Tracking the Changes
If institutions are to invest successfully, they need sound portfolio management strategies. But determining such strategies is not simply a matter of tracking markets, analysing corporate results, and interpreting headline data.
To achieve consistent positive returns, it is also vital to take account of other factors which influence investment decisions – and their longer-term implications.
Two decisive factors were covered in the latest instalment of the Hong Kong University of Science and Technology (HKUST) Business Insights Presentation Series, which took place at the HKUST Business Central on April 6.
The theme of the event was “The Role of Asset Liability Management and Economic Freedom in Investment”, during which two experts provided plenty of food for thought.
Peter Chen, associate professor at HKUST’s department of accounting, noted that value creation depends on the flexibility corporate managers have to invest in growth opportunities, and their ability to make adaptations as conditions change. Economic freedom or institutional factors affect the level of frictions or costs of management in making such investments.
Chen broadly defined economic freedom as the degree to which a jurisdiction’s policies and institutions protect the rights of corporations and individuals to pursue their economic interests without interferences. These range from size of government in terms of expenditure, taxes and enterprises, to legal structure, and the security of property rights. Also important are access to sound money and foreign currency; freedom to trade internationally; and regulations relating to credit, labour, and business operations. Since the 1980s, the Fraser Institute has compiled the indices of Economic Freedom of countries and regions.
Hong Kong consistently ranks at the top in overall score of economic freedom within 157 countries or regions published in the last ten years. The 2015 Economic Freedom Report also shows that higher economic freedom is positively associated with higher income per capita. What Chen is interested is whether economic freedom affects corporate investments and shareholders’ wealth. This is important because such evidence can help us better understand the relation between economic freedom and the wealth and prosperity of a country or region.
To provide evidence on the relation between economic freedom and corporate investments and shareholders’ returns, Chen and his research team employ a real options based valuation model. The model suggests that the value of the firm depends on three capabilities: the ability to re-produce itself, the ability to capture growth options, and the ability to make adaptation in the event of adverse conditions or losses. Lack of economic freedom acts like a brake on manager’s ability to growth even if the firm is profitable, and on manager’s ability to adapt even if the operations are losing money. The results of their research based on more than 180,000 observations from 30 countries during the 2000 to 2010 period demonstrate that corporate managers in countries or region with higher economic freedom make more efficient investment and shareholders’ returns are also higher if their invested firms from country or region with higher economic freedom.
Having established the importance of institutions in corporate investments, Chen discusses what insights he draw about the future prosperity of Hong Kong. Based on his research, he makes two major suggestions. First, given the changed conditions and challenges, Hong Kong needs to invest into an adaptive and learning society, especially education for the young generation. Second, we must attract and develop a deep pool of human capital including investment bankers, financial analysts and accountants as well as other information technicians. This is important to maintain Hong Kong as an international financial centre because a financial centre must have the capacity to serve the firms listed in addition to other market participants such as investors. The lack of interest of a number of already listed firms, for example Wanda Comm, to discontinue their participation in this market is a warning sign. The underlying reasons should be studied carefully. Since market may fail to provide adequate investments in human capital for various reasons, Government can also play a more active role in the development of human capital through better communication and coordination across regulators, private firms, and university educators.
Philip Cheng, adjunct associate professor with HKUST’s department of finance, focused on aspects of asset liability management (ALM). He noted that the same basic principles apply to dealing with a country, a large company, an international bank, or even a personal balance sheet.
In each case, the major ALM risk considerations boil down to interest rates, liquidity, credit, currency, and markets.
“The major worry is asset shrinkage, but I’m proposing most people don’t have the sensitivity to know when a balance sheet is not managed well,” Cheng said. “You have to drill down into the details on both the asset and liability sides. There is a lot more going on than just operations, capital planning, and ROE (return on equity).”
Having a “quality” balance sheet is the key to risk control, as it makes it possible to assess short- and long-term strategies, and make decisions about leverage, he said.
“With that information, you can evaluate how well a company is structured, and know where it is going,” Cheng said. “Managing a balance sheet is like playing chess. You have to think a few steps ahead, looking at the interest rate, local currency, foreign currency, and the cash flow basis.”
Cheng added that interest rate risk is substantially quantifiable. If dealing with five currencies with five different yield curves, they should be factored into asset allocation and values. Elsewhere, the secret is to keep a close eye on the difference in maturities of assets and liabilities – the liquidity gap – and take the necessary steps to prevent any ALM mismatch.
“That is what a good portfolio manager should be thinking about,” Cheng said. “The issue is to understand the potential impact on NAV (net asset value) of the portfolio balance sheet and earnings, and to regard this as a dynamic process, because there can be unexpected cash flow needs.”