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Learn about practical aspects, decision-making, KIC involvement, and more in BOK's external management scheme. Explore objectives, history, selection processes, fees, custodian services, and agreements.
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EXTERNAL MANAGEMENT– A PRACTITIONER’S VIEW(Bank of Korea) Chang-Ho Yoo Reserve Management Department
INTRODUCTION • ■ Objectives of the Presentation • ▷ To explain about the practical aspects of external management • ▷ To introduce the BOK’s practice • ■ Major Contents of the Presentation • ▷ Overview of the BOK’s external management scheme • ▷ Issues in the process of decision-making and implementation • ▷ KIC as an external manager of the BOK • ▷ Other related issues
INTRODUCTION • ■ External management business is not very straightforward • → “art” rather than finance or quantitative science • • Half front office task and half middle office task • ■ In some sense, it is very complicated and difficult • ▷ Many parties are involved • • external managers vs. internal managers • • external management vs. internal middle and back offices • ▷ Not much is known to CBs (due to confidentiality) • ▷ Also, vulnerable to criticism from outside (of CBs) • ⇒ Should maintain a consistent and logical approach
OVERVIEW OF THE SCHEME • ■ Objectives and significance • ▷ Performance enhancement and investment in a new area • ▷ Acquiring advanced investment techniques and strategies • ▷ Training and knowledge transfer • ■ History • ▷ Started from 1992 • ▷ Volume has been increased proportional to the growth of reserves • ▷ Number of funds and investment universe have been expanded • • Entrusting to the KIC since 2006 • ■ Manager of external managers: External Management Team • • Middle office (in Reserve Management Department)
PROCESS Objectives & Constraints ● Investment universe ● Risks and returns ● Number of funds and managers Selection of managers ●Benchmarks ● Investment guidelines Monitoring & Evaluation Actual management ● Active/passive management
PORTFOLIO CONSTRUCTION • ■ Factors affecting the amount of external management • • Investment universe • • Cost/benefit • • Internal capacity of reserve management • ■ The total size can be determined in the process of overall asset allocation • ▷ For new instruments, x% rule is also desirable • ■ Benchmark • ▷ In many cases, market index is enough • ▷ Larger universe by way of investment guidelines • • Should consider the status as foreign exchange reserves
SELECTION OF MANAGERS • ■ Main criteria in selecting external managers; • ▷ Financial status (and credit ratings) • ▷ Management size and experience • ▷ Track record (past performance) • ▷ Risk management capacity • ▷ Reporting capacity • ▷ Fee level • ▷ Training capacity • ■ Simultaneous screening on the same basis over multiple institutions • ▷ The process includes paper screening and presentation
FEES • ■ Flat fees vs. Performance fees • ▷ Flat fees: Proportional to the size of the mandate • • If the size for one manager increases, the total amount of fee will increase • - But fee rate will decrease • ▷ Performance fee: Determined by out-performance • • Benchmark construction and risk management are very important • ▷ Combination of the two types is also possible. • ■ Issues to be considered • ▷ Should fee proposal be a factor in selecting managers? • ▷ Should we negotiate the fee level with each and every manager?
CUSTODIAN • ■ Contributes to transparency and control through external validation of • asset values and performance <source: World Bank Treasury> • (Core services) (Other services) • ■ Multiple custodians? • ▷ Good for comparison, competition, and flexibility • ▷ Difficult to consolidate different reporting, risk management systems Performance measurement Safekeeping Accounting Compliance with guidelines Valuation Reporting Risk measurement (basic)
CUSTODIAN • Truster Asset Delivery Custodian Fee Asset Management Service Administration Service Management Fee • External • Manager • Custodian Book Reconciliation Asset Delivery
AGREEMENTS (IMA) • ■ Contents of IMA (investment management agreement) • ▷ Main agreement: “standardized” • • Definitions • • Powers and obligations of Manager • • Ownership and authorization • • Confidentiality and other legal aspects • ▷ Schedules • • Investment policy and guidelines • - Including benchmark, eligible investments, restrictions and limits • • Fee • • Reporting
MONITORING AND EVALUATION • ■ Reporting • ▷ Weekly/Monthly/Quarterly/Yearly • ▷ Position, strategy, performance, risks, accounting • ▷ Custodian can play a role in reporting • ■ Reviews • ▷ Semi-annually, face-to-face discussion • ■ Due Diligence (on site) • ▷ For monitoring as well as selection purposes • ⇒ Monitoring is time-consuming, but a very essential and important process
REBALANCING • ■ When do we need rebalancing; • ▷ Changes in external management policy • ▷ Rearranging investment instruments • ▷ Consistent under- or out-performance • ▷ Breaches of agreements • ■ Should consider cost of rebalancing • ⇒ Frequent rebalancing is not very desirable • ▷ For new investment instruments, new portfolio can be added • ▷ When necessary, transition management service is helpful
OTHER RELATED ISSUES • ■ Risk management • ▷ Limits reflected in guidelines • • Minimum credit ratings, duration deviation • • Restrictions on derivatives (if needed) • ▷ Soft limit of risks: e.g. tracking error • ■ Harmonization with direct investment • ▷ In terms of accounting, risk management, and other internal reporting • • Time gap due to collecting data • • Difference in accounting practice • • Difficulty in overall risk budgeting
KIC- Establishment - • ■ Background of setting up KIC • ▷ Taking advantage of huge FX reserves and overseas investment demands • • Effectively managing public foreign currency assets • - As an external manager • • Nurturing of asset management industry • ■ KIC Act passed in National Assembly in May 2005 ■ BOK and MOFE agreement: For initial entrustment ▷ Providing KIC with $20 billion of reserves • “Seed money” • $17 billion from BOK, $3 billion from MOFE’s FESF • ■ BOK and KIC conclusion of IMA in June 2006
KIC- Investment - • ■ Relationship between the BOK and the KIC • ▷ The asset truster and trustee • • BOK provides KIC with investment benchmark and guidelines • • Profits and losses of the KIC’s investment belong to BOK • • BOK pays KIC management fee • ■ Investment universe • ▷ BOK’s entrustment: Limited to bonds and high-grade stocks • Investment in PEFs or real estates prohibited • → Assets entrusted by BOK retains reserves status • ▷ Investment benchmark based on international bond and stock indices
KIC- Investment - • ■ Investment strategy • ▷ Sufficient discretion given to KIC • • Financial derivatives permitted • • KIC can freely choose investment strategy • - within its guidelines and risk limits (in terms of tracking errors) • ■ Investment development • ▷ Initial investment of $20 billion to be completed by early next year • ▷ Expected to gradually increase weights of direct investment ▷ More entrustment expected from the Government, national pension funds or other sources
KIC- Further Issues - • ■ Transparency • ▷ By the KIC Act, KIC discloses its operational status and investment • performance annually • ■ KIC is not a typical SWF • ▷ Current sources of KIC assets limited to FX reserves • Not bought by the Government (unlike the CIC) • ▷ But, Korea’s FX reserves are “borrowed money” accompanying liabilities • Resulting from sterilization policy in the FX market • • Fundamentally different from “pure assets”
Q & A Thank you!