Diversification of Investment of the Exchange Fund


14 May 2012

Diversification of Investment of the Exchange Fund


The Financial Secretary, Mr John C Tsang, yesterday talked in his blog about the philosophy and strategies of diversification of investment of the Exchange Fund since 2007.  I would like to expand on those comments and the work of the Hong Kong Monetary Authority (HKMA) in this respect in the past few years.


Why did the Exchange Fund pursue investment diversification?

In view of the trend of declining return from traditional asset classes (mainly bonds and equities in the advanced economies) while volatilities was starting to increase and domestic inflationary pressure was intensifying, the Financial Secretary asked the HKMA to conduct studies on diversification of the Exchange Fund investment in 2007 with a view to preserving the long-term purchasing power of the Fund.  Studies by the HKMA have shown that compared with the traditional assets which are safe and liquid, certain new asset classes can help deliver higher return in the medium and long term despite their lower liquidity and higher risk.  The addition of an appropriate size of new asset classes into the investment portfolio, which originally comprised traditional asset classes only, could achieve some synergy, thereby increasing the return of the overall investment portfolio in the medium to long term.  Even though the volatility of the investment portfolio might increase slightly, due to the low correlation in returns between the new asset classes and the traditional asset classes, it is likely that the overall risk-adjusted portfolio return would be enhanced as a result.  The Financial Secretary, on the advice of the Exchange Fund Advisory Committee (EFAC) and its Investment Sub-Committee, endorsed the diversification of investment of the Exchange Fund by the HKMA.


What are the new asset classes and how much has been invested?

After more than a year of preparation by the HKMA, the Exchange Fund invested in emerging market bonds for the first time in mid-2008, and commenced investment in private equity in early 2009.  We then gradually expanded into other new asset classes, including emerging market equities, real estate and renminbi (RMB) assets.

By the end of 2011, the aggregate market value of the Exchange Fund’s investment in these new asset classes stood at HK$83.6 billion.  A breakdown by asset classes is as follows:


New Asset Classes

HK$ billion

Emerging market bonds and equities


Private equity


Real estate


RMB assets (including bonds and equities)





Investment in emerging market bonds is mainly managed by staff of the Reserves Management Department of the HKMA.  Investment in emerging market equities, which adopts both index-based passive management and active management strategies, is managed by external managers.

For private equity, the Exchange Fund mainly invests in sectors with favourable prospects such as energy, technology-media-telecommunications and healthcare.  Since the sectors and projects to be invested in require highly specialised analysis and personnel with top class professional knowledge, investment projects of the Fund are managed by external private equity fund managers.  By the end of 2011, about 30 private equity investments had been made through various means, such as subscription of funds and co-investment.

We have engaged major international real estate investment managers to help identify prime-quality commercial properties in major overseas cities.  Investment in real estate was also done through the subscription of funds specialising in this field.

In line with common international practices in private equity and real estate fund investment, the HKMA has set aside a commitment amount for each selected investment fund.  When an appropriate project is identified by the fund manager, capital will be drawn down from the commitment amount for investment in the project.  Outstanding investment commitments at the end of 2011 amounted to HK$56 billion.  It is expected that the outstanding commitments will be gradually drawn down in the coming few years as appropriate investment projects are identified by the fund managers.  However, when the investment projects enter harvesting phase and distribution is received from realised investment, the total market value of remaining investments is likely to fall.  As a result, the size of the investment portfolio will change over time subject to the amount of project-related cash inflows and outflows.

Investment in RMB assets is a relatively recent development.  In early 2011, the Exchange Fund was granted a quota of RMB15 billion yuan by the relevant Mainland authorities for investing in the Mainland’s interbank bond market.  At the same time, the HKMA was also granted a quota of US$300 million under the Qualified Foreign Institutional Investor (QFII) scheme to invest in exchange-traded securities on the Mainland.  The Exchange Fund’s investment in RMB assets commenced as soon as the quotas were granted, and both quotas had been used up in 2011.  Investment in RMB bonds are managed by investment managers of the Reserves Management Department of the HKMA, while investments in RMB equities are managed by external managers.


How to ensure risks in the diversification of Exchange Fund investments are properly managed?

Before embarking on the diversification of investment for the Exchange Fund, the HKMA has made reference to the operating models of major institutional investors and wealth funds and consulted specialists with the relevant experience.  The HKMA has also developed a set of stringent investment policies, rules and procedures, as well as risk management practices.  At the same time, we have commissioned relevant financial, tax and legal experts and consultants when handling actual investment transactions, and proceeded with these investments in a gradual and orderly manner.  Apart from the usual and rigorous due diligence vetting, approval by an internal committee chaired by the Chief Executive of the HKMA is required before each individual investment for the Exchange Fund is made.  The HKMA also reports to EFAC and its Investment Sub-Committee on the work of the diversification of investment on a regular basis.


What is the investment performance of the new asset classes so far?

Investment in the new asset classes is intended to be on a medium- and long-term basis.  Such investment, however, tends to produce relatively lower and more volatile return in the gestation stage.  Take real estate investment as an example: set-up costs (including tax, consultancy and legal fees) are incurred whenever a new property is purchased, thereby dragging down the overall real estate portfolio return in that year.  So far, the Exchange Fund has purchased several prime-quality overseas properties, with an average rental yield of 5% - 6%.  We certainly hope the value of these investment properties will appreciate in the long term, bringing additional capital gains for the Fund.  With private equity and real estate funds, it generally takes three to five years for the investment managers to fully utilise the commitment amounts to make project investment.  Private equity funds tend to start liquidating their investment in projects and making distributions to their investors only after a period of six to eight years.  Hence, while regular valuation updates of the investments are undertaken by fund managers, it will take several years before realised gains on investments can materialise.

Diversification in investment of the Exchange Fund has only been implemented for a few years, and it is probably premature to draw any conclusion on the investment performance.  Nevertheless, investment in the new asset classes has proceeded smoothly since our start in 2008.  The combined since-inception internal rate of return1 of our private equity and real estate investment was around 9% on an annualised basis by the end of 2011.  Our emerging market bonds and equities, together with our RMB assets, also produced attractive results, with an annualised rate of return of 7%.  Overall, the combined since-inception return of the Exchange Fund’s new asset classes as at the end of 2011 generally fared better than that of portfolios comprising solely conventional asset classes over the same period.


Will the liquidity of the Exchange Fund be affected by the diversification?

To safeguard Hong Kong’s monetary and financial stability, the HKMA has always attached great importance to maintaining sufficient liquidity of the Exchange Fund.  In this connection, the Financial Secretary and EFAC have determined that the size of diversified investment shall not exceed one-third of the accumulated surplus of the Exchange Fund.  It should be noted that the level of accumulated surplus fluctuates with the Fund’s income and expenditure.  Hence, we will be extremely careful in managing the amount to be invested in the diversification portfolio.   Of the new investment asset classes, while private equity and real estate investments are relatively less liquid, the liquidity of emerging market equities and bonds, including RMB assets, is actually not too bad.  As emerging markets gain depth and maturity, we can look forward to an increase in liquidity of investments in these markets to levels comparable with those of their counterparts in the advanced markets.

The HKMA will continue with its work in diversification of investment meticulously, and review and adjust as appropriate the investment strategy and mode of operation of diversification of investment from time to time in light of experiences, with a view to achieving higher Exchange Fund returns in the medium and long term.


Norman T.L. Chan
Chief Executive
Hong Kong Monetary Authority
14 May 2012

1  Internal rate of return is a commonly used measure in the investment field to assess the performance of long-term project-based investments, taking into account the time value factor of the total stream of cash flows (including contributions and incomes) during the whole investment period.

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Last revision date : 14 May 2012