Sovereign funds and the problem of plenty
Because of their size and rapid growth sovereign wealth funds (SWFs) face many of the same problems as other large and long-term institutional investors in a particularly acute form. They must find investment opportunities on a big enough scale to generate sound long-term returns without overwhelming the underlying markets.
But because SWFs hold money in trust on behalf of the nation, they face additional constraints. Managers are under pressure at home to pursue prudent strategies that avoid large losses gambling with the national patrimony, while investments overseas arouse sensitivities in host countries where their investments are located.
MULTIPLE OBJECTIVES AND FUNDING
SWFs are defined by the International Monetary Fund (IMF) as government-owned investment funds set up for macroeconomic purposes, funded by the transfer of foreign exchange and mostly invested in long-term assets overseas (“Sovereign Wealth Funds — A Work Agenda“, 2008).
SWFs are a heterogeneous group, set up for very different reasons, with a wide variety of investment strategies. The IMF identifies five main categories:
* Stabilisation funds set up by commodity-producing countries to smooth fluctuating foreign exchange earnings and government budget revenues caused by large swings in commodity prices or sudden changes in production.
* Savings funds for future generations which convert non-renewable assets (such as oil reserves) into a more diversified portfolio of assets.
* Reserve investment corporations which aim to increase the return on foreign exchange reserves beyond the relatively low level available on traditional reserve instruments such as currency and government notes and bonds.
* Development funds that fund social and economic projects designed to raise the country’s long-term potential output growth and welfare.
* Contingent pension reserve funds which build up assets of offset unspecified pension liabilities on the government’s balance sheet.
Many funds serve several functions simultaneously; in some cases the objective has shifted over time. The oldest funds are generally reckoned to be the Kuwait Investment Authority (1953) and the Kiribati Revenue Equalisation Reserve Fund (1956), set up to manage revenues from petroleum and phosphate respectively.
Other long-standing funds include Alaska’s Permanent Fund (1976) and the Permanent Wyoming Mineral Trust Fund (1976), both based on non-renewable mineral revenues. Relative newcomers include Ireland’s National Pensions Reserve Fund (2001) and the Australian Future Fund (2004).
PROMINENT BUT NOT ALONE
SWFs are not the only or even the biggest group of foreign assets owned by national governments. SWF assets were estimated around $3.8 trillion at the end of Q1 2010, according to the SWF Institute, which is the leading research organisation in the area.
SWF holdings are still dwarfed by the $8 trillion of official reserve assets held by central banks and national governments, mostly in the form of gold, currencies, and foreign government notes and bonds of varying maturities.
Advanced economies owned $2.7 trillion of reserve assets at the end of 2009; emerging markets and developing economies owned another $5.3 trillion, according to the IMF’s Currency Composition of Foreign Exchange Reserves (COFER) database .
SWFs are not intrinsically different from pension funds such as California Public Employees Retirement System (Calpers) or the Netherlands’ government employees pension fund (ABP) and healthcare and social workers fund (PGGM).
U.S. state pension funds owned assets worth $2.6 trillion in fiscal 2008, according to the National Association of State Retirement Admininstrators (NASRA) [ID:nLDE60H1LE]. ABP manages assets worth 208 billion euros (Dec 2009) while PGGM claims another 96 billion; there are many others only slightly smaller. Individually and collectively these funds operate on a similar scale to sovereign investors.
CAUSES OF CONTROVERSY
While they are not the only managers of big pools of long-term assets, SWFs have become a lightning rod for criticism for three reasons:
(1) Much of the funding for SWFs has come from commodity revenues or transfers from regular foreign exchange reserves. In recent years, high commodity prices, global financial imbalances and the exchange stabilisation policies of Asian exporters have resulted in a surge in SWF assets.
Of the $3.8 trillion worth of assets held by SWFs, $2.2 trillion are directly linked to commodity producers. Most of the rest are attributable to China and other Asian exporters with heavily managed exchange rates and rapidly growing reserves.
Fears about the growing influence of sovereign funds are just another manifestation of concerns about the shifting global balance of power and the huge transfer of wealth (and jobs) away from the advanced industrial economies to commodity producers and exporters in Latin America, the Middle East and Asia.
(2) Foreign exchange reserve managers traditionally focused on a very narrow range of instruments designed to maximise liquidity and minimise credit risk. Historically, almost all reserve assets have been concentrated in currencies, gold, and government debt. China’s venture into mortgage-backed agency bonds was a daring innovation.
Equities and real assets were shunned as insufficiently liquid in case value had to be realised quickly, and posing too much exposure to counterparty credit. Besides, reserve managers have been anxious to avoid becoming stock pickers or become embroiled in controversial corporate management decisions.
But poor returns on reserve assets have become increasingly problematic as yields on government debt have fallen at the same time the pool of investable reserve funds has grown very large.
Some managers have tried to improve risk-adjusted returns by allocating a portion of the reserves to other asset classes such as equities or setting up an independently run SWF with a mandate to invest in a broader range of instruments and take risks that are still unacceptable for the main reserve pool.
For the most part, reserve managers and SWFs have stuck to investments in broad index-tracking strategies. But the prolonged bear market in equities over the last decade has encouraged some to try to improve returns by using a more active approach, or by investing directly in specific companies and projects through private equity vehicles, strategic stakes in corporations, or infrastructure investments.
In this form, SWF funding is much more high profile, and potentially more controversial, than old-style holdings in government bonds and broad equity indices.
(3) SWF asset allocations are much more like those employed by private sector pension fund managers such as Calpers. The portfolio management approach is very similar. SWFs want to hold a balanced portfolio of assets (bonds, equities, infrastructure, commodities, real estate and other alternative assets) to achieve target risk-adjusted returns.
The catch is that SWFs are encumbered by their “sovereign” label. Reserve holdings are always in some sense political in whatever form they are held (think of China’s mountain of U.S. Treasury debt, or the problems in the 1920s and 1930s associated with operating the gold standard and reparations payments). Default, devaluation, repudiation or asset freezes are ever-present risks once a sovereign investor chooses to hold assets overseas outside its own jurisdiction.
There is no evidence SWFs have wielded their non-traditional assets for political or military purposes, or to achieve technology transfer, according to the IMF. But the fact that they might do so in future has made investments by funds with a “sovereign” label much more controversial than those by institutions which are notionally private.