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> Investment: Rainy day funds recast
> By John Plender
> Published: October 18 2010 22:32 | Last updated: October 18 2010 22:32
>
>
> Rethinking risk: SWFs such as that of Singapore have responded to
> the global financial crisis by taking on more risk, increasing their
> exposure to equities
> Up until three years ago, they were widely demonised as a possible
> threat to western security. Then they became saviours of first
> resort to the world’s ailing banks. Today many of them are chastened
> but on the mend.
>
> Sovereign wealth funds – managers of an estimated $3,000bn-$4,000bn
> of government-owned investments – have not had a uniformly good
> crisis. “In 2007 and 2008, [they] proved to be neither an
> unqualified threat nor an unqualified salvation for anyone
> involved,” says Edwin Truman of the Washington-based Peterson
> Institute for International Economics, author of a new book on the
> funds.
>
> While the most heavily publicised hits are the result of ill-timed
> investments in such financial giants as Citigroup, Merrill Lynch,
> Morgan Stanley, Blackstone Group and Barclays, more lasting damage
> may come from the hijacking of the funds by their own governments.
> The SWFs of Kuwait, Qatar, Russia, China, Kazakhstan and Ireland
> have together put more than $100bn into propping up troubled
> domestic banks and collapsing markets. Further raids on national
> nest eggs cannot be ruled out.
>
> Some funds have also been hijacked by public opinion. As ordinary
> people have watched them losing money in western banks, they have
> begun to complain angrily – not least in China, where nationalistic
> feelings can run high – that public money is being squandered on
> foreign ventures. Many of the governments behind SWFs are
> authoritarian and undemocratic but they they are not immune from
> such heat. Following lossmaking investments in US banks, China
> Investment Corporation (CIC), for example, is rumoured to be under
> pressure from Beijing to take on more risk to improve short-term
> performance.
>
> These powerful investors are now rethinking their approach to
> portfolio management and to risk – and the consequences will be far-
> reaching. Given their size and potential for growth, this will have
> a profound im pact on the valuation of global financial assets and
> on volatility – while continuing to raise security concerns in the
> west. At the very least, their behaviour since 2007 casts doubt on
> claims that the funds are invariably a stabilising factor in global
> markets.
>
> Before the crisis, big SWFs – their portfolios often managed like
> pension funds – tended to be “buy-and-hold” investors with a long
> time horizon and, in most cases, no liabilities.
>
> Come the crisis, however, many of these “rainy day” savings funds
> turned, in effect, into stabilisation funds to address problems in
> their home economies and financial systems. Because of the
> unexpected call on their liquidity, they ran into problems like
> those faced in 2007-09 by US university endowment funds hit by cash
> calls from their private equity investments. The enforced
> repatriation of funds meant pulling out of international markets at
> a point when they were very depressed.
>
> Research from Harvard University and Massachusetts Institute of
> Technology suggests that market timing is actually a long-standing
> problem. Examination of 2,662 investments by 29 SWFs between 1984
> and 2007 indicates that they engage in a form of trend-chasing,
> whereby they invest at home when domestic equity prices are higher
> and invest abroad when foreign prices are higher. It also appears
> that, where politicians are directly involved in management, the
> fund is more likely to buy high and sell low.
>
> A further change in direction stems from the decision by a number of
> funds to borrow. Over the past two years Mubadala of Abu Dhabi,
> Mumtalakat of Bahrain, Temasek of Singapore, Khazana of Malaysia and
> CIC’s Central Huijin subsidiary have all made bond or note issues
> totalling more than $30bn. Whether the resulting need to repay
> lenders will bring further pressure to shorten investment horizons
> is unclear, since many of these funds are pursuing private equity-
> type investments where borrowing is the norm.
>
>
> In fact, a number of SWFs have responded to the crisis by taking on
> more risk – which they have a greater capacity to absorb, thanks to
> their long-term time horizon. For a fund investing resource
> windfalls for future generations, heavy exposure to ultra-safe bonds
> would entail paying for liquidity it does not need. So oil-rich
> Norway has increased its exposure to equities, as has Government of
> Singapore Investment Corporation (GIC).
>
> Others have chosen to retrench. In 2007 Chile’s funds were preparing
> to reduce their exposure to low-risk government bonds and put more
> into corporate paper and passively managed equities. But the plans
> were put on hold as a result of the credit crunch. Rather than
> seeking to maximise returns, the country has reverted to running a
> pure stabilisation fund to address the impact on the economy of
> fluctuations in the copper price. In Russia and Kazakhstan, too,
> SWFs have curbed their risk appetite.
>
> Yet in many cases there has been an erosion in the clarity of
> investment objectives. SWFs typically have three very different
> policy mandates: stabilisation; long-term saving; and economic
> development. This is the sector’s “impossible trinity”, according to
> Andrew Rozanov of alternative asset manager Permal Group, who coined
> the term sovereign wealth fund.
>
> WEALTH OF NATIONS
> Abu Dhabi
> Outside estimates put the value of the opaque Abu Dhabi Investment
> Authority, the world’s biggest sovereign fund, at upwards of $600bn.
> The portfolio includes quoted equities, fixed income, property,
> infrastructure and private equity, with global equities the biggest
> category. The aim is to secure the welfare of the emirate and
> provide stabilisation funding when necessary. Adia does not seek
> active management or control. About 60 per cent of the portfolio is
> in index-replicating assets. It is suing Citigroup over losses on
> its $7.5bn purchase of shares in the bank in 2007.
> Russia
> In 2008 the Oil Stabilisation Fund, managing state-controlled energy
> groups’ revenues, was split to recognise its different functions:
> one managing official reserves; the other, which became the National
> Welfare Fund SWF, making higher risk investments. The purpose of
> this SWF is to smoothe fluctuations in energy revenues and to fund
> pensions. But during the financial crisis, when foreign capital fled
> the country, it sold foreign investments to plug the budget deficit,
> support the mortgage market and prop up domestic share prices. It is
> reportedly worth just under $40bn.
> Norway
> The aim of the Government Pension Fund Global is to manage national
> petroleum wealth and to meet rising public pension liabilities;
> while also preventing the “Dutch disease” – whereby windfall
> revenues lead to an overvalued exchange rate that distorts the
> domestic economy – taking hold. The $510bn fund is split 60/40
> between foreign equities and bonds. It takes contrarian views,
> recently buying Greek government bonds; and ethical views, excluding
> from the portfolio in August two Israeli companies involved in
> developing Jewish settlements in occupied Palestinian territory.
> Singapore
> Temasek – the smaller of the country’s two SWFs, with $144bn under
> management – is one of the rare funds in the sector that aims to
> engage with the boards and managements of the companies in which it
> invests. Of its portfolio, 32 per cent is invested in Singapore,
> with 46 per cent in the rest of Asia (excluding Japan). It attracted
> headlines by incurring big losses on the sale of holdings in Bank of
> America and Barclays but has fully recouped the ground lost in
> 2008-09. It boasts a total shareholder return of 17 per cent a year
> since it was set up in 1974.
>
> “A state-owned fund may be successful in pursuing two but rarely, if
> ever, all three of the objectives,” he says. Stabilisation calls for
> very safe, liquid assets that offer low returns. A long-term savings
> fund requires less liquid, higher-risk investments that offer higher
> rewards. “These two policy mandates push in opposite directions,”
> says Mr Rozanov. “The worst outcome is to chase after yield in the
> good years and scale back risk dramatically during the bad years.”
>
> Where stabilisation and long-term saving have been combined, as at
> Abu Dhabi Investment Authority and GIC of Singapore, the funds have
> been so large that they have been able to keep a big allocation of
> liquid assets as part of a long-term investment and wealth
> management objective.
>
> In the case of Ireland and Kazakhstan, by contrast, the financial
> crisis led to the funds adopting all three functions, including
> economic development, where the illiquid and risky nature of the
> investments sits uncomfortably with stabilisation. This, argues Mr
> Rozanov, is unsustainable.
>
> Perhaps the worst conundrum is that so many funds face an impossible
> remit. Saddled by their governments with unpredictable cash calls,
> they must identify assets to match liabilities that are unknown and
> therefore unquantifiable. There is no wholly satisfactory answer to
> that challenge.
>
> One concrete achievement of these investors since 2007 has been to
> fend off the threat of financial protectionism that stemmed from
> western fears that untransparent SWFs would become instruments for
> political and economic power play. This is partly thanks to
> investors such as China’s CIC carefully eschewing sensitive
> investment in the defence and technology sectors. But it also
> reflects the development of a set of voluntary standards to improve
> transparency and accountability. Work by Mr Truman helped inspire
> the Santiago Principles, which enshrine a set of principles and
> practices agreed by leading SWFs under the auspices of the
> International Monetary Fund. They include a commitment to invest on
> purely economic and financial criteria.
>
> In the view of one expert observer, this has resulted in no more
> than soft enforcement of soft law. Certainly the quality of
> disclosure by the big funds remains mixed, with virtuous Norway at
> one end of the spectrum and some more reticent Middle Eastern and
> Asian funds at the other.
>
> So, following the turbulence of the crisis, do SWFs remain
> controversial? Because they are government-owned, they will always
> raise concerns about political motivation. Increasingly they are
> engaged in a mercantilist dash for food and energy security. In
> addition, their rapid recent growth is a by-product of global
> imbalances that are growing more dangerous. Those countries that
> have been holding down exchange rates to enhance export
> competitiveness have piled up huge official reserves that have then
> swollen the coffers of their SWFs.
>
> A new World Bank report compares this development to the aftermath
> of the oil crisis of the 1970s, when producer states’ energy
> windfalls were recycled to developing countries. This time, however,
> money is not being deposited in banks but invested chiefly in bonds.
> And many savings-glut countries are seeking to boost returns by
> channelling money into SWFs that invest in equities. These provide
> more stable flows than in the earlier episode. The equity component
> is particularly welcome since the last thing over-indebted recipient
> countries such as the US and UK need is yet more debt. So, while
> imbalances remain unhealthy, the more they are recycled via equity,
> the less malign the outcome.
>
> The World Bank also argues that SWFs have the potential to boost
> global wealth between 2010 and 2020 by helping recycle surplus
> country savings towards more productive investments in the
> developing world. Excluding China and oil leading exporters,
> developing countries are on average net importers of capital and
> will continue to depend on external savings to finance critical
> investment.
>
> As to whether the SWFs of savings-glut countries enhance welfare at
> home, it depends on what they do. According to Eswar Prasad of
> Cornell University, well run SWFs that smoothe fluctuations in
> natural resource revenues or invest windfalls for future generations
> may be beneficial. But SWFs can also hinder domestic market
> development, he says. Since savings outflows are managed by the
> state, there is no need, for example, to give private citizens
> access to developed financial markets.
>
> Whether the funds grow or shrink in future largely depends on the
> fate of global imbalances, as well as the movement of natural
> resources and commodities markets. There are still potential new
> entrants: Japan is considering establishing an SWF to raise the
> return on its $1,000bn-plus official reserves.
>
> But if today’s currency friction escalates, the US and other
> countries may impose restrictions on capital inflows. And if an
> outbreak of trade protectionism prompts a retreat from export-led
> growth in Asia and elsewhere, inflows into SWFs would shrink as
> would the growth of official reserves. Lower global growth would
> also reduce windfalls from natural resources and commodities.
>
> That said, not all deficit countries will want to bite the hand that
> feeds them with capital. For their part, the SWFs have shown
> themselves sufficiently unthreatening through the crisis to
> guarantee that they will be around for a long time to come, whatever
> the absolute size of the nest egg.
>
> THE WESTERN VIEW
>
> Sovereign wealth funds, around for nearly 50 years, have only
> recently given rise to concern in advanced countries. Partly,
> suggests Edwin Truman of the Peterson Institute, a Washington-based
> economic think-tank, this is because their rapid recent growth in
> developing countries reflects a shift in global economic power.
>
> Then there is the role of governments. Many of those behind the
> funds are not traditional friends of the west, and there is a
> growing fear that SWFs will be used for political and strategic
> ends, especially since China joined in. Some worry that the SWFs
> might introduce a new form of state ownership of strategic assets in
> the developed world.
>
> A broader concern is their lack of transparency, which raises
> questions about potential market abuse. Some western fund managers
> also argue, paradoxically, that a lack of activism could become a
> problem, creating a governance vacuum. Certainly the governance of
> the funds, with notable exceptions such as that of Norway, tends to
> lack accountability to the populations of their countries.
>
> Yet many of the criticisms aimed at SWFs are hypocritical. The
> investment policies of US state pension funds, such as Calpers, the
> Californian state employees’ fund, for example, have been overtly
> political and pro-union.
>
> Meantime, the SWFs have trodden the political minefield with
> relative delicacy. The China Investment Corporation, for example,
> takes stakes of more than 10 per cent in companies only with their
> agreement and avoids sensitive sectors such as defence.
>
> At any rate, where developing countries want to invest
> strategically, say, to secure access to natural resources, they have
> other means available. In its attempt to derail Anglo-Australian
> miner BHP Billiton’s bid for PotashCorp of Canada, China has used a
> corporate vehicle, Sinochem, not one of its SWFs.
>
>