Chinese table tennis: A global inspiration for sovereign wealth funds

Norbert Fullerton

Partner

The bottom line:

By using reference portfolios, sovereign (and other institutional) investors can manage risks more effectively, better evaluate their portfolio's performance and make improvements that align with their long-term investment goals.

China’s table tennis players have been the dominant force in the Olympic games and World Championships for over 40 years – due to government support, a strong work ethic, discipline and world-class coaches. In this article I’m going to focus on a lesser-known Chinese team which has quietly built a strong reputation on a different global stage.

That team is the China Investment Corporation (CIC), the world’s largest sovereign wealth fund. CIC was established in September 2007 with the primary goal of diversifying China's foreign exchange holdings and maximising returns for its shareholders while maintaining acceptable risk levels.

With an impressive track record, the CIC has made significant strides in its investment performance, resulting in substantial growth of its total assets since inception from USD 200 billion to over USD 1.35 trillion as at the end of 2021. Its overseas portfolio delivered a net annual return of 14.3% in 2021, and its annualised net return since inception is 7.2%, reflecting its commitment to generating sustainable, long-term returns.

One of the main reasons behind the strong investment growth of several public funds and sovereign wealth funds, such as CIC, is its comprehensive ‘total portfolio allocation framework’. This framework includes a critical benchmark known as a reference portfolio which has been instrumental in its investment success.

Using a reference portfolio could be a source of inspiration to other sovereign investors, including central banks and government pension funds, looking to enhance their asset allocation decisions and drive their investment performance to new heights.

Defining the reference portfolio

The composition of reference portfolios is the largest influence on investment returns and, typically, comprises a combination of low-cost, passive, listed asset classes that reflect the overall risk appetite that a governing board would be prepared to take.

For example, both the CIC and Singapore's Government Investment Corporation (GIC) use a reference portfolio to measure their risk appetite, but with different asset allocation strategies. CIC’s reference portfolio is composed solely of global equity and fixed income indices, whereas GIC’s reference portfolio is allocated to 65% global equities and 35% global bonds. “The reference portfolio is not a performance benchmark” but represents the risk sovereign wealth funds are prepared to take in generating good long-term investment returns. On occasions when they are more risk averse than the risk profile of the reference portfolio, sovereign wealth funds can lower their actual portfolio’s risk exposure.

By comparing actual performance to a reference portfolio, sovereign investors, like CIC and GIC, gain valuable insights into the sources of return and risk in the portfolio, plus any areas where the portfolio may be over or underweight relative to the benchmark. This also helps to identify potential areas for improvement and make more informed investment decisions.

Sovereign investors deviate from their reference portfolios for several reasons, including:

Strategic objectives

Usually require them to invest in assets that are not included in their reference portfolio. For example, they may invest in infrastructure projects or real estate to support economic development in their home country or region.

Risk management

To manage risks, such as currency or geopolitical risks.

Market opportunities

To take advantage of opportunities to invest in a particular sector or asset class that they believe is undervalued or has growth potential.

ESG considerations

For example, by balancing traditional investing with ESG insights to improve long-term performance.

Typically, institutional investors that use reference portfolios share common features, such as:

These features enable sovereign wealth funds to add value through active strategies and take advantage of market opportunities, making it beneficial to deviate from their reference portfolio.

Better governance

The Trustee or Executive Board focuses on setting high level strategic investment objectives and risk tolerance via the reference portfolio, the investment committee on the appropriateness of the overall investment strategy and delegations, and the internal investment management team focuses on the specifics of asset allocation, implementation and reporting. For example, in 2020, the Qatar Investment Authority (QIA), one of the world’s top 10 sovereign wealth funds, introduced a reference portfolio designed to meet the long-term return objectives, subject to risk and liquidity limits set by the Board. The reference portfolio is then used to develop annual and medium-term investment plans for each investment team. Better delineation of responsibilities is a crucial governance benefit because it frees Boards from the need to understand the extensive range of complex products, structures and strategies associated with implementing investment decisions. The New Zealand Super Fund has found this approach particularly beneficial.

Measuring the added value

One of the main drivers behind the growing interest in reference portfolios is the desire to make, monitor and measure asset allocation decisions better.

Reference portfolios help discover the parts of the decision-making process that are adding value which, in turn, helps the Board or governing body understand what is happening in the portfolio.

The reference portfolio

Anchors the target risk level of the total portfolio; and
Consists of global equity and fixed-income indices.

Strategic asset allocation

Introduces additional asset classes and serves as a medium - to long-term neutral portfolio for improved returns and risk diversification;
Manages intra-asset allocation to optimise the investment footprint across geographies, sectors, industries, themes, and risk attributes; and
Further enhances the risk-return profile through dynamic allocation adjustments.

The actual portfolio

Ensures the effective implementation of the policy portfolio by managing total portfolio exposure; and
Generates alpha via active management by the investment team.

Source: CIC 2022 The difference between the reference portfolio and the strategic asset allocation gives the value add by the selection of strategies. The reference portfolio is also not influenced by short-term market conditions. So, while the strategic asset allocation would typically be set on a calendar basis in order to update it based on the prevailing/short-term market conditions, the reference portfolio is typically changed only to reflect fundamental changes in market conditions or the objectives of the governing Board.

The difference between the performance of the strategic asset allocation and the actual portfolio gives the contribution of implementation timing drag/boost, manager selection (ahead of selected strategy benchmarks), manager fees and transaction costs.

Conclusion

In a world increasingly focused on short-term performance, market sentiment, geopolitics and portfolio diversification, the evolution of the reference portfolio approach to asset allocation for sovereign funds brings a breath of fresh air. Adopting a disciplined and consistent approach, like Chinese table tennis champions, can help sovereign investors manage risks better and make more informed investment decisions – enabling them to achieve (or exceed) their financial goals in the long run.