MW-27 -- The Death of Actively Managed Japanese Funds?

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Issue No. 27
Tuesday, May 13, 2003

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Viewpoint: The Death of Actively Managed Japanese Funds?

The Bottom Line:

o "Active" fund management is becoming a dirty word among
Japan's pension funds. As the Government Pension Investment
Fund (GPIF) and the Pension Fund Association take over
increasing control of the public and corporate portion of
welfare pension funds, pension fund management in Japan will
become increasingly "passive."

o That implies that stock price formation for individual
companies will increasingly be determined by market
capitalization weightings in benchmark indexes such as the
Topix, not by the individual earnings fundamentals of these
companies. This is already happening. According to a Bank of
Japan study in 2000, 87 percent of the movement in individual
stock prices was linked to the specific fundamentals of that
particular company, but by fiscal 2002, this had declined to
70 percent.

o While everyone talks about higher equity weightings long term,
the short-term reality is lower domestic equity asset
allocations. When one considers that the domestic pension
funds have been one of the few investor groups (along with
foreign investors) that provided consistent buying support
heretofore to offset accelerating cross-holding unwinding and
selling by individuals, the removal of this support is causing
the obvious conclusion -- imploding stock prices.

o As for government countermeasures to support stock prices,
it's a classic case of "buy the rumor; sell the fact." The
government (including the BOJ) is effectively becoming the
buyer of last resort, but in amounts that are dwarfed by the
size of potential selling. While the BOJ had long ago become
the "buyer of last resort" for the bond market, the major
difference compared to Japan's stock market is that bonds have
become a safe haven for asset preservation. Moreover, as BOJ
governor Fukui has stated, "it's just a fantasy to believe that
(artificially) lifting stock prices would resolve all the
issues of the economy."

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The Death of Actively Managed Japanese Funds?

"Active" fund managers continue to insist to prospective clients that
they can beat the market. Active managers strive to beat the market by
changing cash levels, over/under-weighting sector exposures and by
seeking "out-performing" companies. However, while actively managed
funds do offer the potential for higher returns, the disadvantages
include: a) higher costs, including management fees, management
expenses and higher transaction fees; b) more unpredictable returns
(higher volatility); and c) tax liability for unit holders on capital
gains generated. In addition, while ultra-long-term data on the US
market show that equities have risen 6.75 percent per annum for nearly
the past 100 years, closer examination shows that the bulk of these
long-term returns were actually generated through dividend yields. At
the same time, long-term studies show that about 70 percent of active
equity managers have under performed the S&P 500 stock index. An
average fund manager will beat the market some of the time. Over the
long run, however, the great majority of fund managers will do no
better than the market average, particularly once various costs are
taken into account.

What about the recent short term? Standard & Poor's has recently
produced a study of the performance of its S&P indexes versus active
managers. Its methodology included asset-weighted returns, which
ostensibly provide a more accurate representation of investor returns
over a specified period. While the aggregate results tend to
substantiate the claim that actively managed funds under-perform (the
average of all sector funds was a 6.0-percent per-annum decline versus
a 3.76-percent per-annum decline in the S&P 500), the under
performance by sector came from only two of eight sectors: health care
and information technology. In the materials sector, 68 percent of
sector funds beat the S&P sector index over the past five years,
mainly because gold and precious metals are not well represented in
the S&P 500, which took on an increasingly "high tech" weighting
during the IT bubble years. Conversely, the sector indexes did better
in sectors traditionally considered income producing. Over the last
five years, 53 percent of REIT funds under-performed the S&P 500
sector index, and 63 percent of utilities funds under-performed the
S&P 500 utilities index.

The study made a specific effort to correct for shortcomings in other
comparisons such as:
o survivorship bias,
o apples-to-apples comparisons, i.e., sector-fund returns
against sector benchmarks, and
o asset-weighted returns weighted by net assets.

The Rush to Passively Managed Funds
"If we cannot achieve investment returns that do not even match the
market's performance, why do we need to pay extra fees to have the
money managed actively," asks a manager in the postal savings division
of Japan Post. That particular observation says a lot about what's
happening in Japan's pension funds these days. The reason is simple:
Active fund management has produced substandard returns. Fiscal years
2001, 2002 and 2003 have seen negative returns for domestic equities,
with pension-fund portfolios performing worse than the benchmark

Thus, there currently is a crisis underway in Japan's pension funds.
According to the Welfare and Labor Ministry, 88.2 percent of
government-mandated "welfare" pension funds had under-funded pension
benefit obligations in fiscal 2001, and the under-funding amounted to
6.98 trillion yen.

It only got worse in fiscal 2002. As of late April this year, the
ministry had approved the return of welfare pension monies by 511
corporations to the government on a total of 1,043 individual and
combined pension funds. Over half of those returning the funds plan to
do so in the form of cash, which means they will have to sell their
current equity holdings (including foreign stock holdings). However,
only a small portion of these holdings have been sold to date, as the
corporations will be selling these holdings in relatively small lots.
In other words, equity selling by corporations returning their welfare
pension funds hasn't really begun yet.

While it is possible to return the funds in the form of stocks, the
ministry has tried its best to make this difficult. Basically, unless
the pension fund has welfare pension assets of over 5 billion yen, it
is virtually impossible to return the funds in shares. The conditions
given by the ministry include: a) the stocks must be a "basket" of
stocks that track the Topix closely (i.e., a passive-fund package);
and b) more than 90 percent of the holdings must be Topix-constituent
stocks that track the Topix with a tracking error of less than 0.2
percentage points.

Thus, more and more companies will be opting to return the portion of
individual corporate pension funds managed for the national welfare
pension system back to the government, and portfolios heretofore
actively managed have become the target of selling by such corporate
pension funds.

Twenty three percent of Japanese pension funds are already managed
passively, and this ratio could well increase significantly in the
next few years, because the corporate pension funds transferred to the
Government Pension Investment Fund (GPIF) will be managed passively.
Part of the reason is that active managers have been unable to
demonstrate performance in a secular bear market that justifies their
fees, and another reason is that, because the big public pension funds
are doing it, asset managers have to offer passive funds to keep their
public-pension-fund clients. In addition, money that was heretofore
managed by the Trust Fund Bureau under the Fiscal Investment and Loan
Program is finding its way into the stock market through the GPIF.

By March 2009, the plan is to have 70-80 percent of these funds
managed passively, meaning that 9 trillion yen of new funds would be
invested in individual stocks according to their weight in the
benchmark index, the Topix. From April, the government postal system
was "privatized" into the Japan Post public corporation. The new
corporation will inherit funds from the Kampo Postal Services Agency
insurance system after revaluing the assets to current market value,
and it is now negotiating with the trust banks to switch from active
management to passive management. Kampo managed 4.9 trillion yen and
the postal savings system managed 2.4 trillion yen in domestic stocks.
This is expected to expand to 7.4 trillion yen and 4.7 trillion yen,
respectively, over the next four years, and if 70-80 percent of these
funds are also managed passively, this would also mean more than 9
trillion yen of new funds will be managed passively in Japanese

Impact on Stock Price Formation
What happens if the amount of passively managed funds increases
relative to the actively managed funds? For one, individual stocks
will not be added or replaced by earnings fundamentals or news
developments, but to merely rebalance the portfolio to match the
benchmark Topix weightings. The prices of individual stocks in the
index will therefore be more influenced by the overall direction of
the market as opposed to individual earnings fundamentals. By using
the 25-day moving average "bull-bear" ratio of rising stocks versus
falling stocks, one can see a rise in the tendency of individual
stocks to be more influenced by the overall market trend.

According to a Bank of Japan study in 2000, 87 percent of the movement
in individual stock prices was linked to the specific fundamentals of
that particular company, but by fiscal 2002, this had declined to 70

The Health and Welfare Agency is in a no-win situation, particularly
as regards pension-fund policy. When it proposed a substantial
long-term increase in the weight of the pension funds being
transferred to the GPIF from the Fiscal Investment and Loan Program,
it was criticized by opponents in the Diet. But now the Liberal
Democratic Party (LDP) and the ruling coalition have included more
active purchases of equities by public pension funds in their package
of stock market support measures. They are proposing to make the old
discredited PKO (public-pension-fund price-keeping operations) actions

The Bank of Japan is also between a rock and a hard place. While it
has already purchased more than 1 trillion yen of blue-chip stocks
from the banks in its program to expand purchases from an original 2
trillion yen to 3 trillion yen, it is under additional pressure from
the LDP to purchase more. Hideyuki Aizawa, who heads the LDP's
anti-deflation panel, said last week: "We will insist loudly" that the
Bank of Japan buy shares in the country's struggling lenders. What his
words mean is that the LDP wants the BOJ to try and catch a falling
knife by buying up bank shares, which at recent rates of declines,
would have the BOJ becoming the majority shareholder in no time.

While public pension funds say they plan substantial increases in
Japanese equity exposure over the long term, the short-term reality is
that pension funds have been reducing their exposure to Japanese
equities. From March 1999 to January 2003, the equity exposure of the
pension funds surveyed by research outlet Nenkin Joho cut their total
exposure to equities and equity equivalents (domestic equities,
foreign equities and convertible bonds) by 11.1 percentage points,
with 9.0 percentage points coming from reduced exposure to domestic

Over the year ending March 2003, the trust banks, considered the
stewards of both corporate and public pension funds, cut their average
exposure to equities and equity equivalents by 8.1 percentage points,
with 5.3 percentage points coming from domestic equities. In addition,
the Reuters asset allocation survey of Tokyo-based investment shows
that recommended equity asset allocations peaked at 52.5 percent last
May and are now down to 47.8 percent and falling in the latest survey.

Keep in mind that foreign investors and the domestic pension funds
have been the two pillars of buying strength that were supporting the
Japanese market amid accelerating cross-holding unwinding and selling
by individual investors for most of the Heisei Malaise. Thus, if you
remove buying by one of the staunchest supporters heretofore of
Japanese equities, and foreign investors become more uncertain that
their contrarian strategies for Japanese equities will work, the
result is obvious -- imploding stock prices.

Buy the Rumor Sell the Fact
The BOJ's purchases of stock from the banks and other government
efforts to purchase stocks merely represent a last resort for the
traditional buyers of last resort, the nation's pension funds. As
Tokyo resumed to normal after the Golden Week holidays, the ruling
coalition parties decided on an outline for "emergency" stock
measures. The nongovernment members of the Council on Economic and
Fiscal Policy also prepared their proposals for the revitalization of
the stock market. These followed a set of weak proposals previously
offered by the Financial Services Agency, ostensibly to address the
same problem. But the government will face a witch's brew of political
and bureaucratic obstacles before the proposed measures can actually
be implemented.

"It's just a fantasy to believe that (artificially) lifting stock
prices would resolve all the issues of the economy," says new BOJ
governor Toshihiko Fukui. The Labor and Welfare Ministry is also
somewhat reluctant to ease the rules that became part of the excess
supply problem, saying that public pension funds' shareholdings will
become one-sided. While the ruling coalition is also recommending
moving up the October deadline to return corporate pension funds to
the government, working-level Labor and Welfare Ministry officials are
cautious about a change in schedule, citing the fact that system
preparations are still necessary. Even if the schedule were moved up,
it probably would be only about a month earlier than previously

Changing the largely dysfunctional Banks' Shareholdings Purchasing
Corp. would require legislative revisions and a hastily conceived and
created private-sector stock-buying entity could merely create two
dysfunctional stock-buying entities. Finally, the newly incorporated
Japan Post is cautious about government and ruling-coalition meddling
in its investment plans for the postal savings and insurance systems.
Prime Minister Junichiro Koizumi, the champion of privatized postal
services, is also reluctant to endorse a plan to have the entity
purchase more stocks.

Investors are Unimpressed
Despite the leading coalition's side show of countermeasures, the
outlook for the markets and the economy will remain cloudy, and the
countermeasures are certainly not comprehensive enough to even scratch
the surface of the vicious cycle of deepening deflation. The asset
deflation after the bursting of the economic bubble has wiped out
1,400 trillion yen, an amount equivalent to all individual financial
assets held by Japanese, and the roots of the current crisis are deep
because of the damage done to the core of the credit system. The stock
market is basically a barometer of the depth of Japan's deepening
malaise and never-ending succession of "crises." "Fixing" the stock
market by artificially buying up stocks without addressing the
underlying economic causes is like administering medicine to alleviate
the fever caused by SARs.

The Koizumi administration stands accused of failing to understand the
severity of the crisis, while the ruling coalition centering on
Koizumi's own LDP stands accused of crying "wolf" over superficial
issues too many times. Without a leader able to circumvent the
existing policy-making structure, the government's policy stance seems
unlikely to change drastically. For Japan to pull itself up by its
bootstraps from the Heisei Malaise, it will first need to establish a
shared sense of crisis, particularly among the administration, the
ruling political parties and the Bank of Japan. It will also need to
make concentrated efforts under strong political leadership, instead
of all the finger-pointing, scapegoating and "emergency
countermeasure" games cooked up over the Golden Week holidays.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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