Allocation of domestic equities in Japanese corporate pension funds has declined since 2005. Should corporate pensions continue to invest in Japanese stocks if they underperform foreign stocks?
Following is an abridged translation of an article originally published in AL-IN vol. 63, March 2022.
Over the past 16 years, Japanese corporate pension funds have gradually reduced domestic equity allocations in their portfolios. According to the Pension Fund Association (PFA) of Japan, allocation of domestic stocks fell from 26.9% in fiscal 2005 to around 9% in recent years. In contrast, the allocation to foreign stocks has remained virtually unchanged at 12-15% over the past 20 years. The ratio of domestic to foreign stocks has flipped from 6:4 in FY2006 to approximately 4:6 today.
Domestic equities have fallen out of favor primarily due to the performance gap between Japanese and foreign equities. The expected return over 5 years for Japanese stocks is approximately 5%, and exceeds 8% for foreign stocks (both annualized, Source: Daiwa Fund Consulting Co. Ltd.). Thus, investors understandably gravitate toward foreign equities, even at the risk of currency fluctuations. Japanese equities have also lost weight among major global indexes. MSCI World (including Japan), a benchmark index for equities in developed markets, comprises nearly 70% US stocks versus 6% Japanese. If the MSCI World portfolio were allocated to reflect the decline in fallen weight to around 6%, the ratio of Japanese equities to foreign equities would widen from 4:6 to 1:16, or restated, "as much as 40%" still being invested in Japanese stocks. Given the above, why do corporate pension funds persist in investing in Japanese stocks? Tomohiro Takahashi, Managing Consultant for Pension Funds at Daiwa Fund Consulting, identified two reasons: 1) as Japanese institutional investors, corporate pension funds feel a responsibility to support Japanese finance; and 2) pension obligations are in yen, so investing in Japanese stocks eliminates any currency risk to earnings.
What happened to change the role of Japanese equities in corporate pension portfolios?
In the early 2000s, corporate pensions combined different styles of asset management -- growth, value, size -- to achieve a neutral Japanese equity portfolio, said Takahashi. Today, however, such style diversification is rarely discussed. In recent years, portfolios have been dominated by growth stocks, while value stocks have fallen out of favor.
With only about 10% of their total portfolio invested in Japanese equities, it is becoming more difficult for pension funds to embrace multiple products and diverse strategies. For example, if assets of a corporate pension fund are JPY 50 billion, only about JPY 5 billion can be allocated to Japanese equities. The amount allocated to passive balanced funds for benefits is subtracted from this amount, so the number of active funds that can be taken on is limited. Takahashi says Daiwa's corporate pension clients are more interested in expanding private assets or replacing alternative strategies, and that domestic equities are not the main topic of discussion.
According to Takahashi, increasing allocation to Japanese equities would require a return reinforcement phase brought about by a reduction in the assumed interest rates on the life insurance general account. Since private assets (the first choice in a return reinforcement) are low-liquidity assets, some funds would be unable to increase their allocations. Instead, they might choose the currency risk-free option of increasing Japanese equities.
The current stock market has been sluggish in the face of rising geopolitical risks and the prospect of an interest rate hike in the US. The Nikkei 225 has fallen more than 10% from its 30-year high of 37,957.78 yen on September 14, 2021, and the market outlook is uncertain. Nevertheless, asset owners have shown no signs of panic. Having survived several "shocks" in the decade or so since the global financial crisis, corporate pension plan managers have adopted a long-term investment stance of commitment to Japanese equities, but in diminishing proportions.
< Masayoshi Koike >