Now that Korea's top pension fund is willing to invest abroad, will foreign firms finally get a real crack at this vast market?
By Donald Kirk
June 2001
Institutional Investor Magazine
Now that Korea's top pension fund is willing to invest abroad, will foreign firms finally get a real crack at this vast market?
Chang Kil Hoon is exhausted. "Every day 20 or 30 people come here to talk to us," sighs the director of investment strategy for South Korea's National Pension Corp. "Another ten or 15 people telephone us. Then we have a lot of investment meetings." The burning topic: Which foreign funds are best suited for the NPC's first-ever foreign investments?
The money involved is modest, but the stakes are huge. At most, 500 billion won (roughly $390 million) of the NPC's nearly W70 trillion in assets will be invested abroad in the first year, says Chang. But if the conservative NPC is pleased with the results, it may well dole out more money and - just as important - influence other public and private South Korean pension funds to likewise invest a portion of their assets abroad. And those funds control nearly W100 trillion of assets - all of it invested domestically. Most of this hoard, moreover, languishes in a local stock market that has had a dismal record (see graph, page 76) and, in any case, will be hard-pressed to accommodate Korea's burgeoning pension assets.
"The increasing size of the NPC fund [alone] is such that the Korean market is too small to be able to absorb it," says Hahm Hong Joo, executive director in the asset management group of Goldman Sachs (Asia), who works out of Hong Kong on central bank and government institution investments. As it is, the fund accounts for close to 20 percent of the market's entire capitalization of W226 trillion. His rival for a slice of the NPC's money, Anthony Moody, regional managing director of Zurich Scudder Investments for Asia and the Pacific, adds: "The difference in the investment return between what the Koreans can earn locally and offshore over time is great. The lesson of [Asia's financial crisis in] 1997 was the importance of diversification."
Dressed up in PowerPoint presentations, this is the basic message that such firms as Fidelity Investments, Goldman Sachs, Merrill Lynch & Co., Morgan Stanley, State Street Bank and Trust and Zurich Scudder have been striving to convey to the NPC. Due to a revision in the National Pension Act, the NPC, as of July 1, will be allowed to invest in foreign funds for the first time. Some five to ten foreign firms will be selected that same month, subject to approval by a fund operations committee chaired by the minister of health and welfare, with final purchase of foreign funds likely by September or October. The leading candidates? They're "a secret," confides the 37-year-old Chang, an Ohio University graduate who returned to South Korea in 1993 and joined the NPC two years later.
The firms vying for a mandate realize that building a relationship with the NPC will provide a point of entry into one of Asia's fastest-growing - and untapped - economies. But they are also aware that the marketing cost-return calculus is full of soft numbers and quixotic assumptions: How much time and effort and expense do they really want to devote to pursuing a minuscule opportunity in hopes that it will lead to bigger things?
A chance to manage $35 million to $80 million now is hardly worth the cost of obtaining the needed licenses and setting up a local asset management operation. What's more, South Korea is leery of outsiders, as many a foreign firm can testify. And even Chang has to concede that he has "no idea" how far the NPC's foreign investment initiative will go. The amounts will be reassessed after one year, notes Han Sung Yun, senior research fellow at the National Pension Research Center across the hall from Chang's office. The hope is that the foreign allocation will reach 5 percent of assets within five years, says Han.
Goldman's Hahm, recruited from the World Bank this year, notes that running funds for the NPC would require a physical presence separate from its securities operation in Seoul. "Do we go betting our business will grow after we get here," Hahm asks, "or do we wait until the business grows and then go in? This is one tough place to do business. Koreans are tough negotiators."
South Korea has a desperate need for asset management assistance. Like most countries, it's contending with pension-funding woes. The three major government plans not covered under the NPC are in trouble, according to a recent report by the Korea Institute for Health and Social Affairs, an adjunct to the Ministry of Health and Welfare, which governs the country's pension programs. The military pension program ran out of money in 1977 and has been funded since by the government. The W2 trillion Government Employees' Pension Fund, covering all nonmilitary government workers, including public school teachers, is expected to deplete its reserves this year, while the third, the Private School Teachers' Pension Fund, with W4 trillion, is forecast to start running a deficit in 2012.
By contrast, the NPC is in sounder financial shape, but it too is headed for trouble. Although currently overfunded, the comparatively young plan only last year began to pay out benefits. And at the current contribution rate, estimates the Korea Institute report, the NPC will begin to run a deficit in 2034 and will have utterly depleted its reserves by 2048.
The NPC is to some extent a victim of its own success. Created some 14 years ago to cover companies with ten or more employees, it extended coverage in 1992 to businesses with as few as five employees, and in 1995 to farmers, fishermen and other self-employed rural workers. Then, in 1999, self-employed workers in urban areas were allowed to enroll. The NPC now controls the nest eggs of 16.5 million of Korea's 46 million people.
The expansion of coverage has put the fund on a rapid-growth trajectory. Assets should go from today's W70 trillion to W75 trillion by the start of next year to W85 trillion by the end of 2002, according to Ham Kwang Sik, an assistant manager in Chang's investment department.
To avoid insolvency, says the author of the institute's study, senior research fellow Yoon Byung Sik, contributions would have to rise, from 9 percent to 35 percent of compensation (split between company and employee). This is far too high a price for either companies or their employees to bear, says Yoon. So along with considering a reduction in pension benefits, the NPC has begun to search for higher returns, notably by investing in foreign stock markets.
It's a wonder it took this long. South Korea's stock market hasn't inspired much confidence. Over the past decade the market has fluctuated wildly, so much so that securities analysts liken it to a casino. Although it did well in the middle of the decade, it receded steadily before hitting the depths during the Asian financial crisis. Recovery at the end of 1999 preceded a long downward slide through 2000 and much of this year.
The NPC exacerbated its poor returns by acting as a major debt holder for public works projects. The returns on such investments, which make up nearly half its portfolio, are in the single digits. Now the NPC intends to scale back these bond holdings over the next five years and redirect most of the money toward equities.
South Korea's new interest in overseas stock markets is an outgrowth of ongoing reforms. The 1997 Asian crisis led to a $58.5 billion International Monetary Fund rescue package that headed off the country's economic meltdown. Seoul was forced to abandon many of the rules that prevented foreign investors from owning controlling stakes in Korean companies and banks. That development, coupled with the subsequent rebound in the economy, has made South Koreans more comfortable with the prospect of local institutions, like the NPC, having dealings with foreign enterprises, such as global asset managers.
"Definitely we are more open now," says Han Seung Chul, fixed-income manager for the NPC. "Without the IMF crisis, we would be on the same course" of shunning foreign companies. So despite the recent volatility in the U.S. markets, Han sees the ability to invest in U.S. stocks as "very positive for us."
But the NPC intends to go beyond just an initial investment in foreign funds. It has already begun outsourcing management of some of its in-house investment programs to domestic firms (which can be in partnership with foreign firms), and plans to expand that approach to its overseas investments, too. Between W1 trillion and W1.5 trillion will be awarded to outside domestic funds in the second half of this year, says Chang.
This program pays NPC an important off-the-books dividend - education. "We learn how to invest, we gain expertise from professional fund managers," says NPC assistant manager Ham. Because of strict limitations on dealing in foreign exchange, the NPC hasn't been able to expand the outsourcing project to international investing yet, but it is pushing the finance ministry for permission to do so. Chang insists, "We will also have foreign firms" for outsourcing.
These kinds of liberalized NPC investment programs will no doubt have an impact on the attitudes of other pension and savings plans in South Korea. Longer term, that may turn out to deliver the biggest pot of gold for foreign asset managers. Although no law prohibits these funds from investing outside South Korea now, "they don't have information about foreign funds and do not have the ability to research them," says Kim Yong Ha, an adviser to the Private School Teachers' Pension Fund who has written extensively on South Korea's pension system. Thus, he says, these funds, including the Postal Savings Fund, the various teachers' funds and the government employees' and military plans, will watch the NPC's offshore experiment closely.
Khwarg Thae Surn, chief executive officer of SEI Asset Korea, a joint venture between SEI Investments in Oaks, Pennsylvania, Tongyang Securities Co. and the International Finance Corp., sees an opportunity in the funds accumulated by companies under the Labor Standards Act passed in 1953. The law requires companies to set aside one month's salary a year for all employees as a retirement benefit. Companies responsible for about one fifth of the annual national corporate payroll of W200 trillion place these funds in separate bank accounts. Hundreds of trillions of won are currently accruing very little interest, according to Khwarg, who believes domestic or foreign asset managers could boost returns.
Then there are South Korean bank accounts. Lee Jae Hyoung, hired this year to lead Fidelity's South Korean fund business, estimates that 10 percent of investable assets are handled by brokerage firms - and the rest by banks. Sixty percent of the bank deposits are in short-term money market funds paying about 5 percent interest, and the remainder are in longer-term deposits that offer 7 to 8 percent rates. Lee, who worked for Merrill Lynch in New York for ten years as a financial consultant, believes the foreign funds will start to lure some of this money into equities.
There is a substantial roadblock, however. The government imposes a 16.5 percent dividend tax on foreign funds. "It's still an unlevel playing field," says Douglas Naismith, senior director of Fidelity's institutional business in Asia.
Given their many advantages, the local investment trust companies would be the logical home for most of this money. But South Korea's soft markets, coupled with the massive restructuring of the country's conglomerates, or chaebol, have weakened many of them. A large number of the ITCs purchased billions of dollars of commercial paper and bonds from companies like those in the defunct Daewoo Group - South Korea's second-largest chaebol until its collapse in mid-1999 - and paid dearly for it. In just one example, the debts that Hyundai Investment Trust Management Co. accrued from Daewoo, not to mention some of the troubled Hyundai Group units, now exceed its assets. Others are in a similar bind.
A huge trove of underperforming assets overseen by financially troubled managers would seem to be an irresistible target for foreign asset managers. Yet South Korea's restrictions on overseas investment and limitations on foreign participation in local markets have kept foreign asset managers away. They can only market their services through a patchwork of local distributors, including brokerages, investment management firms and banks. The local distributors can be foreign owned - Citibank is one of the largest. Even so, most foreign asset management firms have been frustrated by their lack of control over the sales process. Only Fidelity, Franklin Templeton Investments, Schroder Investment Management and Merrill Lynch Investment Managers operate full-fledged South Korean offices registered to sell foreign funds.
Still, the changes promised by institutions like the NPC are starting to attract serious attention. J.P. Morgan Chase & Co. and Cr,dit Agricole have opened asset management offices in Seoul but have yet to register funds for retail distribution with South Korea's securities regulator, the Financial Supervisory Service. Hana Allianz, a joint venture between local Hana Bank and Germany's Allianz Group, has set up an office but so far is selling only domestic funds. Prudential Insurance Co. has invested in CJ Investment Trust and Securities, which owns 98 percent of CJ Investment Trust Management Co., as a first step toward creating a presence in Seoul.
All of the foreign firms are aware that South Koreans feel they have good reason to be wary of outsiders and that gaining the trust of the NPC or any other local institution will be a long-term endeavor. Consider the last century of Korean history. In 1905 Japanese forces occupied the so-called Hermit Kingdom, and five years later they annexed it, deposing the last remnants of the dynasty that had ruled Korea for 500 years. When the Japanese surrendered after World War II, Korea was initially divided into a U.S. military-governed zone in the south and a Soviet-dominated zone in the north. In 1950 the North invaded the South, igniting the Korean War.
Since then Korea has had to contend with the often conflicting desires of the U.S., Russia and its enormous neighbor to the north and west, China. South Korea's postwar economic "miracle," which made it one of Asia's strongest economies, was accomplished through strong, centralized government planning and control rather than through outside investment.
The historic distrust of foreign businesses and markets carries over to South Koreans' approach to investments. The four firms offering foreign funds have managed to garner just W151 billion in assets over the past three to four years, according to the Korea Investment and Trust Companies' Association, a private trade group. Fidelity manages nearly two thirds of that. Foreign fund investment is less than 0.25 percent of the amount invested in domestic funds. "Koreans still have their eggs in one basket," says Edward Campbell-Harris, former branch manager and head of equities in South Korea for Jardine Fleming Securities, now part of J.P. Morgan Chase. Moreover, the tenor of the South Korean market can be highly speculative. Yang Sung Nak, director of Merrill Lynch Investment Managers, notes: "Koreans are momentum investors. They are looking for short-term profit and are concerned about currency fluctuation." Thus far Merrill has attracted just W3.7 billion to Mercury Selected Trust, its overseas fund vehicle. Getting South Koreans to appreciate overseas funds as stable long-term investments will require a major shift in attitude.
The ITCs, despite their financial woes, will fight to maintain their grip on South Korea's markets. In the midst of the Asian financial crisis in 1998, the government-owned Korea Development Bank, under a newly passed investment company law, placed approximately W2 trillion with foreign managers, which included Templeton Asset Management, Rothschild (later replaced by Schroder Investment Management), Scudder Kemper Investment (now Zurich Scudder) and State Street. The idea was for these firms to invest in small and medium-size South Korean companies to help promote economic growth. But the trusts fought bitterly to have the exemption rescinded, charging that foreign firms were being allowed to grab market share. Although the program continues, the KDB never expanded it. "Of course, the Korean ITCs wanted the money," says Andrew Kim, foreign fund manager at what is now Franklin Templeton Investments.
A growing number of foreign firms have nevertheless decided to take the plunge. One of the most intriguing efforts is still in progress. American International Group, together with distressed investment specialist W.L. Ross & Co., is leading a consortium in negotiations for the securities businesses of Hyundai Group, South Korea's largest chaebol until its breakup last year. If the consortium succeeds, the foreign-owned firm that emerges will be able to manage and market funds of all types through Hyundai's brokerage and investment trust arms. The securities unit is one of the top five in Korea, while the fund group is among the top three.
The acquisition could be a big help to foreigners. "In a situation like Korea, where foreign fund managers are frustrated, a joint voice becomes a win-win for everybody," says Goldman's Hahm. "AIG gets in there and opens the market for others." Merrill Lynch and Fidelity, meanwhile, are both studying whether to sidestep local joint ventures and form their own investment trust businesses. Franklin Templeton, originally operating with a local partner, decided to go it alone last year, and the government allowed it to retain its status as a domestic firm. Schroders, says its general manager for Korea, Choi Man Yeon, received its license to operate as a domestic entity this year.
In the meantime, others intend to keep plugging away. Building a successful asset management business in South Korea "is a long-term project," concedes J.P. Morgan Chase's Campbell-Harris, but he firmly believes it's worth the effort. Operating in Korea is not "as straightforward as Hong Kong or even Japan," says Fidelity's Naismith, but over the long haul "it looks to be one of the best places in North Asia to actually do business." He and some of his rivals are about to find out.
