Institutional equity investors in Japan have not experienced cutbacks in sell-side research and sales resources to the same degree seen by their counterparts in other markets around the world. But new research from Greenwich Associates does suggest that Japanese institutions might be relying too heavily on their brokers for essential research and services.
“Japanese institutional investors are benefiting from the fact that brokers in the country are concerned about maintaining market share, which means that they are willing to provide research and other services to a broad base of investors,” says Greenwich Associates consultant John Webster. “But the fact that institutions in Japan are relying more than ever on the sell-side to help them achieve incremental returns might place their needs at cross currents with those of their brokers, who are now providing the same level of research and services that they have in past years, but at much lower commission rates.”
A new report from Greenwich Report analyzes these trends and examines additional key findings of Greenwich Associates’ 2004 Japanese equities market research, including the reduction of buy-side investment staffing levels, the rise in equity assets under management, the growing use of portfolio trading and net trades, and other developments.
The combination of continued under-funding among Japan’s institutional investors and the less-than-clear outlook for the country’s equity markets has increased pressure on investment managers to enhance investment performance.
As in the case of other major economies, the Japanese equity market since mid-year 2004 has failed to maintain the momentum it established in the first half. After a rally earlier in the year, Japanese stocks are up just 3%, and concerns about the Chinese economy and the high price of oil are dampening enthusiasm about Japan’s domestic economic prospects. In addition, while the early-year strength of domestic equity markets improved the position of many pension funds in Japan, the great majority remains significantly under-funded. Despite an increase in solvency ratios among Japanese pensions to 77% in 2004 from 62% last year, only 19% of funds have assets covering greater than 90% of their projected benefit obligations.
As a result of their concerns about the future, institutional investors in Japan are feeling pressed to secure incremental returns, and many managers that have traditionally operated as indexers or ‘closet’ indexers, now find themselves seeking out opportunities to generate alpha. However, new research from Greenwich Associates reveals several trends seemingly at odds with investment managers’ growing need to generate incremental returns. For starters, Japanese institutions are cutting internal investments staffing. Japanese institutional investors have cut their rosters of in-house portfolio managers from an average of 9.1 in 2002 to just 7.1 this year, and foreign institutions lowered their average portfolio management staffing level from 4.7 to 3.5. While both groups have made marginal additions to their analyst staffs during this period, the net effect has been to downsize their overall internal investment capabilities.
These reductions place Japanese investors on an opposite trajectory from that of their buy-side counterparts in other major markets. In the United States, for example, the average number of portfolio managers employed by institutions rose to 11.1 in 2004 from just 9.1 last year, and the average number of analysts on payroll jumped to 10.8 from 8.6. In addition, the number of U.S. institutions reporting to Greenwich Associates that they expect to continue hiring in both areas in 2005 vastly exceeds the number expecting to reduce staff.
“Although Japanese institutions clearly recognize the need to find and generate incremental returns in order to enhance investment performance, they are not following the example of institutions under similar pressure in other markets by building the capacity to do so in-house,” says John Webster. “While the immediate dynamics of the Japanese equity market make it possible for them to rely on broker resources for these tasks, the current economics of the sell-side suggest that this might not be a viable strategy in the long term.”
Domestic equity assets under management among institutional investors in Japan increased by more than 25% to 146 billion over the past 12 months. Among Japanese institutions, specifically equity assets under management jumped from about 88 billion in 2003 to 110 billion in 2004. Equity assets under management at foreign subsidiaries and offshore institutions rose from 27 billion to 36 billion.
At the same time, equity commissions paid by institutions in Japan grew by nearly 40%, with both Japanese institutions and their foreign and offshore counterparts paying more than 64 million. Since average commission rates were basically stable at 13 basis points from 2003 to 2004, it is clear that trading activity was on the rise – a trend that can be attributed in large part to greater overseas investor activity and the growing presence of hedge funds.”