MW-06 -- "Buy and Hold" and Other Myths, Part 2

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

Issue No. 6
Tuesday, November 19, 2002

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Viewpoint: "Buy and Hold" and Other Myths, Part 2

The Bottom Line:

o The Heisei Malaise has Japan's pension funds in a futile
search for investment returns that can beat required returns.
As the stock market implodes and government bond yields are
pushed below 1 percent, even 2.5 percent hurdle rates are
looking impossibly high. The persistent gap between required
returns and actual returns has both companies and
individuals dropping out of the nation's pension system in
record amounts.

o This has corporate and public pension funds seriously but
belatedly looking at alternative investments, including
private equity, hedge funds and REITs. Some estimate that the
pool of funds in Japan dedicated to alternative investments is
JPY1.6 trillion. Corporate pension funds of blue-chip
companies Toyota and KDDI, the Welfare Pension Fund, and Norin
Chukin have already begun to allocate funds for alternative
investments. If Japan's entire pension pool were to
allocate 2 percent of total pension assets, this would imply a
pool of alternative investment funds of at least
4 trillion yen.

o The "dream" of sustainable investment growth and capital gains
for pension returns, corporate profits and even the economy
has long since evaporated. It is high time that the
government, the investment-services industry and individual
investors recognize reality -- "buy and hold" and capital
gains are a myth as long as Japan remains as structurally sick
as it is today. The name of the game is capital preservation,
verifiable value and dividend yield.

Once upon a time, there were only two types of asset managers in Japan
that could manage pension assets -- domestic life insurance companies
and trust banks. The life insurers bundled company pension funds into
one "general account", and offered a virtually guaranteed return. Life
was easy then for corporate pension and public pension fund managers.
Bonds still had actual yields of 4-5 percent, and the stock market was
in a secular bull market that had lasted since the Tokyo Stock
Exchange (TSE) re-opened after World War II.

The hurdle rate (projected return) for pension funds was 4-5 percent,
which was not too hard to meet given prevalent bond yields and a
rising stock market. It wasn't even a big deal if actual returns
on your pension fund undershot your hurdle rate. Even though the funds
were not generating enough returns to provide for future pension fund
payouts, the pension funds in general were in their "accumulation
phase," i.e., more young workers were joining the pension plan than
there were people retiring and receiving pension payouts.

Then the bubble burst, stock prices entered a decade-long spiral that
would pull stock market levels back to where they were 20 years ago,
and the bond market entered its secular bull market, with bond yields
falling to a point where nominal bond yields are fast heading under
1 percent and could eventually be zero.

At the same time, the average age of corporate employees began to
rise noticeably, in keeping with the rapid aging of the Japanese
population. To make matters worse, new accounting rules were
introduced that required Japanese companies to disclose their
under-funded future pension liabilities.

As bond yields continued to slide, the life insurers slashed the
guaranteed returns on their "general account" pension management
plans. Public pension and corporate pension funds poured out of the
"general account" pension management plans to active asset managers,
who claimed they could offer returns that could help the pension funds
beat their required returns. Yet hurdle rates for the pension funds
were stuck in time. Bull market assumptions were also stuck in time,
as most Japanese investors continued to pursue the myth of profit
growth in their equity investments.

As annual investment losses at the pension funds piled up, so did
their unfunded pension liabilities. As companies now had to disclose
these liabilities, they set about making periodic write-offs to make
up for the funding gap, while tinkering with their investment-return
hurdle rates. Corporations have lowered their assumed returns to 2.5
percent, while the National Pension Fund lowered its to 3 percent. Yet
as bond yields continued to slide and the great wealth-destruction
machine of the stock market continued, even these hurdle rates proved
impossible to meet. Corporate pension fund returns in fiscal 2000 were
-9.7 percent, and they were less than -7 percent in fiscal 2001. It no
longer is an issue of generating hurdle-rate returns, but one of
protecting value.

Corporate pension funds have either been dissolving or giving the
portion they managed for the Welfare Pension system back to the
government. Since corporate pension funds started in 1966, 103
have since dissolved, with 36 dissolving in fiscal 2001. A new law
effective from April 2002 allows the companies to return to the
government the substitute portion (welfare pension) portion of
employee pension funds. Surveys show that 20-30 percent of
corporations want to, or are in the process of, returning the welfare
pension portion to the government. It is virtually impossible to
return this to the government in the form of stock. In other words,
the companies have to sell stocks and then transfer the cash back to
the government. The outstanding balance of employee pension funds is
about 58 trillion yen, with stocks held by the substitute portion
amounting to nearly 10 trillion yen. If 30 percent of all companies
return the substitute portion to the government in cash, that
represents 3 trillion yen of selling pressure for stocks.

As we detailed last week, the Government Pension Investment Fund
inherited its share of losses when it took over administration of the
nation's pension funds from the infamous Nenpuku (Pension Welfare
Association). It also inherited a lot of structural problems. For
one, Nenpuku had been dealing with a hodgepodge of investment
managers in a very unsystematic fashion. When, Mr. Terada (formerly of
Nomura) took over as head of the GPIF, he began to review the
contracts the GPIF with outside fund managers. What he found by using
the Sharpe ratio and other analytical techniques was that the
portfolios of all but one of the fund managers in no way resembled the
investment style the managers professed to be pursuing. In other
words, they all changed their investment styles to suit their
perception of trends in the stock market. In the end, they
all were chasing the same kind of stocks and producing the same
mediocre to horrible investment returns.

The corporations have also slowly come to the conclusion that
something was definitely wrong with how their pension funds were being
managed. In reality, their benchmark was not performance relative to
the Topix, but to their hurdle-rate investment return. Kyocera, for
example, recently shocked the asset management community by moving all
of its pension fund assets back under a "general account" of a life
insurer, which offers a guaranteed return of a mere 0.75 percent. This
level of return is dramatically smaller than the pension fund's hurdle
rate of 4.5 percent, which means Kyocera must continually make up the
difference to the tune of several tens of billions of yen a year.
However, Kyocera management's reasoning was simple. Rather
than lose an undetermined amount every year in the markets, it is
better to lose a fixed amount every year.

As for the life insurers, they have been trying to rebalance their
portfolios for the past several years to better align the portfolio
with their asset-liability management guidelines. For example, Meiji
Yasuda Life (to formally merge in January 2004) has revealed that it
plans to reduce its exposure to equities from 14 percent to 10 percent
of assets.

While the Japanese government has painted the hedge funds as "those
unhealthy elements that are pushing Japanese stock prices (such as
bank stock prices) to unnecessarily low levels," in reality, these and
other short sellers in the market are being aided and abetted by large
Japanese institutional investors (including the public pension funds),
who, in their futile search for investment returns that exceed their
hurdle rates, are loaning stock to the short sellers in record
amounts ・ i.e., by upwards of some 7 trillion yen of late. While
still very tentative and almost negligible compared to the total pool
of pension fund assets in Japan, alternative investments, including
private equity, commodities such as gold and REITs have been
attracting definite and noticeable interest. In the initial stages,
however, the actual money being put to work appears to be mainly going
into private equity.

The Welfare Pension Fund has set up an alternative investment
allocation of some 15 billion yen, mainly to be invested in North
American private equity. Corporate pension funds such as Toyota and
KDDI have also set up allocations for alternative investments, while
Norin Chukin reportedly has allocated funds for alternative
investments of somewhere between 300 billion and 500 billion yen.
Japan Alternative Investments, an affiliate of Mitsui & Co., estimates
that the total Japanese investment pool for alternative investments is
now around 1.6 trillion yen. This money is just as likely to go into
overseas investments as it is into domestic investments.

But the intriguing thought of this movement is how this search for
returns by pension funds could be channeled into major corporate
restructuring through funds designed like Ripplewood Holdings. In the
US, pension funds became a major source of funding for alternative
investments, including the endowment funds of colleges. Ripplewood
claims it is anything but a takeover artist. Rather, it is a new
type of relationship investor for Japan. Its track record so far in
Japan has been promising enough to attract significant amounts of
Japanese capital. In fact, Japanese capital now represents about 40
percent of its total funds for investment. The Welfare Pension Fund
says it would like to raise its exposure to alternative investments to
2 percent. If 2 percent of the entire 210 trillion yen pool of
Japanese pension funds were to be funneled through such
channels, the amount of pension funds in so-called alternative
investments could easily rise to over 4 trillion yen, with the entire
amount of Japanese funds in alternative investments rising to above
10 trillion yen. All that is needed are more success stories.

It took them a very long time to come around perhaps because until
the Enron and Argentina default disasters, they had been able to
retain and grow funds under management in money market funds and
government bond funds, but the mutual fund managers in Japan are
finally embracing dividend yield plays or dividend income stocks.
Indeed, there currently is a rush of high dividend yield funds being
set up. Since October of this year, the movement of the major mutual
fund companies in Japan in this direction is noticeable. This is not
rocket science. With coupons on Japanese government bonds (JGBs)
dipping under 1 percent and the forward dividend of the TSE
first section hitting around 1.4 percent, there is a 40-basis-point
yield spread in favor of equities. The crossover between JGB yields
and TSE first section forward dividend yields came in July of this

This is good news for increasing numbers of companies listed on the
first and second sections of the TSE that are trading well below their
book value. Many have been abandoned by sell-side analysts and dropped
from the investing lists of large institutional investors -- yet their
business is cash-flow rich and basically solid.

Brokerage firms, the government and companies themselves pay a lot of
lip service to individual investors. Yet the government has just
introduced a new capital gains tax regime that is confusing as hell.
The mutual-fund arms of the brokerage firms continue to push the
government for tax breaks on stock trading, yet they have not been
able to consistently offer products for more risk-adverse individual
investors -- what good are breaks on capital gains when the reality is
that everyone has capital losses?

The dream by foreign investment firms of garnering a lucrative portion
of Japan's retail investor funds is also tarnished. While there are
73 foreign investment management firms now in Japan, only 10 are
profitable. Getting to the individual investor in Japan involves
huge distribution costs, and local players enjoy cost and pricing
advantages as part of bigger groups. Moreover, the big shift of funds
out of the postal savings system just didn't happen.

In reality, there are probably only around 7 million individual
investors in Japan that actively trade stocks. The brokerage firm that
first figured out how to woo these people was Matsui Securities.
Matsui went to an entirely online business model, slashed commission
rates on trades and was the first to offer margin trades online. As a
result, online trading now accounts for about one-half of all
individual investors, and the online specialist brokers have taken the
lion's share of these trades.

With cross-holdings expected to unwind at a faster pace as banks
scramble (as mandated) to get their holdings of stocks to within their
Tier 1 capital values by September 2004, more and more Japanese
companies are trying to figure out how to attract individual
investors. While the Bank of Japan has promised to buy stocks from the
major banks, these purchases are more likely to help blue chip
companies like Toyota, whose stock price has been penalized (despite
exemplary earnings performance) by unwinding cross-holdings.

Yet the best that most companies have been able to do is offer
shareholder "perks." In other words, if you are a shareholder, you get
something free from the company, be it rice, theater tickets, or a
free night's stay in a hotel. There are no dividend re-investment
programs. Indeed, the Commercial Code does not even allow them. Even
classic dividend plays like the utilities try vainly to market
themselves as "growth" stocks, when they should be appealing to
risk-adverse individual investors with economic value-added and high
dividend yields. Until Japanese companies, the brokers and even the
government abandon the long-defunct growth myth, there will be no "buy
and hold" and indeed, there will be no "buy" from individual investors
for Japanese equities.

-- Darrel Whitten

"What You Should Read After Irrational Exuberance"
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financial markets with views you use.

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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