In his Budget Speech this February, the Financial Secretary earmarked part of the fiscal reserves and a portion of future budget surpluses to establish a Future Fund. The Fund will serve as long-term savings for Hong Kong and will be placed in long-term investments to achieve higher returns. On the recommendation of the Working Group on Long-Term Fiscal Planning, the Government will entrust the management of the Future Fund to the HKMA. By phases, the Future Fund will place up to around half of its capital to alternative investments under the Long-Term Growth Portfolio (LTGP) of the Exchange Fund to enhance long-term return.
The Future Fund is a collective savings plan for the people of Hong Kong. Naturally, it has attracted keen interest from the community. Now is an opportune time to revisit the LTGP’s background and investment strategies, and to explain more about the management and future direction of the Portfolio to promote a better understanding of this important component of the Future Fund. This article will focus on the background and investment philosophy of the LTGP. We will shed more lights on our handling of some investment cases and the future direction of the Portfolio in the next article of this series.
Born in the aftermath of Global Financial Crisis
The Exchange Fund started LTGP investments in 2009 when the financial markets were still licking their wounds from the devastating global financial crisis and the conventional asset markets were still turbulent. A year ago in 2008, the Exchange Fund recorded its first ever negative overall return since the HKMA was established. Finding an alternative path to growth was an urgent task at that time. To diversify risks, we decided to allocate, in a prudent and incremental manner, a small portion of the Exchange Fund to alternative asset class comprising global private equity and overseas real estate. Alternative assets have lower return correlation with conventional assets and therefore can help diversify investment risks and reduce overall return volatility of the Exchange Fund. And, within acceptable risk levels, alternative investments can improve the overall return of the Exchange Fund in the long run in a bid to preserve the Fund’s long-term purchasing power.
Alternative asset is a relative concept to conventional asset which mainly refers to liquid assets like bonds and equities. Because of its medium- to long-term focus, the return of alternative investment is often realised after a longer period of time. The focus on long-term return is reflected in the name of the portfolio, the “Long-Term Growth Portfolio”. This resonates with the policy objective of the Future Fund, and probably explains why the Government decided to put around half of the capital of the Future Fund in the Portfolio.
Building up the LTGP
Rome was not built in a day. Building up the LTGP has been fraught with challenges. We started to explore diversification of the Exchange Fund investment back in 2007. After much preparation and careful studies in the next year or so, the Financial Secretary approved the establishment of the LTGP on the advice of the Exchange Fund Advisory Committee and its Investment Sub-Committee. We made our first alternative investment in early 2009, after confirming that we had the requisite investment professionals, supporting infrastructure and internal control in place. As luck would have it, 2009 was a good timing to invest in alternative assets. After the global financial crisis, many quality assets were sold at a discount while there was limited “dry powder” from other investors. The assets we snatched up in 2009 turned out to be the best performing ones till now.
The LTGP has been expanding since its establishment. As at end-2014, invested amount and undrawn commitment totalled around HK$200 billion. Expansion of the Portfolio gathers further momentum this year. New commitment in the first ten months of this year reached some US$9 billion as compared to US$5 billion last year.
Investing in alternative assets is challenging. Unlike conventional stocks and bonds traded in open markets, alternative asset markets are characterised by lower transparency and consistency in market standards. Information update and dissemination is relatively limited and far between. Identifying market cycles, and assessing and comparing investment opportunities are much more difficult and complicated. Also, with limited investment channels, sourcing good alternative investment deals around the globe is no easy feat. Therefore, our strategy is to have a nimble and capable in-house investment team underpinned by the support of external investment managers.
Making reference to international practices for alternative investments, we established a mechanism under which external investment managers will act as General Partners to source and recommend deals on one hand, and carry out daily asset management and monitoring duties on the other. The external managers we engaged are mostly internationally renowned asset management firms equipped with expertise in the relevant fields, market intelligence, investment network and management platform. They are experienced investment managers and have consistently stellar performance in their respective specialties. The HKMA’s Reserves Management Department focuses on due diligence work of the background and competence of prospective external managers as well as masterminding the overall strategic asset allocation and risk control of the Portfolio. Learning through around seven years of experience, the mechanism has been growing in sophistication and efficiency. The performance of the LTGP has been satisfactory – the since-inception annualised internal rate of return stood at 13.5% as at end-2014.
The LTGP’s Investment Strategy
I. Asset Classes
The LTGP is made up of two main asset classes – global private equity and overseas real estate.
Private equity broadly refers to equity investments not traded frequently or freely in the open market. Their fundraising targets are usually specific institutional investors instead of the general public. Fund investments, such as leveraged buyout and venture capital, and co-investments are common examples of private equity. Private equity under the LTGP also covers non-equity investments (like distressed investment which involves debt investment).
On overseas real estate, we generally partner with major international property investment managers to source and directly acquire prime properties in major overseas cities, such as in the office, retail, logistics sectors, etc. In such investments, we look for stable rental income or value enhancement through re-positioning. We also invest in real estate funds.
The LTGP predominantly invests in traditional and mature markets, including North America and Western Europe, with small exposure to certain emerging markets. Although long-term return is our overarching goal, we also take into account the macroeconomic environment and conditions in the markets we are investing in when making investment decision, and stand ready to adjust our strategy having regard to these factors.
For example, after protracted quantitative easing, alternative asset markets in the US have been awash with liquidity and asset prices have been inflated. With the expected start of the US rate hike cycle following a possible lift-off in December, there may be massive asset re-pricing. Therefore, when investing in the US, we have to make sure that our acquisition prices are within fair ranges and capital deployment is at a reasonable pace.
In the eurozone, the market generally expects the European Central Bank to stick to its accommodative monetary policy, which is anticipated to drive up asset prices and suppress overall return, just like the case in the US a few years ago. At the same time, as the US dollar strengthens against euro and other currencies, non-US dollar assets will inevitably incur exchange losses when their return is translated into the US dollar term. That being said, interesting investment opportunities can still be found in Europe. For example, squeezed by the sluggish economy and new regulatory requirements in the eurozone, some institutional investors are compelled to sell their quality assets, some at a discount to fair value. To capture these valuable but fleeting investment opportunities, we have been tracking the market closely and maintaining close contact with various market players. In the face of challenging investment environment in the eurozone, we will stay vigilant and adjust our investment strategies and asset allocation judiciously so as to achieve a relatively stable overall income in the long term.
In a bid to further diversify risk, we have been gradually increasing our allocation to Asian markets under the LTGP in recent years. Compared with other Asian emerging markets, industry players generally consider the private equity and real estate markets in Australia, Japan and Mainland China more mature. Each market is unique in itself. In particular, systems and market efficiency may vary. Leveraging our established network in the alternative investment field, we will continue to familiarise ourselves with these markets. We will also apply our experience from investing in other markets to identify suitable opportunities in Asia.
Generally speaking, the LTGP does not gravitate towards a particular sector. On the contrary, we seek to diversify risks through investment in different sectors. We will prudently consider sectors widely considered to have high growth potentials in the long run like energy, technology, healthcare, etc. However, one has to note that each of the aforesaid sector can be further subdivided. Take energy as an example. It can be subdivided into oil and gas or a wide array of renewable energy. Each energy subsector has its unique attributes. Therefore, it is an oversimplification to say whether one sector is more suitable for the LTGP than other sectors. Each of our investment decision must be supported by in-depth studies on a case-by-case basis. Indeed, for alternative investments, picking the right investment manager is even more important than choosing the right sector. Therefore, we place great emphasis on partnering with managers with consistently exemplary performance in the specific investment sphere, with a view to striving for a satisfactory long-term return.
LTGP versus Conventional Investments
A common attribute of private equity and real estate is their lower liquidity, meaning harder to cash out in a short period of time. This is also an important attribute setting apart LTGP from conventional investments.
The investment period for private equity is usually five to eight years. As for our real estate investments, they are mostly intended for long-term holding. Disposal of these investments is subject to factors such as market conditions and contractual obligations with investment partners. A longer investment period means that return may not be realised until after many years. In the early life of an investment project, capital is drawn down, especially for investments involving value-added strategies such as corporate restructuring or property re-positioning. Such stage is often characterised by low return or even negative cash flow. Potential return may only kick in towards the later stage of the lifecycle of the project. This is what the industry called the J-curve effect.
Because of the lack of liquid secondary market and other attributes of these alternative assets, private equity and real estate are often regarded as higher-risk investments. For instance, some start-up or distressed companies may have a higher risk of bankruptcy. The heavy loss suffered by some mega investment funds having to put up their assets in a fire sale during the global financial crisis is another sobering example.
Just like all other investments, even after we have conducted meticulous due diligence checking and post-investment monitoring, and partnered only with internationally reputable General Partners, we still cannot guarantee that individual alternative investment projects will not encounter difficulties or even suffer losses. The linchpin to risk control is diversification in the overall asset allocation. Also, with our eyes on the long-term return, we should not be easily swayed by short-term return volatility in making investment decision for the LTGP. We must accept that some projects may earn us a windfall but some others may falter. The long-term overall Portfolio return is what matters.
On the whole, with prudent investment and robust risk management, it is hopeful that the long-term return of LTGP should beat that of the conventional investment. This is validated by the performance of LTGP since its inception in 2009.
(To be continued)
Deputy Chief Executive
Hong Kong Monetary Authority
14 December 2015