Views on the integrity of global capital markets
12 June 2014

Political Motivation, Regulator and Industry Support Fuel Japanese Stewardship Code

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The Japanese Stewardship Code is currently all the rage in Japan.

Three factors make the code an especially hot topic in Japan today. The first is political motivation. Under Prime Minister Shinzō Abe’s leadership — in particular stemming from Japan’s Financial Revitalization Strategy — there is the political will to encourage the development of the markets. Abe deployed massive monetary easing and targeted fiscal support during his first 17 months of office, and his focus has now shifted to structural reform.

The second reason the code has taken center stage is that it has the full support of the regulator. This was confirmed on 5 August 2013 when the Japanese Financial Services Agency announced the formation of the Review Panel on the Stewardship Code for Japan, designed to guide institutional investors to fulfill their roles as fiduciaries by promoting the sustainable growth of companies. The code became operational in February 2014.

Finally, it’s important to note that the industry is collectively behind the initiative. This effort was led by the Government Pension Investment Fund (GPIF), which manages Japan’s US$1.3 trillion of public pensions; it announced on 30 May that it will adopt the Japanese Stewardship Code. In a press release it said that it is doing so “To enhance the medium- to long-term investment return for the insured by improving and fostering the investee companies’ corporate value and sustainable growth is appropriate for the nature of the reserve funds, and critical for the GPIF that holds domestic equities over the long term.”

The end of May marked the deadline for being a signatory to the Japanese Stewardship Code; as of 10 June, 127 institutions controlling close to 95% of the market’s capitalization have signed up for the code.

I recently participated as a panelist at the Alternative Investment Management Association’s Hedge Fund Forum on 5 June in Tokyo, and there were two issues that confounded me as we discussed the Japanese Stewardship Code. One is related to the operationalisation aspects of the code. The other relates to principle seven, which states “To contribute positively to the sustainable growth of investee companies, institutional investors should have in-depth knowledge on the investee companies and their business environment and capabilities to appropriately engage with the companies and make proper judgments in fulfilling their stewardship activities.”

Let me share my concerns.

Stewardship is defined as “the careful and responsible management of something entrusted to one’s care.” For institutional investors (who are the target audience of the code), that something is the financial assets of your customers. For some clients, stewardship would be the safety of the funds. For others, it may be improving the returns of the companies that the fund is investing in.

During the panel discussion, the focus seemed to be on enhancing the return on equity (ROE) of investee companies. One of the panelists explained that the ROE of Japanese firms is very low and suggested that the main problem seems to be a low turnover of their assets.

When I was studying for my CFA exams, one interesting framework we were taught related to the DuPont framework for disaggregating components of the ROE. This comprised of five important financial ratios: leverage, asset turnover, operating margin, interest burden and tax burden. In theory, the ROE of any company can be improved by increasing leverage, improving the turnover of assets, increasing the operating margin, reducing the interest burden and/or reducing the tax burden. My recommendation to Japanese institutional investors is that if ROE is truly the measure to be used for engagement with investee companies, perhaps look at the other components of the ROE as possible return drivers instead of just the asset turnover ratio.

However, as I commented on this, I took a different view. I explained that engagement practices with companies should focus on capital management, strategy, people, risks and opportunities. Essentially big picture stuff. Once this is achieved, and if executed well, the rest should follow within industry and economic constraints.

My other concern relates to institutional investors and their need to have “in-depth knowledge of the investee companies and their business environment” and their capabilities (principle seven). I think this is difficult to achieve for all institutional investors because there is a no one-size-fits-all code, particularly in their requirement to engage with the companies they invest in.

In fact, this is the same position acknowledged by the Organisation for Economic Co-operation and Development (OECD). In a 2013 paper on Institutional Investors as Owners: Who are They and What Do They Do?  the OECD explains that there are two types of capital shareholders. The first are the pure capital providers, essentially those with a short-term mentality, while the second are shareholders who provide capital, information and monitoring. The latter are the ones with an engagement perspective.

The OECD further suggested that engagement strategy is a business model function that should be the prime consideration for shareholders. To put a framework around the rationale for ownership engagement, the OECD came up with six determinants.

  • What is the purpose of the business? Is the firm benefiting from captive assets or are they competing for assets?
  • What is the liability structure? Are daily withdrawals allowed, hence shortening the liability structure, or does it have a long-term liability profile — as in the case of pension funds and insurance companies?
  • What is the investment strategy of the firm? Is it driven by qualitative or quantitative strategies?
  • How many companies is the firm managing? Is it a large fund with thousands of firms to monitor or one where there can be more focus?
  • What is the fee structure like? Is it low cost driven like exchange-traded funds (ETFs)/passive index funds or alpha driven like those of hedge funds?
  • What is the regulatory framework like? In some jurisdictions like Sweden and Turkey, engagement by institutional investors is simply not allowed.

Engagement practices with companies should take into account the above factors before deciding on a strategy. One of the following strategies is usually taken: none, reactive, alpha driven or being on the inside.

Finally, for those investors that undertake active engagement strategies, does it add value?

Empirical evidence seems to support active engagement strategies. A 2013 paper by Lucian Bebchuk, Alon Brav and Wei Jiang on The Long-Term Effects of Hedge Fund Activism looks at about 2,000 interventions by activist hedge funds during 1994–2007 and examines the five-year period following the intervention. The study finds no evidence that interventions are followed by declines in operating performance in the long term. On the contrary, activist interventions are followed by improved operating performance during the five-year period following the intervention.

The results are also present when gauged against two types of hedge fund activities — those that constrain long-term investments (either through using greater leverage, increasing dividends or curtailing investments), and those that are purely adversarial in nature.

In Japan, using data provided by Preqin, the authors show an average return of activist Japanese funds of 17.52% in 2013, comfortably outperforming the overall hedge fund benchmark of 11.17%. Standout performers include Taiyo Fund, which uses a “friendly activist” approach to invest in Japanese equities. And in recognition of that approach, it was recently chosen by GPIF as one of the new foreign asset managers to manage funds on its behalf, which is a real game changer.

The big question here is whether all these efforts will ultimately translate to the sustainable growth of companies in Japan. We would love to hear your views on this matter.


Photo credit: iStockphoto/TommL

About the Author(s)
Tony Tan, DBA, CFA

Tony Tan, DBA, CFA, is co-head of the CFA Institute Ethics, Standards, and Professional Conduct division. He is particularly responsible for ethics education offerings and the professional standards of CFA Institute. He is also a member of CFA Society Singapore.

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