Your rub your eyes and settle in for a long evening at your desk in Capital Tower: Portfolio Management Report, NUS, Singapore

University National University of Singapore (NUS)
Subject Portfolio Management

Overview: 

Your rub your eyes and settle in for a long evening at your desk in Capital Tower, first taking a slightly jealous look out at all the people headed out to dinner on Telok Ayer and Amoy Streets. As a newly minted vice-president in portfolio management, you’ve been tasked with your first major assignment: a large private investment is returning $200mn of capital to GIC, and it needs to be redeployed as quickly as possible, which explains why you’re at your desk instead of meeting friends.

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Your boss, Fu Chen Jane, has asked you to prepare recommendations to the firmwide investment committee for redeployment in $100mn tranches, and all of the capital must be redeployed. Because she knows the IC doesn’t like too much concentration, she’s advised you to pick 2 strategies to invest in. She notes that you’ll also need to briefly explain why you didn’t pick the other 2 projects, though this can be a shorter analysis. Of course, as a VP of group portfolio management at a firm the size and prestige of GIC, if you like a strategy, but want to change something in it to better suit your views, you have that authority (or can at least ask).

You sigh as you spread out your materials on the desk in front of you. You’ve been tracking 4 strategies that Jane told you were of high interest, coming from both internal trading desks and external managers. Two of these will get funded with $100mn, while 2 of them will go away empty handed. Unfortunately, your job has kept you so busy, that you’ve haven’t really had a chance to do a deep dive on any of these strategies. You ask your work-mate who is headed to the pantry to grab you a coffee, and settle in to get to work.

Before diving in, you happen to hear a Ping and look at an email that just came through—it’s a firmwide advisory from operations. GIC has certain margin and short interest liabilities denominated in the Indian Rupee, the US Dollar and the Euro. Because of these liabilities, any hedging costs or benefits back to Singapore dollars from these 3 currencies will not be charged and can be effectively ignored (in other words, unless specifically stated, you can ignore FX hedging costs).

Strategy 1:

The first strategy is one that the equities division has been pitching you for some time. Their perspective is that India is the next major rising power in the world and that economic growth is at a true inflection point…essentially that the next few years will see India’s growth take off at scale like Chia’s did around the turn of the 21st century. Furthermore, they believe that unlike Chia’s tech economy (except for Tick Tock), because there is not “great firewall” around India, some of the Indian tech firms will truly rise to become global powerhouses and not just be centered in one country.

If funded, the trader will buy a broad basket of Indian stocks, but with a particular focus on IT stocks…indeed the trader has indicated he expects a little over 50% of the portfolio to be tech and IT stocks, while the NIFTY (the main Indian stock index of the 50 largest stocks) itself is about 20% IT.  Then the trader will use their expertise and fundamental analysis of Indian tech stocks in an attempt to outperform even more through individual stock selection in the tech space. The equities group has been incubating this strategy since January 2021, and the live returns can be found in Exhibit 1.

Do you invest in this: if so, why, if not, why not? Please use both quantitative and qualitative analyses. Jane reminds you that if you decide to invest, you should probably include at least a bit or economic and demographic data in your analysis (that info isn’t in your existing packet—time to fire up google).

If you would invest, would you change anything? Your boss Jane reminds you that some areas to look at might include:

  • What is the aggregate performance?
  • How much risk is being taken and how are you measuring it?
  • Is the strategy outperforming an appropriate benchmark (and what would be an appropriate benchmark)?
  • Is the trader adding value with his stock selections?

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Strategy 2:

The second strategy is from the internal GIC credit division. They have analyzed credit spreads and feel that global sub-investment grade US corporates are especially attractive at the moment. They propose buying and holding to maturity a portfolio of 5-year maturity US dollar-denominated BB and B bonds at about a 50% BB and 50% B weighting. In order to hedge some duration and some credit risk, they also propose shorting some amount of BBB bonds. Finally, because the strategy is relatively low risk, but low return, they propose applying 3:1 leverage (so the aggregate size of the portfolio would be $300mn ($100mn long BB, $100mn long B, $100mn Short BBB) on $100mn of invested capital.

Yields and cumulative default probabilities are in exhibit 2. If there is a default, it’s estimated that BBB would recover 30% of the face value, BB would recover 25% and B would recover 20%.

The potfolio is relatively well collateralized and the cost for any borrowing is very close to the risk-free rate. You do not have to pay an additional charge for shorting. Finally, the cash you get from any short sales will be held in an account that bears interest at the US risk-free rate. The bond desk tells you that because you are GIC, you can do a 5 year repo (short) of the BBB bonds no problem, and hold them for the full five years with minimal short squeeze risk.

The desk also tells you not to worry about excess initial and variation margin (in other words, you don’t have to account for any additional margin costs, your $100mn cash will be plenty of margin for the entire portfolio).

The bond desk notes that if rates rise by 1%, the portfolio falls in price by 2.5%, while if rates fall by 1%, the portfolio rises in price by 2.7%.

Jane reminds you that this is a really hard one to analyze, but if you think through each item separately, you can probably analyze this pretty well. Some things to consider in your analysis:

  • How do you measure how much you’re getting paid to take the BB and B risk
  • How does that compare to the default risks of BB and B bonds
  • How much is the portfolio actually going to yield (net of costs) before any defaults?
    • What about including expected defaults?
  • Does the BBB hedge make sense? Does the leverage make sense?
    • What is the spread sensitivity of the portfolio?
      • Can you estimate it without the hedge?
    • What is the rate sensitivity of the portfolio?
      • Can you estimate it without the hedge?

Strategy 3:

Strategy 3 comes from an external manager (Oldburger Roundsqaure) that provides “growth capital” to primarily European firms (almost exclusively in the Eurozone). They are structured like a private equity group, but claim that instead of laying people off and cutting costs, they provide “rocket fuel” to companies trying to grow quickly…they don’t really use leverage, and typically negotiate a 20-30% equity stake in exchange for fairly chunky investments in late-stage venture capital and other growth minded private companies. They typically invest $100-200mn at a pop. You would be putting $100mn into a fund that they estimate will close at approximately $2bn in total.

In addition, they claim that they understand the drag that high fees put on any investment. They only change an annual management fee of 1% of total assets pledged, payable at the end of each year…as well as 10% carry (they get 10% of all gains above the $100mn that you would initially put in), payable at the end of each year (once above $100mn in returned capital). The fund is expected to last for 10 years. They charge no deal fees, fairness opinion fees, board observation fees, consulting fees or other fees.

They work on a draw-down structure, and their quoted historical IRRs are all on deployed capital, not committed capital (you must commit $100mn, but they will take it from you when they have investment opportunities, not before). There is a 3 month notice on committed capital, so you could hold securities with 3-month maturities, but not much more than that. At the last meeting with them, you asked for a capital call and return schedule for their last fund (which was $1bnn and pursued exactly the same strategy), and they gave it to you as exhibit 3. While this fund will likely be a little bit different than the last one, you think that the prior fund capital call and capital return history is probably as good a place as any to estimate what the capital call and capital return structure and IRR will be for this fund.

Again, Jane reminds you of some things you might review:

  • What will the reported IRR be of this fund assuming it has exactly the same capital call schedule and capital return schedule as the prior fund (reported IRR will be IRR on called capital only, not accounting for fees)?
  • What will be the actual IRR before fees be if you also factor in the capital you will have to hold as committed capital that can be called on 3 months notice?
  • What is the actual IRR after both the committed capital drag and the fees?
  • What is a likely beta for no-leverage equity stakes in the kinds of companies they invest in (late VC and growth stage private companies)
  • What benchmark or underlying index should you use?
  • Net of fees, does this investment outperform?

Strategy 4:

The final manager is a very long tenured South American asset manager who focuses on Brazilian equities. This strategy goes back to January 1, 2014 and has returns as shown in Exhibit 4. In addition to these returns, they charge a very reasonable management fee of 20 basis points on capital invested.

It’s already been established from on-high at GIC that they want more Latin American exposure and this might be a good way to do it (in other words, you don’t have to look at the economic fundamentals of Brazil, management is already telling you they like them).

Jane reminds you that if you want to do this investment, you’re going to have to account for the costs to hedge the Brazilian Real back into Singapore dollars. She tells you that a 5 year horizon is pretty typical of an investment length at GIC. Jane also indicates that she suspects the manager is just a closet indexer. The right way to analyze this is to calculate the ‘active share’ of the manager (sum of the difference between each stock’s index weight and the manager’s weights/2). Unfortunately, you don’t have this information to hand. However, Jane has confidence you can find some other way to at least roughly get a sense of whether this is true.

Jane indicates a few items you might want to look at include:

  • Is the manager a closet indexer?
    • Might something else be going on?
    • What questions might you want to ask the manager?
  • How much in fees is getting charged for the active management that is actually going on…is this reasonable?
  • Does the manager outperform after fees but before hedging costs?
  • What about after currency hedging costs?

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