Every January, colleagues in the HKMA are busy preparing the announcement of investment performance of the Exchange Fund in the preceding year. Meanwhile, I would like to take this opportunity to set the scene by reviewing the investment environment in 2014 and briefly explaining the strategy and considerations behind the asset allocation of the Exchange Fund.
Investment Environment in 2014
The investment environment in 2014 was exceptionally volatile and definitely not a time for faint-hearted short-term investors. Equity markets in the US and Japan rallied while those in Europe held steady after some fluctuations. US long-term bond yields slipped but short-term yields edged up. Exchange rates of major currencies experienced drastic swings, especially in the second half of the year as the US economic recovery forged ahead whereas the European and Japanese economies stagnated. This was exacerbated by the divergent monetary policy paths undertaken by major central banks: the US had wrapped up its asset purchase programme while the European Central Bank and the Bank of Japan were gearing up their accommodative monetary policies. This had resulted in large amount of fund inflows to the US dollar. The tumbling oil prices, bringing down commodity currencies, also indirectly contributed to the strength of the US dollar. Against such backdrop, the US dollar index surged in the second half of the year registering a 12.8% increase in 2014, the steepest rise in 17 years. On the other hand, the euro dipped 12.2% against the US dollar during the year, which is the second greatest since its launch in 1999. Fund houses and investors had to book exchange losses when converting the value of their non-US dollar assets into the US dollar. The Exchange Fund was no exception.
The Asset Allocation Framework
Bearing in mind the statutory purposes of the Exchange Fund to maintain currency and financial stability, the Exchange Fund’s investment objectives can be summed up as “capital preservation, then long-term value creation”. This means that without compromising the Exchange Fund’s ability to preserve capital and high degree of liquidity, we will endeavour to achieve higher returns in the medium- and long-term to maintain the Fund’s purchasing power. We have explained the objectives and functions of the Exchange Fund on different occasions and in articles over the past few years. These articles are all readily available on the HKMA website1. I would like to take this opportunity to take a closer look on the Exchange Fund’s asset allocation strategy.
The Exchange Fund is not a sovereign wealth fund or an ordinary investment fund, nor is it a hedge fund. It will not engage in short-term trading. The Exchange Fund adopts a prudent asset allocation that aims at relatively stable medium- and long-term returns. Asset allocation refers to the use of quantitative models to analyse relevant data, including the long-term performance of individual asset classes and the correlation of returns among them. For example, the tendency for bonds and equities prices to move in opposite directions reflects a negative relationship between the returns from these two asset classes. Based on the analysis and taking into account the outlook of the investment environment, we then determine an appropriate mix of assets, markets and currencies for our investments. Through such diversification, we seek to achieve a relatively stable overall investment income in the medium- and long-term. An important concept in asset allocation is that there exist short-term fluctuations in the assets values within a diversified investment portfolio. For example, in 2008 and 2011, the respective losses of HK$151 billion and HK$36 billion in the Exchange Fund’s equity investment were offset by gains on bonds of HK$88 billion and HK$72 billion in the respective years. In 2013, a return of HK$82 billion from equities offset loss of HK$19 billion in bonds. This demonstrated that our asset allocation strategy focuses on the overall medium- and long-term return of the Exchange Fund.
There are other essential considerations for the Exchange Fund’s strategic asset allocation. Of the Fund’s liabilities, over HK$1.3 trillion constitutes the Monetary Base and about HK$1 trillion belongs to fiscal reserves of the Government and placements by various government and public funds. It is therefore imperative for the Exchange Fund to maintain sufficient liquidity to support the exchange value of the Hong Kong dollar by selling the US dollar when there are fund outflows, and to meet the cash needs of the Government for public expenditure through withdrawal of the fiscal reserves. More importantly, we must have a robust armoury in terms of reserves to fend off unforeseeable shocks and attacks so as to maintain the financial stability of Hong Kong. Therefore, capital preservation and a high degree of liquidity are crucial. Because of these considerations, a substantial part of the Exchange Fund is invested in safe and highly liquid assets such as the US Treasury securities. Bonds and cash currently account for about 80% of the Exchange Fund’s assets. The remaining 20% mainly consists of equities and, since 2008, a small portfolio which diversified into private equity and real estate investments. The diversified investments had low return correlation with the conventional asset classes such as bonds and equities. This helps spread risks and enhance the Fund’s overall medium- and long-term returns.
This asset allocation strategy defines the investment framework of the Exchange Fund and guides our investment activities with a view to preventing aggressive and massive short-term speculative trading, and therefore reduces return volatilities and risks of huge losses. Nevertheless, with due regard to the special nature of the Exchange Fund and the needs for sufficient liquidity, there is a certain degree of flexibility under this framework that allows appropriate fine-tuning in response to market changes. But this does not mean we could engage in short-term trading or high-risk investment activities.
Some may wonder: given the vicissitude of the investment world, why can’t we swerve our investment directions in response to market movements so as to maximise gains?
The “rear-view mirror” and the “crystal ball”…
The Exchange Fund’s statutory purposes dictated that it is not a sovereign wealth fund or an ordinary investment fund. Nor is it a hedge fund. We do not engage in short-term speculation, short-selling or market-chasing. Besides, there is no crystal ball when it comes to investment. Reading too much into short-term fluctuations and redirecting investments hastily can be counter-productive, and may even inflict huge losses. Take bonds for an example. Between the second half of 2009 and early 2010, the mainstream view was that interest rates would go up and the bond price would fall in the US. Yet it turned out that bond yields consistently slid. At the start of 2014, it was again widely believed that US interest rates would go up, with 10-year US Treasury yield rising from 3.03% at the end of 2013. However, much to the market’s agony, Treasury yield headed the other way and fell 86 basis points, ending the year at 2.17%. Examples of equities taking a similar "roller-coaster" ride abound. After plummeting nearly 39% in 2008, US stocks rebounded by 24% the following year. If investors had been tempted by earlier market surges to stockpile equities in 2007, the year 2008 would probably have spelled disaster for them. Following the herd in panic selling in 2008 would have shunned the upswing in 2009.
Foreign exchange markets are no less challenging and involve a host of complicated factors, including macroeconomic environment, intervention by monetary authorities and geopolitical risks. Added to this is the peculiar structure of our monetary system. Under the Linked Exchange Rate System, the majority of Hong Kong’s foreign reserves must be held in the US dollar as the currency for market operations, with the rest allocated to other highly liquid currencies to reduce concentration risk. This is a common approach adopted by other central banks in managing foreign reserves. Currently, the US dollar and Hong Kong dollar account for 77% of the benchmark currency allocation of the Exchange Fund. As the Monetary Base expands due to capital inflows in recent years, there has been a corresponding increase in US dollar assets needed for backing the Monetary Base. Therefore, the US dollar and Hong Kong dollar assets already represent over 80% of the Exchange Fund. According to statistics from the International Monetary Fund, the US dollar accounts for some 60% of the world’s total foreign exchange reserves. The US dollar share of the Exchange Fund is already much higher than the global average. Despite constituting a relatively small portion of the Exchange Fund, the non-US dollar assets would incur book exchange losses when denominated in a stronger US dollar.
Given the high volatility and low predictability of foreign exchange markets, engaging in large-scale short-term speculation or market-chasing is extremely risky. Two recent examples perfectly illustrate this point. Subsequent to the launch of massive quantitative easing by the US in 2009, the US sovereign credit rating was downgraded in mid-2011. Believing that the US dollar would go on a downward spiral, some pundits suggested that the Exchange Fund should dump its US dollar assets. But in fact the US dollar had stabilised. In the second example, as a result of the quantitative easing in the US, the Japanese yen fell from below 80 against the US dollar in late 2012 to 103 in May 2013. Yet within a month, global market shocks arising from the indication by the Fed to wind down asset purchases had sent the yen back to 94. All these yo-yo movements had taken place in the span of a mere six months. Over the past decade, the Exchange Fund’s foreign currency holdings swung between gain and loss. For example, an exchange gain of HK$50 billion was recorded between 2002 and 2003, with another HK$36 billion between 2006 and 2007. Yet these had been offset by exchange losses recorded in other years. On balance, the Exchange Fund recorded an accumulated investment income of HK$10.4 billion from foreign exchange in the past decade from 2004 to 2013. This accounts for a small percentage of the overall investment gain of HK$670 billion during the same period. It showed that with appropriate asset allocation, foreign exchange gains and losses can more or less even out in the long run. Therefore, drastic changes in the allocation of non-US dollar assets should be avoided to minimise risks of heavy exchange losses.
Just as we could not drive by looking only at the rear-view mirror, it is unrealistic to hope the hindsight from previous episodes could serve as the foresight of a crystal ball in guiding our investment decisions. However, a guiding post for us in the real investment world could be to aim at healthy returns in the medium- and long-term and avoid being easily unsettled by short-term fluctuations. Investment markets, foreign exchange in particular, tend to be highly volatile in the short-term and highly unpredictable. However, we could venture to share some lessons learned:
1. We should focus on the overall medium- and long-term performance of the Exchange Fund instead of fixating on the short-term performance of individual asset classes.
2. The exchange rates of major currencies tend to be mean reverting in the medium- and long-term despite some short-term fluctuations.
3. Investment diversification can help reduce overall portfolio return volatility but is not immune to short-term losses in individual asset classes. It is ill-advised to overhaul the asset allocation rashly and frequently, particularly in the face of extraordinary market conditions.
The investment climate is likely to remain complicated and volatile in the foreseeable future. The US economy continued to recover robustly as compared with other advanced economies. But we could not take it for granted given the looming uncertainty posed by the general weakness in the global economy. Meanwhile, reforms in Mainland China have also entered a critical phase. Investors’ sentiment and market trends will hinge very much on major central banks’ monetary policy stance. We will continue to prudently manage the Exchange Fund investments and fine-tune our investment strategies judiciously under practicable circumstances with a view to achieving healthy returns.
Deputy Chief Executive
Hong Kong Monetary Authority
15 January 2015