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Implementation began two weeks ago û just in time for the wave of sell-offs that roiled stockmarkets from Tokyo to Mumbai.
Daisuke Hamaguchi, director of investments, says the timing has made for a scary debut, because the strategy calls for the PFA to increase its proportion of equity allocations as markets tumble. In turn it will be selling yen bonds.
At the start of the year the PFA had a roughly 40% allocation to domestic and international equities. Although the Japanese stockmarket declined in 2007, performance in other stockmarkets was strong, and that performance has helped the PFA reach a funding level of 115%; that is, it had a surplus against its liabilities.
This surplus has been seriously eroded since the start of the year, however, with the global panic in equities causing markets in aggregate to fall by 20%. The PFAÆs 40% equity allocation has been hit hard, and its funding level has subsequently been reduced to 105-107%. The exact amount is changing each day, depending on market activity. Hamaguchi says this is unavoidable. Nonetheless, the PFA has embarked on a program to increase its equity portion to 45% of total assets.
Hamaguchi says this is not because the PFA has suddenly become a contrarian investor. The PFAÆs new strategy is to maintain a viable level of funding, a task complicated by accounting rules introduced a few years ago that requires assets be marked to market.
This has been under discussion for two years and the board of directors approved the new policy in December. The reason is because the PFA understands all to well the problems of being unable to meet its liabilities. When Hamaguchi joined the organization two years ago, its assets reached a funding level of only 95%. The PFAÆs equity allocation was actually much higher then, at 56%, because the organization was desperate to boost returns. In fact in mid 2005 it would reach its first funding surplus in 13 years.
Over the next 18 months, HamaguchiÆs team gradually cut the equity portion to 40%, involving selling around $20 billion worth of stocks. That was when stockmarkets were strong, and less risk was required to support a funding surplus. The new strategy is to ensure the value of its risk assets matches the value of its liabilities. So as the value of its risk assets û ie the value of its stock holdings û diminishes amidst market turmoil, the PFA needs to increase its allocation, the PFA needs to buy more to compensate.
ôThereÆs no magic in specific numbers,ö Hamaguchi says. The firm found that, last year, a 40% allocation to equity supported a funding ratio of 115-120%, and now calculates that, as the market value of stocks declines, it needs to increase its total exposure to 45% in order to maintain a funding level of 100-105%. ôItÆs a judgement about how much risk to take versus our liability,ö he explains, adding these calculations have gone through months of stress testing and market simulations. ôOnce you set a target exposure for risk, you keep it.ö
Hamaguchi says this should not be confused with liability-driven investment (LDI), an idea promoted by many fund managers. He says LDI is just about diminishing total risk versus liabilities, and in practice means replacing equity risk with fixed-income risk, often via structured products. The idea behind LDI is to minimize asset volatility. The PFAÆs strategy is not to cut risk, but to adjust it versus liabilities. He agrees, however, that like LDI, the PFAÆs strategy recognizes the value of its liabilities and their risk, and doesnÆt merely focus on investment returns.
By linking asset allocation directly to its funding level, the PFA looks to do more trading. Merely tweaking equity exposures by 1-2% means several billion dollars of trades. But Hamaguchi says one reason this strategy is now possible is because execution has become efficient. The PFAÆs in-house equity and bond teams use futures instead of trading physical securities, and anyway the trading costs to large institutional investors have become very low. And in a huge capital market such as JapanÆs, or in major global stockmarkets such as the United States or western Europe, liquidity is ample. Nonetheless a $1 billion trade can still create market impact, so the PFAÆs traders move cautiously over a period of days, if necessary.
Tomorrow: the PFAÆs new strategies in private equity, and an update on its campaign for shareholder rights.
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