AN ANALYSIS OF THE PERFORMANCE OF THE EXCHANGE FUND
INTRODUCTION
1. An analysis of the investment of any fund must take into account its objectives, which may be unique to that fund.
2. In general, the objectives of a fund dictate the investment strategy that can be adopted by that fund, involving a tradeoff between the three basic parameters of investment, namely, the rate of return, risk and liquidity. A higher rate of return can be achieved on the assumption of higher risks, but the demand for higher liquidity or greater protection of capital would imply accepting a lower rate of return.
3. The rate of return, therefore, is by itself an inadequate measure of the performance of an investment manager. A more complete measure of performance is to compare the rate of return achieved by the investment manager against that of a benchmark investment portfolio that reflects the acceptable levels of risk and liquidity.
4. This paper analyses the performance of the Hong Kong Monetary Authority (HKMA) in managing the Exchange Fund since 1993 within the above framework.
5. The HKMA was established on 1 April, 1993. It is responsible for, amongst other things, the management of the Exchange Fund. From 1 January 1993 to 31 December 1996, total assets of the Exchange Fund increased by 85.9% or at a compound average annual growth rate of 16.8% from HK$287.5 billion to HKD534.5 billion. Over the same period, the net assets (total assets less liabilities or the accumulated surplus) of the Exchange Fund increased by 61.8% from HK$106.6 billion to HK$172.5 billion. This represents a compounded average annual growth rate of 12.8%. This is higher than the average nominal GDP growth of 12.1% for the period 19931996.
INVESTMENT STRATEGIES
6. The objective of the Exchange Fund is to safeguard the exchange value of the currency of Hong Kong. The investment strategy of the Exchange Fund is as follows:
1. to maintain maximum liquidity to defend the Hong Kong dollar exchange rate;
2. to preserve capital; and
3. to generate additional returns subject to 1 and 2.
7. To maintain maximum liquidity and to preserve capital, the Exchange Fund must sacrifice return and limit its investments to shorter term securities of the highest credit quality. In order to meet foreign exchange requirements for market intervention purposes, the Exchange Fund has to maintain very high liquidity. One stringent requirement is the ability to convert its assets into cash within a very short period of time. Since the intervention currency is US dollars, and for capital protection and liquidity purposes, the Exchange Fund invests largely in US Government Treasuries. The Exchange Fund therefore pays an opportunity cost (in terms of its rate of return) to maintain high liquidity and low risk.
BENCHMARK INVESTMENT PORTFOLIOS
8. As stated earlier, a meaningful measurement of investment performance in the management of a fund is to compare the rate of return of that fund with that of a benchmark investment portfolio that reflects the investment objective of the fund. The Exchange Funds benchmark includes specific percentage allocations to major currencies, and a mix of shorter term multicurrency fixed income instruments, bank deposits and a small component held in equity markets.
9. By employing his investment skills, an investment manager may position his portfolio slightly differently from the benchmark investment portfolio to take into consideration his judgement of market developments. If he is able to beat the rate of return of the benchmark investment portfolio, his performance will be considered superior.
MEASUREMENT OF RATES OF RETURN
10. A generally accepted measure of the rate of return of a fund without liabilities is the rate of return on the average amount of assets under management in a year (rate of return on average assets).
11. The measurement of the rate of return is less straight forward for a fund with liabilities, particularly interest bearing liabilities. The Exchange Fund has substantial interest bearing liabilities, comprising mainly the fiscal reserves of the Hong Kong Government placed with it, and the Exchange Fund Bills and Notes issued. These are equivalent respectively to 27.3% and 15.6% of total assets as at 31 December 1996. Obviously the need to pay interest on liabilities makes the rate of return on average assets inappropriate as a measure. A more appropriate measure would be the rate of return on the average amount of assets under management net of liabilities (rate of return on average netassets). But given that interest may not be paid on all liabilities, yet another measure would be the rate of return on average amount of assets under management net of interest bearing liabilities. Either of these measures would be appropriate for the Exchange Fund.
PERFORMANCE
12. The relevant rates of return for the Exchange Fund are provided below, along with the corresponding rates of return for the benchmark:
Rates of Return against Investment Benchmark

Exchange Fund
(financial year 1 Jan to 31 Dec)


Return of return on average net assets

Rate of return on average assets net of interest bearing liabilities

Rate of return of benchmark investment portfolio

1993

17.9%

11.3%

7.7%

1994

0.8%

0.5%

3.8%

1995

21.8%

14.0%

13.7%

1996*

7.4%

4.9%

3.0%

1993 to 1996
total return

55.5%

33.8%

30.9%

Compounded
annual return

11.7%

7.5%

7.0% 
* Preliminary estimates
13. For the four years from 1993 to 1996, the total return on average net assets of the Exchange Fund was 55.5%, which is 24.6% more than the total return of the benchmark investment portfolio. Over the same period, total return on average net assets net of interest bearing liabilities was 33.8%, which is 2.9% better than the benchmark. The Exchange Fund outperformed its benchmark in 1993, 1995 and 1996, but underperformed in 1994, when world wide bond prices declined due to the increase in US interest rates.
RATES OF RETURN AGAINST CPI
14. In the period from the end of 1992 to the end of 1996, the cumulative increase in the CPI(A) index in Hong Kong was 31.9%. Over this same period, total assets of the Exchange Fund increased by 85.9% and net assets increased by 61.8%. The rates of return of the Exchange Fund was 55.5% on average net assets and 33.8% on average assets net of interest bearing liabilities. On the basis of any of these measures, the performance of the Exchange Fund compares favourably with the inflation index in Hong Kong. But such a comparison is not particularly meaningful. The primary purpose of the Exchange Fund, which is to provide liquidity to defend the exchange rate, restricts its investments to nonHK dollar denominated assets. Hence, it would be inappropriate to compare the returns of a nonHK dollar denominated portfolio with the Hong Kong rate of inflation, which is the rate of change in the prices of a basket of goods and services in Hong Kong. In addition, investment alternatives in the local financial markets are relatively limited for a fund of the size of the Exchange Fund. There will also be serious conflicts of interest on the part of government as investor and regulator. Even if guidelines permit, investments of the Exchange Fund into HK dollar denominated financial instruments would be potentially inflationary.
CONCLUSION
15. The Exchange Fund is well managed by the HKMA with the relevant measures of the rate of return consistently beating the rate of return of its benchmark investment portfolio and comparing favourably with nominal GDP growth.
Hong Kong Monetary Authority
February 1997
Last Updated on 18 August 1998