Before Ron Otsuki established the Hong Kong investment office four years ago, Manulife ran its international investment operations from London. Today Otsuki and his team are responsible for $9 billion in assets, including on-balance sheet assets for the firm's insurance revenues and off-balance sheet assets for third-party clients. Executive directors Samantha Ho and Seton Lor manage Hong Kong/China and Asia-Pacific equities, respectively.

What drives your investment process?

Ron Otsuki: Our investment philosophy always stems from the underlying product. Most of our products sold in Hong Kong and regionally are insurance-linked, which have different features than mutual funds or the firm's own assets from selling insurance premiums.

What is your asset allocation in terms of equities versus bonds?

Otsuki: In total it's about two-thirds fixed income. For our on-balance sheet assets we take quite a long-term view, measured in terms of business cycles. We group insurance products into large buckets that we also split by currency. Then we optimize their asset mixes using historical returns, earnings stability and capital requirements, among other factors.

Has that asset mix changed?

Otsuki: Our fixed income allocation can vary quite a lot, but we've kept it pretty stable, because we need a certain return to meet our liabilities. We have long-term liabilities and short-term assets. The past years of falling interest rates delivered a windfall in terms of capital gains, but on the asset side, the average portfolio yield has been falling. We've kept the portfolio relatively short-duration, although we're fiddling with it to determine when to change that stance as interest rates rise. It's painful, but we've managed to outperform against our benchmark, which is based on our liabilities.

And in currency terms?

Otsuki: We match off our assets and liabilities by currency but also invest in US dollars and the euro and hedge that back into Hong Kong dollars. The euro and the yen look more attractive, but interest rates in yen are too low and asset swapping euros doesn't effectively capture the higher yield because the wide interest-rate differential makes it expensive. So we do partial hedges.

We can't stretch the portfolio for yields. It's a pretty boring strategy right now because credit spreads are low in all currencies. Instead we're tightening our credit quality. We're relatively short duration. But equity yields have also been low, they're single-digit in the US, although in Asia, with China, it's a different story.

What is your Hong Kong and China equities stance?

Samantha Ho: For our on-balance sheet funds from our insurance policies, we use the Hang Seng Index as our benchmark and we can't differ too much, as we're allowed only a 15% non-index bet in the portfolio. We've added value in utilities and in China IPOs, which have done very well, and in property stocks.

What direction is the Hong Kong property market taking?

Ho: It looks all right in the long term, but now after a strong start in September, the stock market is consolidating, and we now need to see improvement in the physical market. We need to wait; the economy is doing well but property prices went up faster. The market will catch up, except in selective luxury areas where prices are a little too high.

Is the government encouraging a glut based on unrealistic demographic projections?

Ho: Over the past 30 years, there has been a correlation between economic growth and property prices. But there's always the risk of government policy. The more they don't do, the better it is for the physical market. You'd think by now the government would have learned its lesson. Although Hong Kong isn't the only government that does this.

Otsuki: The Hong Kong government doesn't send up trial balloons, so it doesn't achieve more of a buy-in to its policies. This leads to flip-flopping, making it hard for investors to make long-term strategic allocations.

How do you play a slowing China?

Ho: Investors are worried about its austerity project. There are two schools of thought. The first is that this program isn't finished. The second is that we've already seen the results of tightening so there won't be more big measures. I'm more conservative, I don't think credit tightening policies end after just two or three months. It takes time to see if they're working, which can take a year or more. I don't think we'll measure the impact of credit tightening until the third or fourth quarter, although so far the outcome looks promising.

How do you define a soft landing, versus a hard bump?

Ho: A hard landing would be GDP annual growth at 6% or less. But if China grows at just 6-8% this year, that's all right, and that's my assumption. The government is targeting the right sectors. The risk is a spill-over to other sectors, but so far I haven't seen any signs of that happening.

How do you manage a portfolio, then?

Ho: The first step is easy, you avoid the sectors the government is tightening. So everyone has shifted into utilities, power and energy. The hard part is knowing when to get back in, because there will be a rush. You also have to ask whether the sectors that appear to have no problems are properly valued. I think oil and energy still look attractive, though, because consumption is strong. These are safe for now, but valuations could stretch. Telecoms, that's safe, people see that as a utility. But we're more careful about commodities.

Otsuki: We've avoided commodities. Prices have fallen from their peaks, but not enough. We know 2004 earnings are going to be fine but we're evaluating 2005 earnings to see whether we should go in, and that depends on both the China economy and global demand.

What about regional equities?

Seton Lor: These portfolios are for our off-balance sheet assets and our style is top-down, because in Asia country selection adds value. Historically here countries are important. We have a small team so we employ a quantitative analysis to narrow down stock selection. Then to avoid excess volatility, we overlay this with a view of long-term themes. A big theme is that Asia has been the beneficiary of an expanding China, so the China outlook is critical to all of non-Japan Asia. We're cautious about China, so we're cautious about Asia. On the other hand, the Japanese recovery appears sustainable.

What makes Japan attractive?

Lor: Its growth is more from internal sectors, not from exports, which bodes well for Japan if the US or China slows. We've seen deflation ending in consumer prices, property prices, even golf club membership prices. That gives companies better pricing power and encourages consumers to buy right away. Bank NPLs are finally coming off, and S&P made its first bank upgrades since the 1980s. Companies are paying more attention to profits and returns on equity without leveraging the balance sheet.

How is that reflected in your portfolio?

Lor: We focus on the domestic sector. Our position turned neutral last Summer and we're overweight financials.

Are Japanese government bonds still toxic?

Otsuki: Japanese interest rates are too low. But maybe in a few years, inflation will return and that will push rates high enough. In the future we see an improving currency, given the positive current account, but the yen hasn't yet appreciated. So on two counts, Japan still isn't where we want to go.

And Asian equities?

Lor: China works with blunt instruments and we have to second-guess the data, so markets will be volatile. For our off-balance sheet mandates we're close to our maximum cash holding of 10%. PEs may look cheap but we need to factor in potential earnings downgrades. Taiwan and especially Korea are export-driven, so we need to see a domestic recovery kick in. At the margin, the risk premiums for global assets are falling, which means investors take on extra risk to invest in Asia. The region outperformed US equities for the past two or three years, and I think that's still true in the long run, but for the near term I think Asia will under-perform. One place we've upgraded to neutral is Malaysia, which is a good place to hide, because the domestic economy is isolated from international markets and is doing well.