What will amount to a minor piece of history will be acted out early this month in a Tokyo conference room when 60 Japanese industrial executives sit down for an investment seminar. Top of the agenda: investment performance measurement.
Nothing unusual about that–until you look at the dichotomy between the agenda and the executives’ credentials. The course will concentrate on the basics of standard investment performance measurement techniques: those who come to learn include top pension executives from the cream of Japanese industry. It is the first seminar of its kind organised by Japan’s influential Pension Fund Association or, probably, anyone else in Japan.
Unbelievably, for most of the participants, it will be their first glimpse of time-weighted performance measurement and other measurement techniques which generations of fund managers in America and Europe have taken for granted.
The seminar is an oblique but powerful tribute to the swathe that nine newly-licensed foreign-owned trust banks have been cutting through Tokyo’s financial community. For some people in the financial services community, the foreigners’ arrival is the biggest thing to happen since Captain Perry’s black ships dropped anchor off Yokohama in the 1850s. The foreigners have been licensed to enter a variety of businesses previously open only to Japanese firms. The most important is pension fund management but some of the newcomers also hope to apply strange western methods to services like custodianship.
The Pension Fund Association’s executive adviser, Noburu Terada, admitted that the performance measurement seminar was partly inspired by the arrival of the new players, who have been loudly proclaiming they will come clean about the real performance of their portfolios–to the embarrassment of Tokyo’s investment establishment which has traditionally furnished clients with perfunctory, often misleading, investment performance figures.
The foreigners’ frankness about investment performance could prove the least of the worries for the trust bank and life insurance company cartels that have hitherto had a lock on running Japanese pension money. Some visionaries think the foreigners’ more sophisticated stock-picking techniques, for instance, could embarrass their established rivals, whose intuitive approach is notoriously erratic. And that in turn could prove the catalyst for a more rational, research-oriented tone on Tokyo’s particularly emotional stock market. At the very least, as some pension sponsors pointed out, the foreign banks could create an important lobby for non-traditional fund management products such as index funds. Meanwhile the cosy fee structure of the existing pension managers in Japan could come under pressure.
What matters at present, however, is performance reporting, according to Chris Nowakowski, president of the Connecticut-based performance measurement firm, Intersec. “Pension fund sponsors in Japan want more meaningful performance figures,’ he said. “The foreign banks are very eager to give more detailed information and that is bound to force the Japanese fund managers to improve their reporting.’
By one of those cultural quirks that leave westerners gasping, Japanese fund sponsors have in the past meekly accepted reports that provide simply a single number representing the “cash basis’ performance of the portfolio in the latest year. The figure bears only the sketchiest relationship to reality because it ignores all unrealised gains and losses–it simply reports on movements in book values. That can be used to produce almost any desired result, by manipulating realisations.
Why such an odd system? Part of the explanation is that the tradition dates from the days when the financial institutions ruled the Japanese corporate system and industrial companies had to go cap in hand to them for financing. In any case, in Japanese eyes there is a certain warped logic to the method. As Terada pointed out, a company’s funding requirements are related not to market values but to book values. If book values have improved strongly the client gets a commensurate reduction in his funding requirement.
One thing is certain: the impact of the foreign trust banks will be quite out of proportion to their size. For the moment at least they are midgets: Union Bank of Switzerland boasts the biggest capitalization of the newcomers with only 5 billion (about $25 million) in initial funding. Credit Suisse has about $15 million and most of the other players–which include Bankers Trust, Barclays, Chase Manhattan, Chemical, Citicorp, Manufacturers Hanover and Morgan Guaranty–are making do with only $5 million.
The market they have in their sights is huge: at the last count, the Japanese pension industry’s assets totalled 16.6 trillion (about $90 billion). That was up 18% from 1984 and it represents an eightfold increase over the figure 10 years ago.
Almost as significant for the foreigners are two rapidly growing vehicles for discretionary fund management–tokkins and fund trusts. These are used by corporations to invest surplus cash on a medium-term basis and involve a tax angle particularly important to corporate Japan. They enable a company to take trading positions in other companies’ shares without disturbing the tax position of strategic holdings in the same companies, built up years ago at miniscule share prices.
Armin Frauenknecht, vice president in charge of Union Bank of Switzerland’s Japanese trust bank, quoted figures indicating that Japan’s total pension assets are expected to grow by more than 50% to $140 billion by 1990. Meanwhile the tokkin business, with assets of $20 billion in 1985, should grow to $50 billion–and the fund trust business should shoot from $12 billion in 1985 to $30 billion in 1990. The fund trust business is potentially the most interesting for the foreign trust banks because it gives them a chance to manage money with minimal restrictions. Management of pension money is heavily regulated and in the case of tokkins the trust companies handle only custody (outside investment managers such as securities houses do the investment management).
But although the pie looks attractively large, on past experience the foreigners can hope for only a few crumbs. Perhaps with an eye to dampening unrealistic hopes among superiors at headquarters, the foreign trust bankers in Japan are anxious to play down their prospects. As one Swiss banker in Tokyo pointed out, foreign banks are used to being poor relations: collectively the nearly 80 foreign banks now represented there account for only 20% of lending in Japan. James Russell, representative director of investment advisory, Manufacturers Hanover, said: “Our market penetration will be slow. I will be surprised if the foreign banks make it to 5% of the total pension business in five years.’
Frauenknecht said: “We are not overly ambitious about how much money we will bring in. Our best chance is in fund trusts.’ Some Japanese trust banks are almost dismissive of the challenge. A senior executive in the international finance department of one Japanese trust bank commented: “The foreigners may get to 4% in the pension fund business in 20 years. If they have special features they may do it quicker.’ Sumio Kurachi, a general manager of the pension trust department of Sumitomo Trust said: “The foreign banks do not have a strong marketing position in winning pension business.’
Like most of the newcomers, Dennis Ferro, president of Japan Bankers Trust Company, was optimistic about the contribution they can make to Tokyo’s investment management industry. “We bring a lot of excellent expertise from other markets,’ he said. “We hope to be an attractive alternative for pension sponsors here. As long as we are assessed in value-added terms we will be a real competitor.’
One thing in the foreigners’ favour is that the traditional links between corporate Japan and the fund management industry are beginning to weaken, making it possible for the first time for corporations to field chunks of their pension business to outsiders. Ferro explained: “Until now, sponsors have allocated their pension money only to managers with whom they have had a close, long-standing relationship. But pension funds have been a phenomenon of the last 20 years and, now that they amount to really serious money, sponsors will think a little harder about getting better performance.’
An additional boost is the increasingly multinational nature of Japanese business life. Ferro commented: “Japanese companies are setting up pension funds for employees in the US and elsewhere and see the way that the business is organised abroad. They are bound to import those attitudes back to Japan.’
Several foreign trust banks are counting on winning business from the burgeoning community of foreign-owned manufacturing companies in Japan. Frauenknecht, for instance, said: “Foreign companies have been increasing their employment here and they are thinking about working with a trust bank or insurance company. We will probably understand them better than our Japanese competitors.’
But even business from foreign-owned companies may not be the sitting duck the newcomers hope. At IBM Japan, for instance, pension fund administrator Masahiko Kayama doubted whether the foreigners offered anything special. “What we need is good performance and it remains to be seen whether the foreigners will be any better than the Japanese companies,’ he said.
Some of the foreigners see useful hidden attractions in doing trust business. Russell of Manufacturers Hanover pointed out that a traditional perk for trust banks in Japan was that part of the clients’ funds could be used on the banking side of the house. “Up to 30% of the portfolios can be recycled as long-term yen funds on the banking side,’ he reported.
The value of this perk has, however, diminished somewhat recently. A Japanese trust bank executive commented: “If loan demand is tight then the benefit of being able to use the money on the banking side is valuable–but over the last 10 years demand for long-term yen loans had been weakening. A decade ago loans accounted for 50% of portfolios, but now they are down to less than 20%. Meanwhile bonds have been becoming more important in clients’ portfolios.’
At least the foreign banks can look forward to healthy fee income. The existing trust bank industry has a complicated but well-padded scale of fees. According to Osamu Toba, president of Morgan Trust Bank, the scale works out at about 0.3 to 0.5% of assets for a typical portfolio in the case of “sub-managers’. This is the rank that most of the foreigners aspire to (“managers’ get more but have to look after all the paperwork). In addition, there is a juicy hidden bonus: it is traditional in Japan for fund managers to get a 20% share of the hefty commissions stockbrokers rake off from pension portfolio activity.
The big question is whether the newcomers will go along with the industry’s fee scale (which is set down by the trust bank association) or be tempted to undercut. So far the only bank that has been thinking out loud about breaking from the cartel is Manufacturers Hanover. Russell said: “The existing fee structure could be undercut. It is pretty good by US standards. And remember that it is for a mix of business–bonds and equities. Under existing rules each investment manager and sub-manager has to invest a proportion of his money in each.’
Others among the newcomers are anxious not to rock the boat. Toba of Morgan Trust Bank said: “The fees are standard and have the blessing of the Ministry of Finance and the Ministry of Social Welfare. We will charge the scale fees.’
Alan Phillips, chief executive, Barclays Trust and Banking Company (Japan), arrives at the same conclusion from a different angle. His point is that price-cutting is rarely a way to sell investment services anywhere–and is particularly inappropriate in quality-conscious Japan. He said: “We would prefer to sell on performance.’
For some of the foreigners the question of going with the scale is bound up with whether they should join the Trust Bank Association, although one of them, who complained about the high membership fees –about $100,000 a year–said he would like the association to consider some form of associate membership for the foreigners that would entail a lower fee.
Foreigners worry, too, about the possibility that the association will act as a damper on the development of new products. “We would like the association to introduce more flexibility so we can price different products separately,’ a foreign banker said. “A good example is index funds. In the US, management fees for running them are lower than for other funds and that is partly why sponsors like them. Also we would like to charge more than the present scale fee for overseas investment.’
Another factor that makes the more thoughtful of the foreign bankers uneasy about getting tied too closely to the association is that the trust banks as a group have been losing market share in fund management to the life insurance companies. According to Terada of the Pension Fund Association, that is partly a reflection of the life companies’ lower fee scale. Comparisons are hard to make because the life companies’ fees are a function of what a sponsor contributes each year. But Terada estimated that the life company scale works out to about 0.25% of total assets under management for a typical sponsor. On his figures, the trust banks managed only 64% of Japan’s total 1985 pension assets–down from just under 70% in 1980. The life companies showed a corresponding increase in market share.
The association, however, could be a useful ally for the foreigners if it chooses to help. It might join them in lobbying for repeal of a Ministry of Finance rule that prevents investment advisers from giving specialist advice on one part of the portfolio only. By law, no more than 10% of a pension fund may be in foreign investments.
Ferro commented: “We obviously have expertise in overseas markets so it would be natural for a sponsor to be interested in us running the 10% of its assets invested overseas.’
The reaction of the Japanese trust banks to the foreigners’ predicament is a shrug. One trust bank executive commented: “Under the present system it is impossible to split a portfolio into specialities. If our clients asked for this service we would be obliged to go along with them. But we haven’t had such requests. The present system suits us.’
The foreigners may, however, get a more sympathetic ear at the Ministry of Finance. Euromoney put the problem to Masashi Takemura, manager in the ministry’s long-term finance section. He said: “We apply some restrictions in how pension money is invested–but these are the same for all. They are aimed at ensuring a prudent spreading of risk. However, if the new trust banks want to organise their business in a different way, we would give it consideration.’
He added that, as far as he was aware, neither the foreign banks nor anyone else had made any representations on the subject. “If we don’t receive representations, we can’t do anything. We want to be fair to the foreign banks–one of the reasons we opened the market to them was to ensure that our banks got good access in foreign markets,’ he said.
One foreign investment banker maintained that the problem was largely an imaginary one. As he pointed out, each of the foreign banks is working closely with a partner among the Japanese trust banks. The arrangement has the Ministry’s blessing and is intended partly to ensure that the foreigners have adequate back office support. It would be natural, he maintained, for the two sides to work jointly on clients’ portfolios–with the foreign bank advising on the investment of the international proportion. How the two sides divide up the fees is a matter between themselves.
Many foreign banks are hoping that the 10% limit might be raised–perhaps to 15%. Russell put it this way: “Overseas investments could become disproportionately important. At the margin, foreign activities could be pivotal in determining investment performance. That part of a portfolio invested in the domestic market will probably have an experience close to average. There is room for much more divergence overseas –a lot depends on which markets and currencies we choose.’
As the foreigners are able to present themselves as experts on international investment, many of them are giving fund trusts and tokkins their special attention. Their point is that these vehicles are not restricted in the proportion they can put overseas.
In selling the attractions of overseas investment, the foreigners are in many cases pushing against an open door. As one Tokyo fund manager said, cash-rich Japanese corporations are well aware that bond yields look better overseas, and on a price/earnings basis almost every overseas stock market is more attractive than Tokyo. He added: “Besides, if you are Matsushita and you are worried about what the Americans will do about trade friction, buying a few shares in General Electric and Westinghouse is a modest way to hedge your bets.’
In the case of tokkins and funds, the foreigners will enjoy the usual well-padded fee structure that the Tokyo investment establishment has made almost as traditional a part of Japanese life as sushi. The more ambitious of the newcomers, however, are not in the game just to be international specialists. “With or without relaxation of foreign investment rules, the only way we can make real money here is to run Japanese money invested in Japanese securities,’ said one player. But there are big obstacles in their way–particularly, it seems, the insularity of many of the executives who run corporate pension departments in Japan.
“These people are hard to sell to,’ said Frauenknecht. “The pension function has traditionally not been an important one in Japanese corporations. Many of these people do not speak English and know little about what goes on abroad.’
The answer, as Morgan’s Toba sees it, is ot blaze such a spectacular performance trail in managing Japanese securities that no-one can ignore the firm. Toba, an articulate Japanese-born former commercial banker who has worked for Morgan most of his career, reckons that the application of American investment techniques could reap a big pay-off in Tokyo stocks. “In the area of investment management, Tokyo is a much less developed market than other financial capitals,’ he said. “We have a lot of expertise to bring to this market–investment techniques that are not familiar here. We will be organised and disciplined and follow the modern portfolio theory approach to investment. This market is where the US market was in the 1960s.’
He added: “Basic research is somewhat lacking here. Investment decision-making is very intuitive in Tokyo. Betas, for instance, are not used here. They are something we will introduce.’
Toba hopes to demonstrate quickly that Morgan can beat the indices. “If you track our approach through past periods in Tokyo, you see that our performance would have been pretty good,’ he said. “We hope to really take off here after three or four years.’
One question that occurs to some observers is that, if the rational investor can so readily outperform the Tokyo averages, how come everyone has not been playing Tokyo by Graham and Dodd rules for years?
Kurachi of Sumitomo Trust provided a part answer: “There has not been much institutional activity here in the past. Institutions held mainly strategic long-term investments and did not trade very much. Now there is so much more cash around that they are trading more.’
Toba made a point often cited by foreign observers; that the market is driven by Japan’s big four brokerage firms. “They do “theme of the week’ selling. Everyone jumps on the bandwagon and it rolls for a while. Everyone hopes not to be the last to jump off.’
Certainly Toba has plenty of support for his views among other entrants. Ferro of Bankers Trust pointed out that the range of price/earnings ratios in Tokyo is much wider than on other important exchanges. He commented: “That is certainly an indication that the market is not as efficient as Wall Street. Typical P/Es here run from about eight to more than 50. Some companies here are valued on 100 times earnings. In the US, of course, the range is much narrower–from about eight to 25. We think there are probably inefficiencies both at the lower end and the upper end of the Japanese range.’
Timothy Schilt, Japan investment strategist at Morgan Stanley, agreed that a fundamentalist Wall Street approach should handsomely outperform the market over time– but added that practitioners would have to brace themselves for long periods of underperformance.
But Toba has other arrows in his quiver. He reckons that, just by cutting down on portfolio turnover, he can get a start on most of the competition. “A turnover of 250% a year is not high here whereas 60% would be about typical in the US, he said. “When you realise how expensive it is to trade here, you can see how important it is to keep turnover down. A round trip here costs about 1%.’
If Toba does succeed in racking up decent performance numbers he should not have too much trouble poaching disgruntled customers from his competitors. Frauenknecht pointed out that many sponsors had been burnt by bad performance, particularly in tokkins with heavy exposure to the weak dollar. He said: “The disappointment with the investment advisory companies is enormous, so tokkin sponsors are quite willing to work with reputable foreign banks like ourselves and the other foreign trust banks.’
His impression was borne out by Tamotsu Hanada, managing director of Mitsubishi Trust. “We are custodian for a lot of tokkins and we know that the performance of some of them has lagged behind those we manage ourselves. Many tokkins have lost money in the last two years.’
One consequence of the Morgan strategy is that the status of Tokyo equity analysts is bound to rise. “Analysts are already becoming more important in Tokyo,’ said Toba. “Some brokerage firms are now sending their young analysts to US business schools.’
The analysts should get a further boost from a better flow of information from Japanese companies. “Some very large companies here have not placed a lot of emphasis on investor relations in the past,’ said Ferro. “We think that is changing. One factor is that we think activity will grow in time. Companies are not going to want to have a depressed share price when that happens.’
The big question now is whether the Japanese can adapt so rapidly to the new circumstances that any edge the newcomvers have could be quickly lost. The Tokyo stock market, for instance, has visibly become more professional even before the foreigners buy a single stock.
Does this mean that the foreigners will have no advantages to exploit? Is everyone going to play by the rules of Wall Street? As Schilt of Morgan Stanley pointed out, institutions now account for about 50% of trading volume in Tokyo compared to only 38% five years ago.
There are signs that the Japanese money managers are already moving fast to blunt the foreigners’ weapons. Toyo Trust has started giving clients American-style performance reporting.
And Sumio Kurachi reported that Sumitomo Trust is talking to Intersec about giving at least some clients performance figures on a Western basis. “We know Intersec is making some impact here,’ he said. “And we know some pension funds are interested in Intersec’s figures.’
He added. “We have not reported our figures on an internal rate of return basis because until now we have not been very highly computerised. Now we are installing computers so we can give more figures.’
Meanwhile some of the Japanese trust banks have been strengthening their securities research departments. Both Sumitomo Trust and Mitsubishi Trust have advertised for analysts–an unusual thing to do in Japan. Kurachi said: “In the past we have not had a lot of analysis. We relied on research from the brokerage firms. Until now our 15 equity portfolio managers did their own analyses. Now we have 15 trainee analysts and we have advertised for experienced analysts.’
Yasuhiko Hatano, director of international business promotion at Sumitomo, was even more frank in his acknowledgement that the foreigners will not have the field to themselves. “We are experimenting with new investment techniques and expect to absorb their skills. Report services are quite important and we may change the way we do our reports. Their performance could be a stimulus to us.’
In the circumstances, it is no surprise that the foreigners are cautious about predicting when they will hit profitability. Russell put it like: “In a situation where things are changing all the time, we want to be cautious. We are looking for breakeven in five years. The Japanese, I gather, have been telling the foreign banks not to rush things–that it took the Japanese trust banks 10 years to break even after the war.’