Too Much Beta Dragging Down Japan, Norway?

Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, on Friday reported a profit of 9.1 trillion yen ($84.4 billion) in January-March, swinging from a record loss in the prior quarter, thanks to an upturn in stock markets:
The fund, which managed 159.2 trillion yen of assets as of end-March, had quarterly profits of 2.7 trillion yen on domestic stocks and 5.1 trillion yen on foreign equities, its earnings results showed.

Japan's Nikkei stock average rose 8.4% during the quarter, boosted by speculation the U.S. Federal Reserve's next policy move would be an interest rate cut.

The GPIF had suffered a record 14.8 trillion yen loss in the three months ended in December as worries about the escalating U.S.-China trade war battered global markets.

Given the ultra low interest rate environment in Japan, the fund has retreated from unprofitable domestic bonds and pushed into foreign assets.

It had 26.3% of its portfolio in Japanese bonds as of end-March, compared with 36.15% in September 2016 when the Bank of Japan launched its policy of pinning 10-year government bond yields around 0%.

By contrast, the GPIF’s foreign bond holdings accounted for 16.95% of its portfolio in the latest quarter. It bought a net 630 billion yen of foreign bonds during the quarter, according to a Reuters calculation based on the fund’s results.

The fund allocated 23.55% to domestic stocks and 25.53% to foreign stocks.
The Daily Express also reports the world’s biggest pension fund posted a gain for a third consecutive fiscal year as overseas stocks rallied and strength in the dollar versus the yen helped boost the value of its assets abroad:
Japan’s Government Pension Investment Fund returned 1.5pc, or 2.4 trillion yen ($22.1 billion), in the year ended March 31, with assets totalling 159.2 trillion yen, it said Friday in Tokyo.

Overseas stocks were the fund’s best performing investment, handing it a gain of 3.1 trillion yen, while domestic equities lost 2.1 trillion yen. Its investment income was 698 billion yen for overseas bonds and 596 billion yen for domestic debt.

The GPIF’s recovery from a record 14.8 trillion yen loss during the October-December quarter comes as Japan heads into this month’s national elections, where social security ranks as the most important issue in media polls.

Global equities and bonds rallied in the first three months of 2019 as U.S. and European central banks turned dovish amid U.S.-China trade tensions.

“While interest rates remain low, investments that can generate returns are getting limited,” said Hiroshi Matsumoto, head of Japan investment at Pictet Asset Management Ltd. in Tokyo. “In such an environment, we think there is no other choice but to take on risks in assets such as stocks and alternative investments if you want to improve returns.”

The GPIF doubled stock holdings and cut bonds as part of a strategy revamp in 2014 with the assumption that rising prices would erode the spending power of Japan’s low-yielding debt. Since then, the shift has helped the fund generate a positive return for four out of five fiscal years.

During the fiscal year, the MSCI All-Country World Index of global stocks rose 0.5pc and the S&P 500 Index gained 7.3pc, while the Topix index dropped 7.3pc.

Yields on 10-year U.S. Treasuries fell 33 basis points in the period, while benchmark Japanese government bonds yields dropped 14 basis points. Japan’s currency weakened 4.1pc against the dollar.

The GPIF has a general target to keep 25pc of its basic portfolio in domestic stocks and 25pc in overseas shares. The permissible range of deviation is 9pc for local equities and 8pc for stocks abroad. The fund holds the majority of its stock investments in strategies that track indexes.

Alternative assets accounted for 0.26pc of GPIF holdings, below the allowable limit of 5pc.
With only 0.3% in alternatives, it's no wonder GPIF swings like crazy every quarter depending on what happens to global stocks and bonds:

Earlier this year, Norway’s $1tn oil fund, the world’s largest sovereign wealth fund, suffered its worst performance since the depths of the global financial crisis as weak equity weighed on the fund's performance:
The fund — Government Pension Fund Global — had a return of minus 6.1 per cent in 2018, leading it to the largest ever annual drop in krone terms in its value.

The results are likely to stoke a debate about the wisdom of the fund increasing its equity holdings from 60 per cent to 70 per cent of its assets just as many expect stock markets to end their decade-long bull market.

Yngve Slyngstad, the fund’s chief executive, said the investor had reached its 70 per cent target in recent days following a spurt of equity buying in November, December and January as it used the then market turmoil to spend about 3 per cent of its assets on purchasing shares.

Asked by the Financial Times if the fund had been guilty of buying shares at the wrong time, Mr Slyngstad said: “We will only know the answer to this some years from now. You have to be very clear to yourself that a contrarian strategy may work sometimes and may not work at other times. We do not make predictions on the future development of the market.”
Slyngstad's decision proved to be right as markets bounced back strongly in Q1, and along with them the fund posted a 9.1% annualized return as at the end of March:


Of course, that's just a quarter and as Slyngstad points out, they will only know if moving to the 70% equity target was a right decision in years.

I've already covered Norway's giant beta problem and GPIF is in the same boat and worse because its allocation to alternatives is much lower. Norway has started investing in real estate all over the world but it recently lowered its target for real estate in its portfolio to 3 to 5% from 7% on concerns the global boom is nearing an end (a wise decision, especially now that real estate vulture funds are building up their fire power).

The swings in Japan are making people very nervous and some are saying it will cost GPIF's CIO his job. I wouldn't be so quick to blame Hiromichi Mizuno, it's not his fault the fund's returns swing hard with equity markets. He's steering a giant ship which moves at a snail's pace.

But both Mizuno and Slyngstad need to ramp up their allocations to private markets and to do this properly, they really need to think outside the box. Given their giant size, it won't be easy to scale up private markets, something they're both very aware of.

Why ramp up privates and why is the strategy so important? Because the volatility of these giant funds is quite frankly, unacceptable even if they invest over the long run, and they need to to reduce it by partnering up with the right partners, getting the most bang for their buck while reducing overall fees.

To be blunt, they are both late to the private markets game but if they have the right partners and strategy, that doesn't matter.

On another note, Norway and Japan are showing conflicting approaches to ESG investment:
A growing consensus has emerged among asset owners and managers that there is no escape from addressing climate change. Yet there is precious little agreement on how to go about it. At one extreme is Norway’s $1tn sovereign wealth fund, the world’s biggest, which has just been given the go-ahead by the Norwegian legislature to dump shares in coal and energy companies. At the other is Japan’s $1.36tn Government Pension Investment Fund (GPIF), the world’s biggest retirement pot, which believes fund managers should engage with companies on climate change rather than divest.

What these two financial behemoths nonetheless have in common is a commitment to climate-related risk reduction. In the case of Norway, which is Europe’s biggest petroleum producer, there is a national vulnerability to confront as the future of fossil fuels becomes more problematic. But the divestment is not quite as radical as it appears at first sight. The fund is retaining its holdings in integrated companies such as Shell and BP because it expects them to be the biggest future investors in renewable energy.

That said, the difference in underlying philosophy is real. In a seminar at the recent meeting of G20 finance ministers and central bank governors in Fukuoka, Hiromichi Mizuno, chief investment officer of GPIF, told me he was passionately opposed to negative screening. The one thing you know for sure about the people to whom you sell the shares, he said, is that they will be much less concerned about climate change than you are.

For GPIF, with 90 per cent of its equity portfolio passively managed, the issue is essentially about the choice of indices. The two it uses to address climate change overweight companies with high carbon efficiency and good disclosure of climate emissions, while underweighting those that do greater environmental damage.

The mere fact of underweighting provides an incentive to improve carbon efficiency and disclosure. But GPIF is also dedicated to prodding its fund managers into active stewardship, with a particular emphasis on the environmental, social and governance agenda (ESG).

The Japanese fund is in the vanguard in all this. Yet larger institutional investors are increasingly recognising that the E in ESG represents wider opportunities over and above risk management. Since the Paris accord proposed the introduction of carbon reduction targets, implementation by governments inevitably implies an impact on corporate earnings, cash flows and balance sheets. Many business models in such sectors as energy, transport, utilities and construction are no longer viable as a result.

Fund managers that are obliged to disclose their voting record are thus under pressure from asset owners and public opinion to prod companies into explaining how they plan to manage the transition to a low carbon world. At the same time they have to process corporate disclosures on environmental issues, which have multiplied since the Task Force on Climate-Related Financial Disclosure was established by the Financial Stability Board at the request of the G20.

This is where the opportunities arise, chiefly for active managers, since the markets are almost certainly inefficient in their pricing of climate-related risks. This reflects the lack of uniformity and variable transparency in corporate disclosure.

Some fund managers remain sceptical about the social and governance components of ESG. Yet the evidence of the benefits of integrating ESG into the investment process is by now pretty compelling. The most comprehensive academic survey of 2,200 individual studies on the subject found that the great majority showed a positive relationship between ESG and corporate financial performance.*

Yet it does not require academic evidence to recognise the costs of bad governance. Think only of the trouble at Nissan, which boils down to the oldest governance failure in the book: an over-dominant boss accountable to a weak and unbalanced board. The ESG sceptics must surely be a dwindling band.

* ESG and Financial Performance, Journal of Sustainable Finance and Investment, Volume 5, Issue 4. Gunnar Friede, Timo Busch and Alexander Bassen.
It's important to note that Norway is already exposed to the oil & gas sector, the whole point of their large fund was to diversify the earnings they receive from selling oil and gas.

In that sense, I'm not surprised they divested from coal and energy shares.

Anyway, my personal philosophy lies more with Hiromichi Mizuno, pensions shouldn't be divesting from many investments unless they violate human rights and I believe there is a strong case to be made to divest from tobacco, but even there, there will be opposition.

Lastly, a few of my readers sent me the Guardian article on CPPIB quietly divesting from US migrant detention firms. I'm well aware of this and covered it back in December 2018 here.

Basically, these are trivial investments made by one of the internal quant programs based on factor investing and once they added a qualitative screen, they filtered these investments out based on ESG criteria. Importantly, there is nothing sinister going on here.

Below, Hiromichi Mizuno, GPIF's CIO, appeared at the Milken Institute in June as part of an interesting panel discussing investing for the long term.

And Yngve Slyngstad, chief executive officer of Norges Bank, discusses the trade war between the U.S. and China, his investment strategy, his global property investments, London's property market, investing in technology companies, his concerns over inflation, how technology is disrupting markets and his outlook for finance (September 2018).


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