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1 Many Japanese Active Stock Funds Are Closet Index Funds Searching For a True Active Fund October 2014 Summary Many Japanese stock funds that call themselves actively-managed funds are actually closet index ones. In addition to investing in larger companies, a true active fund would either also invest in midand small-cap stocks, or invest in a small number of companies regardless of their size. However, many fund managers at Japanese asset management companies for institutional investors are risk-averse for a number of reasons, including direct or indirect influence exerted by their company s parent company and affiliates such as a securities company or bank, among others. Conditions on which an asset management company is able to operate a true active fund would probably include being independent (that is, not having a parent company such as a securities company or a bank, which may inevitably lead to conflicts of interest), having a firm corporate governance framework in place for the reason that it is a listed company or similar reason, and having a roster of non-japanese clients who, unlike Japanese clients, would demand that the fund takes risks Many Japanese stock funds that call themselves actively-managed funds are actually closet index ones. Closet indexing, where the fund manager strives to minimize the risk of underperformance by emulating an index (i.e. actively manage a portfolio but in reality more or less tracks a benchmark stock index), exists throughout the world, not only in Japan. According to research by Professors Cremers and Petajisto of Yale University (2009) *1, approximately 20% of U.S. mutual funds in 2002 that claimed to be active stock funds were actually closet index funds. *2 Of particular interest is that true active funds, representing about 40% of the study s universe, had outperformed the closet index funds *3. Accordingly, global investors have begun moving away from closet index funds to other funds, including funds that employ a smart beta strategy. There is no strict definition of smart beta. However, it is an investment strategy that attempts to deliver better risk-adjusted returns by using alternative weighting schemes. In a report prepared for the Norwegian Government Pension Fund-Global, Professors Ang, Goetzmann, and Schaefer of Columbia University (2009) *4 determined that the excess returns generated by many so-called active funds were due to the use of smart beta. They also pointed out that true active funds that generate excess returns, which cannot be

2 attributed to smart beta, are extremely skilled at selecting individual companies and / or emphasize being highly engaged with management. Not surprisingly, since the report s publication, there has been a shift from closet index funds to smart beta and true active funds. In Japan, true active stock funds are extremely rare. According to Professor Suto of Waseda University in Japan, Professors Menkhoff, and Beckmann of University of Hannover (2005) *5, fund managers at Japanese asset management companies tend to have extremely short investment time horizons, be prone to herding, and be excessively risk-averse. According to Cremers and Petajisto (2009), this risk aversion is one of the main reasons for poor fund performance. Furthermore, other empirical research, including Professor Wermers of University of Maryland (1999) *6 and Wermers and Associate Professor Yao of University of Iowa (2010) *7, suggests that short investment time horizons and herding have a negative impact on fund performance as well. As for the reason why Japanese fund managers have this tendency, Suto, Menkhoff, and Beckmann (2005) pointed out that many Japanese asset management companies are subsidiaries of financial institutions, which may suggest a lack of independence and decision making. In addition, parent companies and their affiliates may send their staff to their asset management subsidiaries for training purposes. There are even times where transferees are temporarily assigned to manage portfolios. Lacking investment experience and knowledge, these temporary fund managers are prone to herding because they may rely excessively on the opinions of others, such as sell-side analysts. Moreover, many clients of these affiliated asset management companies are Japanese institutional investors. The counterparties at these institutions are often also temporarily assigned to their position. With no experience and desire to cause problems, the asset manager s clients are extremely risk-averse and demand that their funds are managed in a safe, conservative manner. Under these conditions, it is probably inevitable that so-called active funds managed by non-professional fund managers with risk-averse clients are closet index funds. Suto, Menkhoff, and Beckmann (2005) conclude that independence and good governance are important factors determining an investment company s capabilities to manage a true active fund. While these characteristics may be common amongst European and U.S. asset management firms, in Japan there are only a few that are independently managed and that boast good corporate governance. In addition, there are also an extremely small number of Japanese asset management companies that have clients who actively take on risks (e.g. non-japanese ones) over a sufficiently long period of time, and in turn, demand that their funds actively take on risks. Today, there is a growing need for true active stock funds in Japan. Recently, the largest pension

3 fund in the world the Government Pension Investment Fund, Japan or GPIF *8, who is well-known for their risk-averse portfolio management style, began to replace closet index funds with smart-beta funds. *9 As a result, some closet index fund asset managers have scrambled to launch new funds that are supposed to be true active funds. It is too early to determine whether these funds will become true active funds. Until then, an investor is better off identifying true active funds managed by independent asset management companies that have good corporate governance and years of experience working for clients who demand risk-taking.

4 Notes: *1 : Cremers, KJ Martijn and Petajisto, Antti, How active is your fund manager? A new measure that predicts performance, Review of Financial Studies, vol. 22, no. 9, p , *2 : Cremers and Petajisto (2009) define closet index funds as funds with a tracking error of 6% or less and an active share of 60% of less. Active share is an indicator of to what extent the weights of constituent shares in a portfolio differ from those in the benchmark. It can range from 0% to 100%, with 0% indicating a portfolio whose constituent shares and their weights are exactly the same as those of the benchmark, and 100% indicating a portfolio that contains none of the benchmark s constituent shares. *3 : Cremers and Petajisto (2009) define a true active fund as one with an active share of 80% of more. *4 : Ang, Andrew, Goetzmann, William N. and Schaefer, Stephen M., Evaluation of active management of the Norwegian government pension fund--global, *5 : Suto, Megumi and Menkhoff, Lukas and Beckmann, Daniela, Behavioural biases of institutional investors under pressure from customers: Japan and Germany vs the US, Corporate Finance and Governance: Europe and Japan Comparisons. Joint Conference with CEPR and REITI,(September 2005), *6 : Wermers.R, Mutual Fund Herding and the Impact on Stock Prices, Journal of Finance, Vol. 54, No. 2, p , *7 : Wermers, Russ. and Yao, Tong., Active vs. Passive Investing and the Efficiency of Individual Stock Prices, Working Paper, The University of Iowa,

5 *8 : Towers Watson, The world s 300 largest pension funds - year end 2011, ds-300-largest-pension-funds-year-end-2011 *9 : Government Pension Investment Fund, Japan, GPIF s selection of domestic equity investment managers and revision of manager structure, 2014/4/4.

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