MW-05 -- "Buy and Hold" and Other Myths

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 5
Tuesday, November 12, 2002

"What You Should Read After Irrational Exuberance"
A weekly strategic analysis of Japan's economy and
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Viewpoint: "Buy and Hold" and Other Myths

The Bottom Line:

o People inevitably point to the 1.4 quadrillion yen in personal
financial assets as a stabilizing force in Japan's current
economic and financial malaise. However, a realistic
estimation of the final cost of cleaning up nonperforming
loans, government sector debt, under-funded pension
liabilities and other latent losses in Japan's economy,
combined with the fact that it will be Japan's savers and
taxpayers who will eventually have to pay for this cleanup,
leads one to the conclusion that this pool of savings is
already effectively spoken for.

o Moreover, it is highly likely that the realizable value of
this pool of financial assets is much, much smaller than the
book value would indicate (yes, the 1.4 quadrillion yen figure
is a book value number). The Government Pension Fund (GPIF),
life insurers and other stewards of these financial assets
continue to lose money in the stock market at a record pace
and are nowhere near the returns required to adequately fund
for future payouts of these funds.

o The GPIF in particular is guilty of serious wrong-headed
thinking. With control of the nation's pool of pension funds
finally wrested from the grasp of the MOF's Trust Fund Bureau
and its political pork-barrel Fiscal Investment and Loan
Program, the GPIF is now embarking on a major expansion
of its market-risk profile at precisely the wrong time.

o The fund's critics claim that the GPIF needs a dose of
reality, and MoneyWatch heartily agrees. If the GPIF was
enjoying a surplus of reserves over future pension liabilities
and was in its accumulation phase, it could afford to assume
more risk to the principal (fund reserves). As it stands, the
fund continues to accumulate investment losses, under-funding
liabilities continue to grow, and it is in its payout phase.
In other words, now is not the time to be increasing the
fund's risk profile by throwing more good money after bad in
Japan's stock market and dramatically increasing the risk
profile of the nation's pension funds.

During the US secular bull market between 1982 and 2000, the mantra
was "buy and hold" and "stocks for the long run." The argument was
that average return of stocks in the US over the very long run (i.e.,
the past century or so) has been around 6.5 percent, or much better
than bond yields, before transaction costs. Moreover, it was argued,
the premium that investors demanded for more "volatile" returns in the
stock market was too high, judging by the experience of the 18-year
bull market. Therefore, the Dow Jones Industrials was supposed to have
gone to 40,000.

What someone forgot to mention however is that in reality, dividend
yields actually provided the bulk of the long-term average return on
stocks in these calculations. Moreover, taking the earnings risk
premium for the US market between 1982 and 2000 was like taking the
Japanese market's earnings risk premium from the 1970s to 1989 --
i.e., you only looked at the major secular bull-market phase and
ignored the rest. Over the very long run, bear markets in equities
have lasted 20 years on several occasions, and for 10 years much more
often. In other words, buy and hold is not such a good idea in a
secular bear market.

Japan's public pension system had long been a means of pooling
personal financial assets at the government level and using them to
underwrite government bonds as well as to invest in economic
infrastructure projects through the Ministry of Finance's Trust Fund
Bureau and the Fiscal Investment and Loan Program. Moreover,
what money that was invested in financial markets through the Pension
Welfare Service Public Corp. and through the Welfare Pension funds
administered by corporations for their employees was restricted by a
government-mandated asset allocation -- the infamous 50-30-30-20
rule. The rule says pension funds had to maintain 50 percent of their
pension assets in principal-guaranteed instruments, while a maximum of
30 percent could be held in equities, of which a maximum of 30 percent
could be held in overseas securities, with a maximum of 20 percent of
total assets held in real estate investments.

For years, asset managers railed against this mandated asset
allocation. The government-mandated asset allocation, it was claimed,
doomed Japanese pension funds to substandard returns, as while the
stock market was soaring, fixed income returns were in a secular
decline. Because the expected returns on domestic and overseas stocks
were higher, the theory of efficient portfolio diversification would
dictate that a higher level of domestic and foreign equities would
reduce the volatility of returns (risk), while maximizing potential

The other structural impediment to "fair" market returns for Japan's
pensioners and savers was the archaic, developing-country
infrastructure that funneled the nation's savings into government
bonds and social infrastructure projects through the Fiscal Investment
and Loan Program. Over the years, the FILP had become the "shadow
budget" and a pork barrel for politicians. To manage money in the
financial markets, the Pension Welfare Service Public Corp. (Nempuku)
had to actually borrow the money from the Trust Fund Bureau at what
were essentially long-term bond rates. Thus the fund began with a loss
equivalent to the long-term bond yield and had to produce market
returns that not only provided for future pension liabilities, but
also the borrowing costs of the funds.

The government decided to thoroughly review the entire plan and to
basically de-link the nation's pension funds from the Trust Fund
Bureau and the FILP. The pool of public pension funds was transferred
to the GPIF, a new organization that also absorbed the old Nempuku.
They did this because it was obvious that both the old FILP method of
funding and the Nempuku were no longer working. Private sector
researchers estimated that the nonperforming loans of
government-affiliated corporations that received funding from the FILP
had reached some 84 trillion yen, while the Nempuku was also running
up cumulative losses紡mounting to some 2.8 trillion yen by fiscal
2000. The idea was to not only transfer the funds being managed in
financial markets by the Nempuku, but also to manage the 130 trillion
yen still being controlled by the Trust Fund Bureau. An immediate
transfer, however, would be a disaster for the FILP. Consequently, a
gradual transfer plan was implemented, with the balance of this 130
trillion yen being gradually transferred to the GPIF by fiscal 2006.

The key assumption in revamping the administration of the nation's
pension funds was that putting these funds to work in the markets
would, in the end, produce economic returns for the nation's
pensioners, instead of being merely a huge cookie jar for politicians
and their cohorts to dip into whenever the economy hits a rough spot.
They dip into the cookie jar by issuing more government bonds to fund
fiscal stimulus packages. Or they did it when the stock market looked
to be dropping through psychological resistance zones by pressuring
the nation's public pension funds to buy stocks.

Given these structural and political issues surrounding the public
pension system, it is not surprising that the investment track record
for the nation's public pension funds has been horrible during the
Heisei Malaise. The GPIF was just set up in fiscal 2001, and many of
the cumulative losses in its portfolio were inherited from the old

As of fiscal 2001, the GPIF was still obligated to pay the MOF
interest on 24 trillion yen of funds that were "borrowed" by the
Nempuku from the Trust Fund Bureau. However, the GPIF itself
under-performed most of its benchmarks last fiscal year and lost some
1.0 trillion yen on domestic stock investments. The losses continue
this year to the tune of 834.3 billion yen in the April-June period of
this fiscal year alone. For corporate pension funds, companies can
choose to expense current earnings to fill the gap between pension
funding shortfalls that arise because of the gap in actual returns and
projected returns. In the GPIF's case, there is no separate earnings
flow with which to offset these cumulative losses except to ask
current contributors to the plan to pay more.

According to the GPIF's medium-term asset allocation policy, the
GPIF's total exposure to domestic equities is slated to rise from a
current 5 percent to 12 percent, and for foreign equities from 3
percent to 8 percent for a total equity weighting of 20 percent versus
the current 8 percent. Ostensibly (based on current pension reserves),
the GPIF's exposure to Japanese stocks would rise from 5.9 trillion
yen to 17.6 trillion yen over this period, or by 2.3 trillion yen per
year. On the surface, this is good news for the stock market, for the
asset managers who are vying for GPIF mandates and for brokers who
will be executing the trades. In fiscal 2001, the GPIF paid some
30.8 billion yen in commissions.

However, MoneyWatch has problems with the underlying assumptions in
this medium-term asset allocation scenario. In a secular bull market,
the assertions about expected returns were correct. Making money in
stocks (at least above and beyond bond returns and inflation) was
easy, the rising tide lifted all boats. In a secular bear market,
however, all of these assertions are dead wrong. Indeed, as Andrew
Smithers and Stephen Wright pointed out in "Valuing Wall Street:
Protecting Wealth in Turbulent Markets," in a secular bear market, the
real name of the game is protecting wealth, not trying to increase it.

Besides the lingering structural impediments and political meddling,
the other time bomb for Japan's pension funds is demographics. When
the population was young, and the number of those entering the work
force was larger than those retiring, there was a structural surplus
in the nation's pension funds because the growing working population's
contribution to the national pension pool was growing faster than the
amount of withdrawals from the pension pool by retiring workers. This
was the "accumulation phase." With rapid aging of the population,
however, the opposite occurs. The growth of withdrawals from the
pension pool from retiring workers begins to exceed the growth in new
contributions from new workers entering the pension system. In other
words, the fund enters maturity, or the "payout phase." Structurally,
Japan's pension system has entered the "payout phase," which greatly
increases the pressure to produce returns sufficient to provide for:
a) new pensioners, and b) projected pension fund liabilities as
calculated by benchmark investment returns (currently 4 percent for
the GPIF).

Thus management of the nation's pension funds has begun to
structurally shift to equities just at the wrong time, i.e., when the
Japanese equity market is in the midst of a major secular bear market,
and when the pension pool is entering the payout phase. Just like the
assumptions that drove the current glut of new office space in Tokyo
(i.e., by the time the buildings are completed, the economy and the
property market will have recovered), the assumption that the stock
market will have recovered sufficiently by fiscal 2006 to outperform
the bond market sounds plausible enough now, given that the Tokyo
stock market has plunged 80 percent from its 1989 peak. However, one
has to consider the mature nature of these pension funds. When it is
still in the accumulation stage, a pension fund is like a young couple
in their 30s -- their capacity for risk is higher, and they have time
to make up for their investment mistakes. Therefore, their weight in
equities can be much higher.

However, individuals near retirement have a much different risk
profile. Their capacity for risk is noticeably lower, and they have no
time to make up for investment mistakes. Consequently, the preference
naturally is for current income (i.e., dividends and bond coupons)
rather than capital gains.

In other words, now is not the time to increase the market risk
profile of the GPIF pension fund. Aside from the demographics, the
fund's problems are further compounded by the facts that a) corporate
bankruptcies are soaring, b) the number of funds giving up on managing
the government welfare pension portion of in-house pension plans and
pushing administration of these plans back to the government is
growing. Many now use the word "declining" when describing the
condition of employee pension funds. A record 29 employee pension
funds were dissolved in fiscal 2000, the fourth consecutive year of
double-digit figures. A total of 103 funds have been dissolved since
the system was started in 1966.

The asset managers that the GPIF subcontracts management of funds to
have not demonstrated any particular ability to insulate public
pension money from the implosion of capital values in the Japanese
stock market. The major investment trust companies in Japan themselves
are seeing two digit declines in their assets under management. The
top three -・Nomura, Daiwa and Nikko ・ have seen their net asset
values shrink by 37 percent since last September alone, or by 13.7
trillion yen. They have even managed to lose money on "virtually"
risk-free money market funds by investing in Enron and Argentina

The structure of the Government Pension Investment Fund administration
also leaves much to be desired. Given the less-than-a-decade history
of direct management of pension assets by plan sponsors, it is no
exaggeration to say that most of the individuals responsible are
relative, if not actual, newcomers to the field.

The fund's critics claim that the GPIF needs a dose of reality, and
MoneyWatch heartily agrees. If the GPIF was enjoying a surplus of
reserves over future pension liabilities, they could afford to assume
more risk to the principal (fund reserves). Given the current
situation where the fund continues to accumulate investment losses and
under-funding liabilities continue to grow, now is not the time to be
increasing the fund's risk profile.

-- Darrel Whitten

Written by Darrel Whitten

Edited by J@pan Inc staff (


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