Views on improving the integrity of global capital markets
27 February 2012

AIJ Investment Advisors: Made (off) in Japan

The unfolding scandal in Tokyo involving pension investment management firm AIJ Investment Advisors Co. is depressingly predictable. Details are still emerging, but it appears that some $2.3 billion of client assets are unaccounted for, much to the surprise of both regulators and institutional investors who retained AIJ to manage money on their behalf. The pity is that it really doesn’t have to be this way, especially for institutional investors. There are simple tools that can be used to minimize the possibility that you will be taken for a ride by a Ponzi-type scheme. 

Even without the benefit of a full investigation, several red flags should have aroused interest on the part of investors. First, where were the assets kept in custody, and where were the trades? There appears to be a brokerage firm, ITM Securities, which has a shared ownership structure with AIJ. This is a huge red flag, and investors should demand strong audits of holdings and trades where this type of relationship exists, particularly for smaller asset managers.  Since over 90 percent of the firm’s assets seem to have disappeared, investors, and possibly regulators, must have been relying on AIJ’s own reporting of the state of its accounts. This is Madoff lesson 101. Failing to verify accounts and asset balances is simply inviting unpleasant surprises when it comes time to accessing those assets. The CFA Institute Asset Manager Code of Professional Conduct specifically calls on asset managers to arrange for independent third-party review and confirmation of client-account reporting to head off just this sort of situation.

Second, investors may have been impressed by returns that seemed too good to be true. An AIJ client who is an institutional investor is quoted in Bloomberg as saying of the AIJ head, “We found him to be a confident and breezy talker.” Again, echoes of the Madoff scam where reported performance was so extraordinary that it should have provoked much broader skepticism and examination. Prospective investors should demand that asset managers comply with the Global Investment Performance Standards (GIPS®), and should also look for third-party verification of performance results, wherever possible.

We’re also reminded of the pitfalls associated with investors deferring their own due diligence in favor of relying on someone else’s rankings. If you recall, this is uncomfortably similar to what many sub-prime debt investors did when they relied on credit rating agencies rather than dig into the structure of deals on their own.

AIJ’s management style purportedly relied on use of equity and bond futures, options trades, and derivatives. There’s certainly appropriate use for all such instruments in modern portfolio management, but investors should have the resources and capacity to understand fully how more complex instruments are used before they commit assets to such management strategies. It is too easy to defer to the “experts” who talk a good game but who may not actually be any more knowledgeable when it comes to these complex instruments. It remains to be seen if AIJ was a case of managers misusing these instruments or if the description of portfolio techniques was entirely fictitious. Here again, the CFA Institute Asset Manager Code requires managers to demonstrate a firmwide risk-management process to assure investors that appropriate safeguards are in place to manage risk appropriately. AIJ investors should have asked for, and reviewed, AIJ’s documentation in this regard to understand how — or if — the firm balanced the risks of complex financial instruments with potential returns.

AIJ is just one more example of why investors raise doubts about the integrity of capital markets.  As Japanese regulators now scramble to examine other asset management firms to detect similar problems, we hope this is an isolated matter. But it frames the need for regulators to be proactive and thorough in their regulation of an industry prone to high-profile ethical breaches. Meanwhile, the asset management profession should be looking for every way possible to reassure investors of its proactive commitment to integrity. Adoption of the Asset Manager Code is a step in this direction. Likewise, investors should be looking for signals from firms wishing to manage their money that they are committed to ethical conduct, a vow that goes beyond the pretty language in their sales brochures.

About the Author(s)
John Rogers, CFA

John Rogers, CFA, is the former president and CEO of CFA Institute.

2 thoughts on “AIJ Investment Advisors: Made (off) in Japan”

  1. Yoshiharu Okazaki says:

    I see some similarity with Madoff case and sub prime loans on its surface. But this has a much deeper root that is related to Princton Bond incedent of 1999 (loss estimated at Y120billion by the investors )and also Komazawa University losingY15billion in derivertive trades .

    Both cases it was lack of due dilligence on the part of so called
    “pro investors” ( by the law). Also, the regulators did not reinforce
    necessary rules by learning fron the past incedents. They do not
    understand unique features of fund management industry and its global industry enviroments. Therefore this incedent happens because of the unique industry and regulatory environments in Japan.

  2. Yasuhiko Nakase says:

    Thank you for posting this commentary in a timely and relevant fashion.
    This scandal roots in the serious underfunding problem that the commingled pension funds of smal-to-midium-sized companies are faced to. That is caused by the serious aging of the population and the difficult market environment. Plan sponsors cannot afford to provide enough contribution to fill the underfunding, which results in inability to restore the pension funds by returning the delegated benefit liability to the government (Daiko Henjo). The background is so complex that it is not suitable to describe it here. In sum, the pension funds that suffered had to desperately jump on the “excellent” hedge fund to reduce the underfunding, as they themselves have a structural problem similar to Ponzi-scheme.

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