PMAA’s Lee: China will be ‘put on the spot’

Do Yoon Lee, CIO of South Korea’s Police Mutual Aid Association, reflects on the GFC and thinks the next downturn may emanate from China.

Do Yoon Lee, chief investment officer at South Korea’s Police Mutual Aid Association, structured and invested in collateralised debt obligations at Korea Investment Management during the global financial crisis and then at Samsung Asset Management after the crisis. He sat down with PDI to discuss the risks of derivatives, his view on the asset management industry, and how Police Mutual Aid Association has prepared for the next downturn.

What do you think about the impact of the global financial crisis and how it changed the landscape?

DYL: There were crises over the course of the centuries. In Europe, the Dutch tulip bubble occurred in the 1600s, and the south sea bubble in the UK. In Asia, Japan experienced a housing bubble in the 1980s as the fluctuations of the Japanese yen and low interest rates pushed domestic investors to look at the real estate market.

The impacts of these were well known. In the US, American Insurance Group was bailed out and two of the top five investment banks disappeared. In retrospect, the subprime mortgage crisis was triggered due to the collateralised loan obligations that were impossible to track back to their original underlying assets as the derivatives market was out of the regulator’s radar.

This raised issues about the financial system including the risks of derivatives and underwriting standards. The three credit rating agencies were blamed for it and, as emotional revenge, they downgraded the US’ sovereign debt rating, although I think this was futile as the US dollar is reserve currency and they can print more money to pay back sovereign debt.

Afterwards, central banks opted for quantitative easing. To some degree, they helped global economic recovery. However, given the historic pattern of the economic cycle, which I believe is every 10 years, the next downturn is coming but seems delayed as we built up the tolerance level against crises.

How did the crisis affect your allocation activity when you were at Korea Investment Management? How did the credit sector perform during and after the crisis?

DYL: I remember the day when a broker in Hong Kong brought secondary CDOs to me. I could not identify their underlying assets as they were issued based on other CDOs. Back then, the Korean derivatives market was not evolved enough to support such transactions, so I did not pursue them further, luckily.

After Daewoo fell, corporate South Korea was not doing well, contracted by a shortage of liquidity. There were many sellers but very few buyers of these CDOs. The market was full of sellers as no one wanted to buy them.

In the 2000s, asset management companies offered ‘initial public offering rights’ to investors if they committed to CDO funds. It was common to offer such exceptional rights to keep the bond market afloat. The performance of these hybrid funds was driven by IPO stocks, not by CDOs.

I was pulling different tranches from underlying assets based on their cash flows and default risks to issue secondary CDOs. For instance, investment grade bonds and higher tranches pulled from BBB rating pools were included in secondary CDOs in Korea. Those with junk rates were recorded as equity loss. The overall return was in double-digits.

After having a few conversations with other institutional investors, it seems that aftershocks are still felt when it comes to mid- and long-term asset allocation plans. In PMAA’s case, listed equity exposure is capped at 10 percent. What is your view on this, and how has it changed since you joined PMAA?

DYL: The Police Mutual Aid Association is overseen by the National Police Agency of Korea. Per our latest annual meeting held in October, committee members decided to maintain the current 10 percent cap for the listed equity allocation.

Before I joined, the allowance for equity allocation was as low as five percent, compared to that of other saving funds in Korea such as Military Mutual Aid Association or Scientist Mutual Aid Association which are holding over 15 to 20 percent equities.

Given the risk-averseness of the organisation, our approach to equities is more conservative. The committee did not approve tweaks to the investment policy statement with regards to levering up the maximum cap for equity allocations.

The biggest change that I made is setting up an investment platform. We now only invest in offshore alternative assets such as power plants via funds of funds not via project funds sourced from brokerage firms.

This is because some brokerage firms tend to source deals offshore and sell them down to domestic funds like us. They gained 200bp of commission from us. This seemed excessive given that asset managers only required us to pay a management fee of 20bp when acting as investment trust companies.

What do you think about the increasing demand for Environmental and Social Governance (ESG)?

After the economic recession, ESG has been discussed by industry participants as a long-term framework on governance and social responsibility. For instance, the National Pension Service of Korea is moving towards adopting the stewardship code. However, this is still at an early stage and larger entities should set up standards. This trend will help building up trust between corporates and investors in the long-term.

Do you see any area of risk that might be a trigger for the next downturn?

I do not know exactly, but China will be put on the spot because of its shadow banking activities and the debt level of corporates and the government. Looking back at the early 2000s, I structured China funds when I was at Samsung Asset Management. I questioned their transparency and accounting standards when evaluating state-owned enterprises. Japanese sovereign debt also might be a trigger for the next downturn.

Given the illiquid nature of private investments, how has the risk of illiquidity played into your decision to up your private market allocations?

When allocating to alternatives, we capture them as held-to-maturity assets. As we pursue illiquid premiums for better returns, default risks matter more than liquidity risks when considering structured bonds.

Does PMAA have sufficient liquidity management and risk management?

As we hold assets to maturity, not much liquidity management is needed. However, we will still be vigilant about the liquidity of our investments. For risk management, we are looking thoroughly at our exposures and have budgeted risk management consulting for next year.