Traditionally risk-averse Japanese institutions are massively rebalancing their portfolios and moving into alternative investments at record rates.
Some of the country’s largest investors have publicly announced their intentions, and other Japanese institutional investors are beginning to follow suit. In a recent Preqin study of Japanese institutional investors, 42% of investors indicated they would increase allocations to private debt, 39% indicated they would increase allocations to infrastructure, and 37% indicated they would increase allocations to private equity.
What is behind this rebalancing of portfolios into alternative investments? Yield, or, more precisely, the search for yield. Japanese banks, pension funds and life insurance companies all require steady returns on their portfolios in order to service current liabilities. However, the Bank of Japan has been holding 10-year Japanese government bond yields around 0% as part of the government’s Abenomics policies, leaving local investors with minimal levels of return on local bonds.
Additionally, dividend yields of Japanese equities have averaged just 1.8% in recent years. Investors are therefore being forced to rebalance their portfolios at record rates into higher yielding alternative investments.
What type of alternative investments are proving popular? Overseas equities and fixed income, private equity, private debt, infrastructure and other alternative investments are among the most popular options with Japanese investors today.
Of these, the most prevalent have been exposures to international equities and bonds. The value of Japan’s holdings of foreign equities has tripled since 2012.
One key trend to arise in recent years is an increasing interest in private equity. The asset class was not previously on the radar of most Japanese institutional investors, but many now view it as an essential component of yield-starved portfolios.
What type of fund structures are being used to make alternative investments? The preferred investment vehicle for most Japanese investors wishing to access alternative investments is the Cayman Islands fund. In 2016, 94.3% of the foreign domiciled funds that were publicly offered in Japan were established as Cayman Islands funds.
The reasons why Japanese investors prefer the Cayman Islands over other fund domiciles is not dissimilar to investors in other jurisdictions. Vehicles established in the jurisdiction typically offer increased flexibility, speed to market, cost considerations and a familiarity with both the fund structure and the jurisdiction, among other reasons.
The newfound interest in private equity in Japan has also seen the development of a new type of Cayman Islands investment vehicle: the “private equity type” unit trust. This hybrid vehicle is basically a Cayman Islands unit trust (the preferred investment vehicle for many Japanese investors) that incorporates some characteristics of a private equity fund, including a capital call feature and defaulting investor provisions.
Aside from a general familiarity with the unit trust structure, many Japanese investors find a PE-type unit trust offers tax benefits when compared to the limited partnership structure typically used by international investors when making private equity investments. In addition, many Japanese investors wish to hedge any non-Japanese yen (JPY) currency exposure arising from making non-JPY denominated investments.
Yen hedging is more difficult when using a limited partnership structure, given gains/losses arising from investments are not recognized until the relevant investment has been realized, which may be many years after making the investment.
In a PE-type unit trust structure, by contrast, both realized and unrealized gains are distributable and there is a current net asset value that can be used for the purposes of calculating the non-JPY exposure that is to be hedged.
What is the future outlook for alternatives in the Japanese market? Japanese institutional investors have already shifted a lot of assets away from domestic bonds and equities into alternatives, but the current signs are that this will continue and may increase.
Faced with a negative benchmark interest rate (-0.1%), many ordinary savers may similarly seek increasing exposure to foreign bonds, equities and alternative investments. A shift into alternative investments by ordinary savers, were it to occur, could be significant. Total household currency and deposits currently consist of about 52.5% of financial assets in Japan (compared to only 13.1% in the US).
Another contributing factor could hasten the shift into alternative assets – Japan’s rapidly ageing population. The country has the fastest ageing population globally; 28% of its population are 65 years or older, and this will rise to over 33% by 2040 and 40% by 2065. This fast-changing demography will greatly increase annual liabilities further for many Japanese institutions, driving even more interest in higher yielding alternative investments in the coming years.
It is not coincidental that many global asset managers are now showing a keen interest in the world’s third-largest economy.
Nick Harrold is a funds and investment management partner at Maples Group