AIJ was suspended on Feb. 24 by Japan’s financial regulator after it couldn’t account for all of the 185.3 billion yen ($2.3 billion) it managed for clients as of March 2011. Japanese pensions including those representing unions were among clients that had money with AIJ, which hasn't been accused of wrongdoing.

The suspension of AIJ that sparked the biggest investigation in the history of Japan’s fund industry resembles the impact on the hedge fund industry after executives at Internet provider Livedoor Co. were arrested in 2006 for fabricating profits, according to a client report by GFIA, which advises investors seeking to allocate money to hedge funds. Livedoor raised concerns about the finances of second-tier companies that many Japan-focused hedge funds had invested in.

“We think this will be the Japanese pension fund industry’s ‘Livedoor moment,’” said Peter Douglas, principal of Singapore-based GFIA. “The tap of Japanese pension fund money, to boutique managers, will turn off.”

Japanese pensions have been trying to diversify their investments beyond traditional assets such as bonds and equities into alternative investments that include hedge funds, as they face challenges funding retirement benefits in an aging society.

Bright Spots

AIJ had 122 contracts with domestic corporate pensions and one with a foreign investor as of March 2011, according to filings with Japan Securities Investment Advisers Association. Eight retirement funds had allocated more than 30 percent of their money to AIJ, while one of them had more than half of its 9.1 billion yen it manages with AIJ, according to Japan’s health ministry data.

“What is particularly unfortunate is that this group of investors has been among the very few bright spots in the Asian hedge fund industry over the last two to three years,” Douglas wrote in the GFIA report. “We see a good number of Japanese boutiques, as well as some pan-Asian specialists, that have largely filled up with Japan pension fund money.”

Thirty-two percent of 119 Japanese pensions had wanted to add alternative investments this fiscal year, according to a survey in April 2011 by JPMorgan Chase & Co. (JPM)’s Tokyo-based asset management unit. Alternative investments also include private equity funds, real estate, commodities and infrastructure.

Tighter Oversight

As a result of the AIJ scandal, Japanese pensions will converge on the larger “safer” managers, both domestic and international, while smaller independent consultants will gradually disappear because the need for more formalized advice and due diligence overwhelm their ability to deliver advice, according to GFIA.

Japan’s investigation of the industry may lead to tighter oversight of pension money investment. A total of 265 asset managers in Japan will be required to submit status reports to the financial watchdog by March 14. The reports must contain details of a firm’s operations, contracts and their amounts, and any past complaints from customers.

AIJ’s investigation also adds to growing criticism of Japan’s corporate governance following Olympus Corp. (7733)’s admission it covered up losses by overpaying advisers.

“Following hard on the heels of the Olympus scandal, there’ll surely be some ill-conceived legislation drafted to prevent further such governance lapses,” Douglas wrote in the report. “The combination of Japanese caution and Japanese consensus and homogenous decision making will lead to unhelpful outcomes for the industry.”

To contact the reporter on this story: Tomoko Yamazaki in Singapore at tyamazaki@bloomberg.net

To contact the editor responsible for this story: Andreea Papuc at apapuc1@bloomberg.net

http://www.bloomberg.com/news/2012-03-02/aij-suspension-to-be-livedoor-moment-for-japan-pension-funds-gfia-says.html

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