns, and assisting their home economies in providing capital to a new breed of companies.

The latter is important, as the world continues to undergo change as a result of the ongoing impacts of digital services and big data.

And these investments do not have to merely take the form of public SME allocations, be they via passive of active funds. Pension funds can also opt to plump more of their money into SMEs via venture capital funds. As both alternatives research provider Preqin and the Financial Times reported last year, Asian venture capital is gaining steam, as tech start-ups in the region attracted investors.

In their hunt for returns, Asia’s pension funds would do well to recall that their own economies do still offer value. It’s just not necessarily to be found in the largest firms on offer.