Japan’s institutional investors remain keen to diversify into offshore alternatives, but increasing hedging costs are forcing them to consider new ways of hedging or investment opportunities in Europe, according to a new report by alternative data provider Preqin.
The cost of hedging US dollar-denominated alternative assets back into yen in particular is eating into the potential returns of offshore assets like real estate and private equity.
“As the vast majority of overseas alternative assets are invested in US dollar-based strategies, US dollar hedging costs for yen-based investors are a major issue,” said Mitsui & Co. Alternative Investments in a June 21 report from Preqin about how Japanese institutional investors expect to tap into these assets over the coming year.
The report noted that the widening differentials between US and Japanese interest rates have jacked up the hedging costs.
“Many investors expect to earn returns between 3% and 5% net of hedging costs, which are currently assumed to be around 3% for yen-based investors,” said the report. That means sourcing offshore US dollar investment returns of at least 6% to 9%, a difficult proposition in vanilla asset classes.
At present, the Bank of Japan maintained short-term interest rate target at -0.1% as of June while the US Federal Reserve has kept the target range for its benchmark interest rate between 2.25% 2.5%.
Despite some indications that the US central bank may be turning dovish, it seems unlikely that interest rates between the two will narrow soon. Robert Kaplan, the head of the Federal Reserve Bank of Dallas and one of the rotating members of the Fed’s federal open market committee, argued that it would be “wise to take additional time and allow events to unfold as we consider whether it is appropriate to make changes to the stance of US monetary policy”.
HUNGRY FOR ASSETS
But the cost of hedging US dollar assets and returns to yen hasn’t stopped many asset owners from seeking offshore investment.
Almost all (96%) respondents to the survey said they intend to invest more in private equity over the coming year. Real estate (86%), infrastructure (76%) and private debt (54%) – collectively the main asset classes within the alternatives asset space – gained considerable interest as well.
An investment executive at a Japanese asset owner told AsianInvestor on an anonymous basis that the hedging cost weren’t among his organisation’s top concerns.
"The biggest concern for me is elevated private prices everywhere," he said.
As previously reported, the high valuation of private assets have concerned other investors, such as Axa Singapore and family offices, at a time the market is seeing some record-breaking amounts of fundraising activities. At the end of June last year, private capital dry powder across the world had reached $2.1 trillion, according to the data provider.
Instead, the report noted that Japanese investors are using various methods to get around high hedging costs. Some are taking advantage of the currency peg between the Hong Kong dollar and US dollar with schemes to reduce hedging costs with total return swaps.
“All sorts of solutions to this problem are in demand,” according to the report.
Nigel Rayment, an investment specialist in global fixed income for currency & commodities at JP Morgan Asset Management, added that investors from Japan could consider an insurance-based dynamic hedging strategy.
This strategy essentially remains unhedged when the US dollar is stable or strong and it hedges when the currency weakens, limiting FX related losses to a pre-specified amount over a defined period, Rayment said.
EURO ASSET APPEAL
The rising cost of hedging returns back from US dollar-denominated assets is also leading more Japanese asset owners to consider adding euro-denominated alternatives to their portfolios.
Europe is among the top three most-preferred geographies for infrastructure and private debt. “As the historically low interest rate environment has persisted in the eurozone as well, the interest rate differentials between the euro and the yen are smaller than ever,” the Preqin report noted.
While US alternative assets dominate, the eurozone has been getting some investment from Japan. The country’s Pension Fund Association, one of its biggest asset owners, had ¥11.9 trillion ($111 billion) in assets under management as of March 31, 2018. Shuzo Takahashi, head of private equity for the fund, said it has 60% of its ¥700 billion ($6.55 billion) private equity programme concentrated in North America but another 20% in Europe.
Stan Howards, founder and director of Teneo Partners noted in the report that euro-denominated assets are “growing in popularity due to the relative affordability of the hedging costs between the euro and the yen”.
The continent “does look more attractive because of the hedging costs,” agreed the unnamed Japanese executive. He said it was most appealing for certain lower-yield fixed income-like strategies.
For all the focus on hedging costs, Ee Fai Kam, head of Asian operations at Preqin, cautioned that the most important issue for Japanese investors is to understand what alternative assets entail, including strategy and their risk/reward profile.
“Investors must understand the alternative market and the importance of diversification, what instruments would suit the best for them in addition to looking at the trend – and that’s when they can mitigate the risk," agreed Yokaze Ito, senior research analyst at Preqin.
The Preqin report surveyed the appetite of Japanese investors for six alternative asset classes in March. Investment banks constituted the largest number of respondents (26%), but pension funds (23%) and insurance companies (18%) made up over 40% of overall respondents.