Avoiding complexity

The structured products market has evolved rapidly, but Sung Cheng Chih of the GIC thinks that technology may be moving a little too fast for some investors. By Nick Sawyer

The name of the game for investment managers over the past few years has been how to generate yield. It's not been easy. Equity markets have been shaky, interest rates have been low and – until the recent downgrade of General Motors and Ford – credit spreads have been locked at tight levels.

As spreads have tightened and equity volatilities plummeted, an array of new products have emerged aimed at giving investors an extra yield kick. In the credit world, for instance, technology has evolved from synthetic collateralised debt obligations (CDOs) to CDO squared and, most recently, to CDO cubed, as dealers increase leverage to improve returns for investors.

But is financial technology moving a little too fast for some investors? Sung Cheng Chih, director, risk and performance management department, and chairman of the operating committee at the Government of Singapore Investment Corporation (GIC), thinks so. "If a sponsor does not have the ability to value the instruments and manage the risk of the investments, then it's highly debatable that they should get involved," he says.

That's particularly true of products such as CDO squared, where the overlap in credit default swaps within the various reference portfolios means that a default in a popular name – a General Motors, for example – could have an impact on several of the reference portfolios. The analysis required to calculate this correlation would require systems beyond the reach of most investors. But even relatively vanilla products like CDOs are not covered by many of the buy-side risk management and pricing systems available on the market.

"The argument made to investors is that CDOs are very good value and that they can exploit some of the undervalued assets. But are sponsors the best placed to take advantage of that? I think not," says Sung.

The GIC has opted for a simpler approach. It has long used derivatives, particularly in its foreign exchange department, which is responsible for hedging all of GIC's currency exposures on a corporate level. But it also uses a variety of exchange-traded and over-the-counter equity and fixed-income derivatives such as futures, swaps, options and credit default swaps to take both directional and relative value views on the market. Using cash securities and more liquid OTC instruments such as CDSs, an investor can often replicate the exposure of a more complex product such as a CDO, says Sung.

"What sort of exposure are investors trying to get? The first order is directional, and that can often be replicated through other instruments," he notes. "If investors can replicate that through CDS, high yield bonds or asset-backed securities, then do we really need to go through an intermediary, particularly when we are not seeking significant leveraged exposures?"

The GIC was set up by the Singapore government in 1981, charged with managing with managing the city-state's foreign reserves. Now, it is one of Asia's largest investors, with more than $100 billion in assets under management. Divided into four main divisions – the public markets group; a private equity investment arm called special investments; real estate; and corporate services, which houses the risk and performance management department – the company's objective is to achieve a certain real rate of return in excess of the average inflation rate in the US, Japan and Europe.

As its assets have grown, the firm has looked to expand into other asset classes. For instance, a separate alternative investment unit was set up in April 2002 aimed at delivering absolute returns. Then, in July 2004, an external fund management division was established, designed to appoint and manage a portfolio of external fund managers across a number of different strategies including global fixed income, global developed equities, emerging Asia equities, active currency, and total return overlay.

"Institutions have to be realistic about where they have the best chance of succeeding," says Sung. "Once a sponsor realises that in-house capabilities are limited, if it wants to invest in new assets, it has to decide whether to invest in in-house people and systems, or to look externally."

There has been a growing trend among pension funds and sponsors in Asia to outsource to external fund managers. However, while a number of investors have increased their allocation to hedge funds, Sung says that many of the large sponsors are still wary about this asset class. "Not knowing what is in the portfolios is quite a big impediment, and I would be surprised if many of the big sponsors are prepared to make high-percentage allocations to hedge funds in the way some endowments have done," he says.

Instead, he wants to see more traditional asset managers diversifying beyond long-only strategies, yet still maintain a high level of transparency. "Some asset managers are already diversifying away from long-only, but there are two crucial differences to hedge funds – once is that they are not giving up liquidity and transparency, and the other is that they charge lower fees," he says. n