For many years Japan has been an insurance-market behemoth and Japan Post Insurance Company is one of the giants with $1.13 trillion.

But the industry has not been immune to change. Between 1997 and 2001 seven life insurance companies became insolvent, and there is a question mark over whether it was a low interest-rate environment that caused this fallout.

Given that history and the current low interest-rate environment, investment risk manager at Japan Post Insurance Company Ryujiro Miki, who will speak at the Conexus Financial Fiduciary Investors Symposium, says it is worth exploring the potential effects on the insurance industry.

 

Mixed messages

The economic statistics in Japan are grim: the official government bond rate is 0.8 per cent, having peaked at about 8 per cent in 1980. Similarly, the Nikkei peaked at ¥39,000 in the 1990s and now it’s at ¥8000.

However, the bond market in Japan is unique in that 92 per cent of the nation’s debt is domestically owned. Furthermore, the Japanese government owns 40 per cent of the banking system directly, and about half of government bonds are held by government-owned institutions.

“Japan owns the bond market, external debt is very tiny; we are self sufficient,” Miki says.

“Since the peak of interest rates the Japanese industry has been trying to get rid of excess capacity so inflation has not been an issue but deflation has been… The debt-to-GDP ratio is 200 per cent – much worse than Greece – but the net-debt position is half that.”

The Japan Post Group is 100-per-cent owned by government. It is made up of two gigantic institutions, both of which are the largest in the world: Japan Post Insurance, which has $0.8 trillion of US-dollar-denominated Japanese government bonds (JGB), and Japan Post Bank, which has $1.8 trillion of them.

“We hold roughly 30 per cent of JGB,” Miki says.

The Japanese government is looking to sell the stock of a number of holdings in order to recapitalise after the earthquake, most recently the airline, and Japan Post Group is on its list.

 

Lesson from the 1980s

The potential listing has great consequences for the market more widely. If it lists and diversifies its asset allocation away from domestic bonds, it could have an effect on interest rates.

Back in the 1980s interest rates were deregulating but there were also a number of structural issues that contributed to the demise of the seven insurance companies, worth about $120 billion. These included financial deregulation and globalisation, a maturation of the death-coverage market and fierce competition for private insurers to raise assumed interest rates to struggle against public insurers.

In the 1980s insurance coverage was meeting its limit, according to Miki. While interest rates were deregulating, investment-style products were becoming more popular.

“Investors wanted high-return products and insurance companies were competing against the mutual-fund industry,” he says.

But really, Miki says, it was the absence of risk management, and asset-liability modelling, that led to the failures in the 1980s, not low interest rates per se.

“Under the circumstances, there was too much rapid expansion and concentration on risky assets, but there was a lack of corporate governance, an absence of risk culture and good management,” says Miki, who at the time was in the investment-planning department at one of Japan’s private insurance companies.

One of the main lessons from that time is that asset-liability modelling is the key to hedging interest-rate risk, Miki says, but he believed enterprise risk management, or lack of it, was the real cause of the insurance companies’ demise.

“It wasn’t the bubble bursting alone, but bad management also,” he says.

At the International Centre for Pension Management’s biannual meeting in London, Jack Gray and Generation’s David Blood had a tête à tête on sustainability.

An academic at the Paul Woolley Centre for Capital Market Dysfunctionality at the University of Technology Sydney, Gray has written a paper, Misadventures of an Irresponsible Investor, that at its core suggests that there is an opportunity cost to not doing something else by spending a disproportionate amount of time on “responsible investment”.

David Blood, former chief executive of Goldman Sachs Asset Management, has built a business around sustainability at Generation Investment Management, alongside royalty of sorts – the former US vice president Al Gore and Mark Ferguson, son of Manchester United manager, Sir Alex Ferguson.

Sustainability, it seems, is working out OK for Blood, with the UK press reporting he took home more than £10 million pay in 2009 alone.

 

Blood and Gore vs Gray

Gore and Blood do have some sensible investment tenets, in my opinion, based on long-term incentives being the antidote to the short-term greed that many attribute with causing the recent crisis.

Gray, on the other hand, is confused.

Most would describe Gray as an intelligent man. And I would now add brave to that description.

To admit, in front of a peer group of leading investment minds and the largest institutional investors in the world, that you “don’t get it” takes courage.

In the closed session, delegates – mostly pension funds and some academics – were asked a simple question. Were they long green or long brown?

The audience vote showed that 30 were long green, and 20 were long brown.

 

The metamorphosis of “responsible”

While this is a blunt investment question, in reality it is not that simple. Many funds say they have dual incentives.

But Gray’s philosophy is that markets are not driven by morality and, in any case, society is not that moral as a collective. But he also admits he is confused.

“I abhor the view that companies’ motives are to only drive profits. But when it comes to pension funds, I flip over and think that is their only reason for being,” he says. “I’m confused.”

What Gray does object to is the use of the word “responsible” for what he sees as an investment analytical approach that started as the enhanced analytics initiative named by Raj Thamotheram, then at USS.

This initiative ran for four years between 2004 and 2008 with the aim of stimulating sell-side analysts to produce research that incorporates ESG issues in such a way as to enable fund managers to integrate them into their investment decisions. It was claimed a success and a stimulant for exponential growth in this research.

Somehow enhanced analytics has morphed into responsible investment or sustainability or ESG, depending on who you talk to.

 

Flowing into the mainstream

Nomenclature in this sector is a problem.

Even the latest biennial sustainable and responsible-investments research by the European Forum for Sustainable Investment (EUROSIF) concedes that the judgment of whether something is SRI is “very much coloured by the cultural and historical diversity of Europe”.

At this stage, the report says, there is no consensus on whether a unified definition of SRI exists within Europe, regardless of whether that definition focuses on the processes used, societal outcomes sought or the depth and quality of ESG analysis applied.

It’s a challenge for investors to understand the various product offerings, and for service providers it may mean national distribution is required depending on country preferences.

The sustainability-driven Generation has a concentrated low-turnover portfolio, focusing on long-term advantages.

There is an argument that this type of investment doesn’t need a label, but should be just part of good analysis.

Gray says infrastructure managers, for example, have always taken social and environmental factors into account.

“The Economist reported recently that we may have reached our “peak car” use. Infrastructure investors would take that into account when they are valuing a toll road. Property guys have also always done it.”

Personally, I believe in sustainability. But I don’t believe in marketing.

Taking into consideration themes such as water and other resource scarcity (a big theme of Gray’s former employer, Jeremy Grantham), growing and ageing populations, peak car use, climate change, good management practices, governance and decision making should not be viewed as ESG screens, tilts, implementation, overlays or philosophy.

These are the practices that investors should expect from funds managers. It is simply taking into account the future in assessing the price of assets now.

In the United Kingdom there are around 1.5 million employers, and it is estimated more than half of them do not offer a pension to their employees.

The pension system in the UK is fragmented. There are more than 10,000 mostly defined-benefit plans and, unless you are a government employee or in the high-income bracket, there is very limited coverage.

Auto-enrolment, the opt-out defined-contribution system designed to fill this gap, was introduced in the UK on October 1.

The government-funded pension fund, NEST, is one of the funds on offer under the new regime, and conexust1f.flywheelstaging.com had an interview scheduled with the chair of the fund, Lawrence Churchill on that day – the first day of the rest of the fund’s life.

 

Starting from scratch

Churchill and his staff have spent the past two years preparing the fund for this date. They have the infrastructure, including appointed investment managers and more than 250 staff, in place to start managing pension money.

“A lot has been happening in the past two years, NEST has changed the basis of competition and it’s been beyond my expectation,” Churchill says. “We are a low-cost option and we’ve used simple language, trying to get all the technical jargon out of the way, and it’s landed incredibly well.”

While October 1 was the first day of compulsion, the fund has taken on some “volunteers” with 200 companies and about 2000 employees, and about £1 million of assets already running through the fund.

“We’ve learnt a lot and it has been a reasonable test of our infrastructure,” he says.

Auto-enrolment will be phased in, reaching 8 per cent in 2017, with contributions split 3 per cent from the employer, 4 per cent from the employee, and a 1 per cent tax relief on net pay.

NEST has two main competitors: the People’s Pension, which is an established UK operator traditionally focused on the building industry; and Danish fund ATP’s offering, Now.

“It will be terribly interesting to see how this plays out,” Churchill says.

 

Industrial-strength governance

The fund is aimed at low-income workers and does have some constraints for growth, in particular it can’t take contributions of more than £4400 per person a year.

Churchill says one of the fund’s strengths is its focus on good governance.

“We’ve put a lot of effort into good governance and become slightly famous for good governance,” he says. 

“We have taken advantage of starting from scratch and we want industrial-strength governance. Our trustee structure is like a FTSE 100 company – we have committees at the board level and delegations to the executive.”

The chief investment officer of Railpen, Chris Hitchen (pictured right), chairs the NEST investment committee, which is responsible for setting high-level strategy including strategic asset allocation, risk budgets and responsible investment.

The implementation of that, within parameters, is given to the executive, which includes 15 internal investment staff, who manage a risk-driven asset allocation with 12 different risk indicators, and a different risk allocation at each phase of retirement.

The internal team has a monthly asset-allocation meeting and reports back to the investment committee on a quarterly basis.

The fund has taken a largely outsourced model – both investments and administration are outsourced – and it doesn’t have a licence.

The assets are held 100 per cent in regulated markets and 100 per cent in liquid markets. The largest mandate is with UBS and the other managers are State Street Global Advisors, Blackrock, F&C Investments, HSBC and RLAM.

 

Encourage saving

From an investment point of view, there are many particular characteristics of the fund. For one, it is largely indexed, with the average fee being 50 basis points.

“What we’re doing as an aggregator is bringing wholesale costs down to a retail market,” Churchill says.

And for young members the default fund is unusually defensive.

The philosophy behind this, Churchill says, is that it is better to encourage saving per se, than to tempt people to opt-out because they have had a bad or volatile investing experience.

The fund’s chief investment officer, Mark Fawcett (pictured right), says the amount of risk taken when you have a small amount of money is less important than actually continuing to save.

“When you are very young, you have a small amount of money to invest. If you take a lot or a small amount of risk it is irrelevant because the amount of money is small. When you are 30 to 50 years old, it is more important,” he says.

NEST has done extensive research and has found that young people in particular are adverse to volatility and losing money, and a reaction to that could be to opt-out of the fund all together.

“You have to keep saving to create a pension,” Fawcett says.

 

Long-term relationships

Risk management and diversification are the drivers of investment management for NEST, and the fund “believes” there is better value in passive management.

“It is better to use resources on asset allocation,” Fawcett says.

More than half of mandates awarded are passively managed.

In addition, the fund is looking to have long-term relationships with its service providers, including its investment managers, demonstrated by mandates being open ended.

“We went into it saying if you do what you say you’re going to do then you’ll be around,” he says. “We want to keep managers focused so we don’t believe in artificial horizons – even 10-year mandates are artificial time horizons. If two years from the end of their term they are underperforming, then they will take more risk.”

While it is not on the immediate horizon, Fawcett says it is possible assets will be managed in house.

It is a requirement that the fund uses a consultant for manager searches, and both Aon Hewitt and Mercer have been used so far.

Fawcett says the other unique aspect of the fund is that the default fund is a series of target-date funds, one for every year of retirement, and there is dynamic management within the target-date funds.

The target is on expected retirement date, and risk is managed according to annuity prices, not the size of the pot. Something other defined-contribution funds could learn.

“We are trying to philosophically see our way through conversion risks,” Churchill says. “We focus on retirement income.”

He says the fund is looking to broaden its range of retirement-income offerings and will work with providers to add products such as low-cost, advice-lite drawdown products.

 

In an interview with conexust1f.flywheelstaging.com, John Kay, economist and author of the UK government-commissioned enquiry into long termism and the UK equity markets, has said it is “fanciful to imagine large number of trustees will have the skills and knowledge to have long-term relationships with corporates”.

Kay says the key players in the UK equity chain are funds managers, and while 20 years ago the role of pension and insurance companies would have been emphasised, that is not so today.

 

Embrace the complexity of ownership

 

In Kay’s review, the emphasis was on funds managers, who he says have a critical role in the buy-and-sell decisions of shares as well as voting.

He says semantics around the word “owner” are not particularly helpful and get in the way of the discussion.

“There are different characteristics of ownership,” he says, adding that funds managers need to see themselves more as owners in order to alter their behaviour.

The recent so-called Shareholder Spring, when many institutional investors and funds managers voted down executive-pay issues, was a step in the right direction, according to Kay.

However, he says, in the long run he would like to see more engagement.

“Corporate governance has become about stopping people doing bad things. The Shareholder Spring was prompted by the excesses of executive pay, but I’d like to see more focus on things like concentrated portfolios that are differentiated from each other.

“There is a high degree of closet indexation and pre-occupation with tracking error. I’d like to see a a different structure in funds management.”

 

The culture of singular excess

The number of intermediaries and the cost of intermediation in the UK market is excessive, he says.

One of the findings he emphasised was a move to reduce the role of transactions and trading, and move to a relationship-based culture.

“This is a philosophical shift that will take place over a long time. But I’d like institutions to feel more comfortable giving long-term mandates, for example.”

Kay believes one of the more important recommendations from his review is to form an institutional investors’ forum in the UK to facilitate collective action.

“There needs to be an emphasis on fiduciary duty to encourage asset managers to change their actions. This could be through giving asset owners the ability to give long-term mandates that are more absolute-return focused.”

The next step in the reform process is for the government to respond to the review. This is expected to happen in November.

 

Equity allocation by UK pension schemes continues to fall, but the assets are being re-allocated into “everything else except gilts”, according to Mercer chief investment officer, Andrew Kirton.

Last year equities allocations by UK pension funds fell by 5 per cent, according to Mercer, as they attempt to deal with the enormous amount of pension liabilities. Kirton estimates there is £1-trillion worth of liabilities in the UK pension system.

However, because government bonds are so expensive, allocations are tending to move into other defensive assets, such as property and asset-backed debt.

“Equities have fallen progressively and last year fell by 5 per cent on average,” he says. “Last year property debt became popular for the first time here, and the way we are advising pension schemes is encouraging that. We are saying to have a risk-reducing portfolio and a growth portfolio, and diversify both portfolios.

“The UK government us paying 2-per-cent yield for 10 years – we haven’t been at these levels since 1760. The US is also at a record low of about 1.5 per cent. So the government can borrow at less than the rate of inflation, which is a good deal, but for investors it’s another question.”

 

Popular alternatives

Mercer also expects the demand for inflation-linked bonds to continue.

The UK has the highest allocation to equities when compared with its European peers.

According to the 2012 Mercer European Asset Allocation Survey, UK funds allocate 43 per cent to equities, compared with the allocations of the well-respected systems of The Netherlands at 24 per cent and Denmark at 20 per cent.

In the UK the most popular alternative assets are diversified growth funds, global tactical asset-allocation funds (global macro), fund of hedge funds and emerging markets debt.

In continental Europe the most popular alternatives, according to Mercer, are emerging markets debt, high-yield bonds, funds of hedge funds, commodities and private equity.

 

Closing trend

The UK market is undergoing a transformation, with a trend for defined-benefit funds closing to new entrants. The UK has about 10,000 pension schemes, and the defined-benefit system is prohibitive to mergers because of the difficulty in pooling liabilities.

This week auto-enrolment, an opt-out defined-contribution system for employees without pension coverage, was introduced in the UK.

Last May, when Norway’s Government Pension Fund Global bought 4 per cent of the Formula One motor racing group from private-equity firm CVC Capital Partners, its goal was clear. The sovereign wealth fund, which invests Norway’s oil revenues, wanted the inside track on Formula One’s IPO in Singapore, scheduled for June. Instead, the GPFG’s foray into grand prix rapidly hit a roadblock, as volatile equity markets forced the flotation to be delayed.

The setback barely registered at the Oslo headquarters of Norway’s central bank, which manages the fund, founded in 1990, on behalf of Norway’s 5 million people. After all, the GPFG currently holds assets worth about 3.7 trillion Norwegian kroner ($640 billion), and vies with the Abu Dhabi Investment Authority as the world’s largest sovereign wealth fund. With Brent crude oil futures selling at more than $110 per barrel in September, Norway’s fund is also gushing liquidity. In the second quarter, the government poured $12.5 billion of oil revenue into the fund, mostly from StatOil, the state-controlled petroleum group.

 

Seek other markets

Nonetheless, the Formula One deal is emblematic of the fund’s need to discover something even more valuable than oil: riskier, but potentially higher growth investments. At present, the fund is required to return 4 per cent of its value each year to the government budget. The central bank’s governor, Øystein Olsen (pictured right), believes that in a global downturn, that 4-per-cent rule effectively short-changes the next generation of Norwegians.

“The real return on bonds in the fund’s portfolio can now be estimated at 1 per cent,” Olsen declared last February in his annual address. “With a normal risk premium on equities, the real return on the whole fund can be quantified at 3 per cent… If the return on the fund actually proves to be 3 per cent, we will have drained almost $174 billion from the fund over the next 20 years with the current 4-per-cent rule.”

So far Norway’s parliament, mindful of voters demanding more public expenditure in hard times,  has refused to heed the governor’s advice that a 3-per-cent target is more realistic.

“It is difficult to obtain a large excess return within a fund as large as the GPFG,” acknowledges Jan-Tore Sanner (pictured above left), vice-chairman of the parliament’s finance committee, which monitors the fund. Sanner suggests the GPFG’s investment team should “seek other markets in order to meet the 4-per-cent real-return benchmark”.

 

A theory of relativity in practice

That is precisely what Norway’s central bank intends to do. At present, the GPFG allocates 60 per cent of its portfolio to equities and 40 per cent to bonds. Under a new investment mandate issued in March, the central bank aims to reduce Europe’s share of the portfolio in the coming years from about 50 to 40 per cent in equities, and 60 to 40 per cent in fixed income. Meanwhile, the GPFG will start buying emerging-market debt and increase its equity exposure in developing countries from about 9 to 12 per cent of the stock portfolio. The fund will also switch from a regionally weighted capital allocation – the reason why Europe and therefore the troubled eurozone, Norway’s largest trading partner, looms so large on the balance sheet.

“There is no fixed regional weighting anymore,” says Øystein Sjølie, the fund’s spokesman. “Instead, the allocation is determined by the relative market capitalisation of each market.” To avoid skewing the fund’s focus too far from its historic investing regions, the mandate then adds a factor adjustment of 2.5 for “developed European markets, 1 for the US and Canada and 1.5 for other developed markets” and emerging markets.

 

The transparency hammer

As he attempts to fulfil the new mandate, three challenges confront Yngve Slyngstad, the fund’s cerebral chief executive. The first is purely technical. Any shift by a fund this large in a fresh direction could excite unwanted attention from investors if it is not handled discreetly and incrementally. Slyngstad – a former philosophy student – is not in the business of moving markets if he can help it.

The second challenge is persuading Norway’s citizens that the new mandate sets the right course for the fund in a hazardous investment climate. To Norway’s credit, the fund sets a standard of transparency that few asset managers, let alone sovereign wealth funds, can match. Ordinary Norwegians can check the year-end valuations of every stock and bond holding on the fund’s website or raise their blood pressure by watching the portfolio’s real-time market value shoot up and down on the home page.

The problem for Slyngstad and his management team is that when investing times are bad – as they mostly have been since he took charge in 2007 – they get hammered by the public. In particular, many Norwegians still cannot fathom why the fund increased its equity allocation from 40 to 60 per cent of the portfolio through the credit crunch of 2007 and financial crash in 2008, largely by purchasing small-cap stocks. This was despite Slyngstad patiently explaining at his public meetings across the country that short-term losses could become long-term gains when stock prices had fallen so low.

Investing under national scrutiny makes the fund’s third challenge all the harder: proving that its chosen new fields, emerging markets and real estate, can deliver those elusive higher returns. Emerging markets may be the riskier venture, because while the fund has small offices in Singapore and Shanghai, it understandably lacks in-house expertise in Asia. There are also investment opportunities in developing countries that the fund won’t touch, either because of its ethical guidelines (the GPFG doesn’t buy tobacco or weapons) or because of Nordic caution. Pakistan, for instance, is considered too unstable to provide sufficient protection for investors.

 

Low-need liquidity in Paris and London

Real estate, which the fund began buying last year, may represent more promising terrain, even though the asset class is relatively illiquid. This could be to the GPFG’s advantage as a long-term investor, says Stephen Schaefer, professor of finance at the London Business School, and co-author of a 2009 study commissioned by Norway’s government to analyse the fund’s strategy.

“The Norway fund has a very low need for liquidity,” argues Schaefer. “It has a strong revenue stream from oil and is projected to be cash positive for many years to come.”

Norway’s property portfolio, currently confined to London and Paris, boasts an array of fancy addresses. The fund holds stakes in a number of buildings on London’s Regent Street in a joint venture with the Crown Estate, which manages the British monarchy’s historic assets for the benefit of UK taxpayers. Across the English Channel, the fund has teamed up with French insurance group AXA and, more recently, Italy’s Generali Group, to invest in a string of properties in Paris’ upmarket eighth and ninth arrondissements.

To date, the GPFG’s real estate holdings, valued at about $1.9 billion, are a tiny fraction of the fund’s total portfolio. These small beginnings, however, belie the scale of Norway’s real estate ambitions. Between 2012 and 2020, the fund aims to spend $43.5 to $52.1 billion on properties outside Norway, turning the GPFG into one of the world’s largest real estate investors. It is a massive bet on a highly cyclical sector with only one certain outcome: property developers from New York to Sydney can soon look forward to a new Nordic competitor on their home turf.