The ¥108 trillion ($1.3 trillion) Government Pension Investment Fund had a good quarter. It has reported that from October to December (third quarter, as its fiscal year ends March 31), it made investment income of ¥618.7 billion ($7.6 billion) and a total rate of return of 0.58% on its portfolio.

As put by the observant Investing Japan’s Institutional Capital blog, “GPIF is already past the tipping point where it pays out more in benefits each year than it receives in contributions to the national pension. So its investment earnings are vitally important.”

[On a separate note, ijapicap has also begun sifting through the murky circumstances around the suspension of business at AIJ and the possible losses at the pension-fund manager. Worth a read.]

The biggest contributor in this period was international equities, which delivered 8.76%. Domestic bonds eked out a mere 0.38% gain, while domestic equities and international bonds lost money.

Fund managers are keenly awaiting GPIF to implement its decision to expand into emerging markets, so they will no doubt be cheered by the surprisingly good performance of international stocks. International stocks had performed disastrously in its second quarter, losing -21.36%.

The GPIF informed the local media that it would need to delay its EM investment programme because it is taking longer to implement. This has been spun as owing to pure technicalities over opening accounts and so forth. This may be the case, but that terrible performance in FYQ2 wouldn’t have helped the technocrats make their case for adding “riskier” assets.

Hopefully the good Q3 results will put such qualms to rest, if any exist. The GPIF, as a long-term investor with a critical need to gain returns, must begin to allocate to emerging-market stocks and local-currency debt.

The bad news is that the GPIF is so big that EM allocations won’t have much of an impact on its performance either way. Most emerging markets are relatively illiquid or present other types of barriers (limited free float, capital controls, no secondary markets for bonds), which will make it hard for a $1.3 trillion fund to make effective use of them. The GPIF should go through the bother, however, because over time these markets will deepen and provide a meaningful opportunity.

International equities make up 10.13% of the portfolio, which is important but not decisive over the long run.

The good news is that FY2010 saw the GPIF book a 2.18% gain on its international stock portfolio, helping to offset losses elsewhere; the total portfolio still was down for the year, but not by much.

Moreover, the GPIF is beating its benchmarks for international equities: its time-weighted return is above the benchmark return by 0.2%. That includes Q3 when, ironically, the GPIF actually underperformed its international-equities benchmark by 0.5%.

This shows how difficult it is for a fund of this size ever to do well.

Most of GPIF mandates are passive, and even where it goes active, it is too big to allow for a lot of nimbleness. That means that the GPIF will almost always underperform the benchmark: it is effectively tracking market-cap weighted indices, minus fees. Those fees may be very low, but they operate according to scale, too. So in periods like autumn 2011, there isn’t much the GPIF can do.

Looking at its fiscal year to date, the GPIF is net down by -2.54%, with an investment loss of Y2.9 trillion ($37 billion). The biggest drag on performance? International stocks, due to that terrible August-September period. The strong yen further complicates matters for overseas investments.

Unfortunately, for all of these reasons, the most important asset class to GPIF is likely to remain domestic fixed income. These comprise 67.4% of the total portfolio, with a market value of ¥72.8 trillion ($895 billion). In FY2010, they posted a modest return of 1.95%, lower than international equities but providing far more investment income. They also hewed tightly to the benchmark.

The GPIF’s greatest risk is domestic interest rates. It, and other big Japanese institutional investors, will see the income from its domestic bond portfolio gradually decline, as older instruments with higher coupons mature and the GPIF is forced to buy new debentures: today the 10-year government bond yields 0.99%, and even the 30-year yields only 1.96%.

Switching 1-2% of the GPIF portfolio to EMs (and even that’s ambitious) is not going to save the day – but better to begin now, and be ready for the day when the yen weakens and emerging capital markets deepen.