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Investment Results of the Exchange Fund in 2009

As readers will be aware, the investment results of the Exchange Fund for 2009 were announced today: an investment income of $106.7 billion, or 5.9%, more than recouping the $75 billion investment loss in 2008.

Looking back on 2009, the global financial markets and investment environment continued to be volatile and full of uncertainty. In the first quarter of the year, major equities markets continued to feel the pressure of the global financial crisis. However, the effects of the huge fiscal stimulus packages and unprecedented monetary easing in the major developed economies were gradually felt, leading to a resurgence of market optimism from about March last year, followed by signs, however tentative, of economic recovery and improvements in corporate earnings. The major stock markets in the US and Europe rose by over 20% for the year. The Hong Kong market rose by over 50%, propelled by the robust economic growth of the Mainland and investors' optimism about the economic outlook for Asia. As a result, the Exchange Fund's equities holdings contributed nearly $100 billion to its investment income.

By contrast, bond investments were adversely affected by a sharp rise in yields (or a fall in prices) in 2009 as investors moved away from the extreme caution we saw in 2008 and rediscovered their appetite for riskier assets. Yields on 10-year US Treasuries surged 160 basis points during the year. A number of factors contributed to this: the increased supply of government bonds, uncertainties about the timing of the inevitable exit from monetary easing, and a resurgence of inflation expectation among investors. Shorter-term US bond yields also rose, though to a smaller extent, with two-year Treasury yields rising about 40 basis points. The unfavourable market conditions brought a small loss of $0.7 billion to the Exchange Fund's bond holdings, even after taking into account the interest income.

While the equities market fared better than the bond markets last year, it is worth bearing in mind that different asset classes perform differently in different financial and economic environments. This is precisely why investors, including the Exchange Fund, diversify their investments. The surge in equities last year was just a reversal of the safe-haven flows into bonds which led to a freefall in stock prices in 2008. The Exchange Fund's bond holdings therefore help absorb occasional shocks from the prices of riskier assets and provide a stable income stream over the long term.

In interpreting the performance of the Exchange Fund, I would urge readers to bear in mind three points:

First, while it is understandable that people usually pay more attention to the performance in the past year, we should also be aware that the Exchange Fund is a long-term fund. The investment performance should be measured over a longer time horizon and not just based on a single year. This is why we have introduced three-year, five-year and ten-year returns and a return since 1994 in this year's announcement. The Exchange Fund has achieved an average annual compound return of 6.1% since 1994, well ahead of the average compound annual inflation of 1.5%, meaning the purchasing power of the Fund has been more than maintained.

Secondly, the large capital inflows into the Hong Kong dollar since the fourth quarter of 2008 resulted in an expansion of the Monetary Base by about $640 billion. This phenomenon made the management of the Exchange Fund particularly challenging. The Currency Board system requires the expansion of the Monetary Base to be matched by a corresponding increase in the liquid US dollar assets in our Backing Portfolio. In supporting the Monetary Base, which has reached one trillion dollars, the money must be invested in short-term US Treasuries and other high-quality bonds. So the ballooning of the Backing Portfolio in 2009 effectively meant a greater weighting towards this class of assets, which did not do so well last year, therefore affecting the overall return of the Fund.

Thirdly, some people may compare the returns of the Exchange Fund with those of other funds. But we should remember that the statutory and investment objectives of the Exchange Fund are very different from those of other funds, making direct comparisons inappropriate. Investment and endowment funds typically aim to maximise returns over quite long periods and do not have to emphasise capital preservation and liquidity to the same extent that the Exchange Fund does. They therefore have greater weightings towards riskier assets and a higher tolerance for volatility in returns in a particular year.

Looking ahead, financial markets will remain volatile and it remains to be seen just how strong and sustainable the current global economic recovery will be. While the prospects for the global financial system are improving, the overall fundamentals are still fragile. In particular, banks around the world may face pressures in increasing capital and financing in the next two to three years. Uncertainties over the timing and pace of the exit from monetary easing and the direction of interest rates also continue to cloud the outlook and global markets are therefore likely to be more volatile. The HKMA will remain vigilant in managing the reserves.

Eddie Yue
Deputy Chief Executive
28 January 2010

Last revision date: 1 August 2011
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