Profitability for fund managers in Japan, both domestic and foreign, has been falling since 2005. That trend continues but there are signs it is stabilising.

According to data compiled by Nomura Research Institute (NRI), management fees remain stable while revenues have enjoyed a modest gain against assets under management.

Demand for hedge funds may play a big role in that, says Sadayuki Horie, senior researcher.

He says the data regarding pension funds’ allocation to hedge funds is misleading. According to NRI, in fiscal 2010 only 5.2% of total employee pension fund assets and 4.3% of defined-benefit corporate pension plan assets were allocated to hedge funds. Both seem like modest declines from 2009.

But this obscures the fact that, among big funds, hedge-fund demand is much higher. Horie says larger asset owners will typically have 10% allocated to alternatives, a figure that may well rise.

Japanese pension funds have always been big users of hedge funds, because of their quest for yield, but relied primarily on funds of hedge funds. When many FoHFs threw up gates in the 2008-09 crisis, many Japanese pension funds suffered. There is now a general distaste for such structures unless there is sufficient liquidity, says Horie.

Pension funds are looking more to single manager funds, provided they are big and liquid enough.

But the real beneficiary has been investment banks. Horie reckons around 80% of large pension-fund allocations to alternatives is now to hedge-fund index replication strategies. Moreover, these are receiving allocations out of pension funds’ bucket for core investments, while single managers are receiving allocations from buckets dedicated to active satellite strategies.

This may explain why fund managers are still struggling to improve profitability in Japan. Their bread-and-butter areas such as defined-contribution plans have attracted paltry assets. Meanwhile, management fees to both institutional and retail funds may have flattened, but they remain far below 2004-05 levels.

Average institutional fees are now just above 0.4%, and average retail fees are around 0.55% for active foreign bond products, the most popular type in Japan.

Only foreign equity funds have notched any fee gains, up from around 0.6% in 2007 to 0.65% in 2010 – but still a far cry from the 0.8% they attracted in 2004.

Foreign profit margins have fallen to 5% in 2010, from a peak of 25% in 2004, while for domestic managers margins have declined from 40% to 20% in the same period.

But Horie says this appears to have bottomed out. Total revenues in FY2010 rose by 7%, from ¥660 billion in 2009 to ¥704 billion last year. However, any gains will remain modest as long as the biggest clients continue to look to investment banks for structured or indexed absolute-return solutions.