Making the most of Sovereign Wealth Funds

With a lack of transparency and political complications affecting the use of SWFs worldwide, it’s no wonder there are wide disparities when it comes to their correct use, writes Pierre-Emmanuel Iseux, Member of the Executive Board, La Compagnie Peter Hottinger

Sovereign Wealth Funds (SWF) are government investment funds responsible for managing assets, usually with a long-term outlook. The assets under management come from many sources, but in most cases, the funds’ assets are funded by oil, gas or mining royalty income, or other trade surpluses of owner states.

More than 40 sovereign wealth funds have been created since 2006. The rising price of oil and other commodities is the prime factor that has forced numerous states to diversify their domestic financial reserves into what are often regarded as more lasting investments.
Today, over a hundred sovereign funds manage assets estimated at over $5,000bn in aggregate, accounting for more than two percent of the world’s bonds and equities market.
The assets of sovereign wealth funds are highly concentrated. Over two-thirds of the assets are held by half a dozen funds located in the UAE (managing some $800bn), Norway ($550bn), Singapore and Saudi Arabia (with $400bn each), Kuwait (over $300bn) and China ($750bn).

As a group, however, these funds exhibit wide disparity. Several major categories of fund can be distinguished:
Economic stabilisation funds: these are created by states whose budget resources are heavily dependent on exports of commodities, mostly oil and gas, and are designed to guard against price fluctuations (eg Fundo Soberano de Angola).
Funds managing reserves for transfers to future generations: these are developed in countries where the state anticipates the phased depletion of its source of wealth by accumulating reserves for the benefit of future generations, and invests in creating its future development model (eg Abu Dhabi Investment Authority).
Funds to finance pensions: certain States create funds to supplement the funding of pensions, which is falling short on account of the increasing demographic imbalance within the population (eg Norway’s government pension fund).
Reserve investment funds: certain states with high trade surpluses invest part of their foreign-exchange reserves (eg China Investment Corporation).

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While politico-economic factors underlie the emergence of increasing numbers of SWFs, it is nevertheless worthwhile to point out some of the important key factors in the successful creation and utilisation of such funds.

Objectives in compliance with international rules
The exposure to international markets of these investment vehicles may cause their objectives to evolve over time. For example, a fund devised to stabilise a country’s income may be changed into a fund for financing pensions, or for developing the country’s infrastructure.

Sovereign wealth funds therefore must exhibit two main types of profile:
– A political profile, to represent the state and its economic interests; and,
– A financial profile, to diversify its sources of income and provide for part of the country’s contingent or future financial requirements.

However, the recent development of these funds in countries that are often emerging has aroused mistrust among industrialised countries, where owners of assets are potentially for sale.

Accordingly, in 2008 the Santiago Principles were developed under the leadership of the IMF, in coordination with the International Working Group, establishing an agreed framework for supervision, with the development of GAAP to govern investment by SWFs.

These principles take the form of recommendations concerning the policies of investment, financing, risk management, the legal framework and transparency.

The main recommendations are:
– Establish a robust, transparent governance structure allowing appropriate supervision of operations, management of risk, and guaranteeing the accountability of senior managers.
– Ensure compliance with current regulations and with transparency requirements applicable in countries in which sovereign wealth funds are invested.
– Guarantee investment by sovereign wealth funds according to economic criteria.
– Have a role in the stability of the world financial system and ensure the free movement of capital and investments.

SWFs are also required to observe ethical restraints and standards of moral probity and integrity. The same rules cover malpractice, insider dealing, conflicts of interest, the policy for disclosure of portfolio assets, and various checks and inspections to deter all unethical or fraudulent activity.

The separation of duties between the investment committee, the fund management teams and the custodian banks is designed to curb any untoward or unethical action.

Origin of income-generating resources
No theoretical model exists to determine the level of financial reserves that a country must retain prudentially, and above which it may set up a SWF. However, to estimate a country’s ability to respond to a liquidity crisis, the ratio of reserves to short-term foreign debt is used.

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The level of reserves to retain must be higher if the current-payments balance is heavily in deficit, or if the currency parity is overvalued. That level may, conversely, be lower if the currency rate is flexible, or if the state is capable of borrowing in large amounts at short notice on the international capital markets.

For stabilisation funds, dedicated incomes are usually based on the difference between commodity prices and a benchmark level. For savings funds, deposits are mostly determined as a proportion of budget or commodity revenues, and may differ widely between funds.

As an example, that proportion is set at 25 percent of all oil revenues in the US State of Alaska. On the other hand, the Kuwait Investment Authority (KIA) – a savings fund dedicated to future generations – receives 10 percent of (oil or non-oil) budget revenues, together with financial investment income.

In every case, to ensure total transparency, any injection of resources is voted-on and must be part and parcel of government tax legislation.

Global governance framework
More than half of the SWFs in existence are separate from the state’s government and central bank, existing under independent legal entities. Some are public law entities such as KIC in South Korea, KIA in Kuwait, QIA in Qatar or ADIA in Abu Dhabi.

Others are private companies such as CIC in China, Temasek Corporation and GIC in Singapore. In every case, they are managed by a board of directors comprising six to 12 members, appointed by the finance minister and often by another member of the government.

Other SWFs are not independent legal entities but are aggregations of financial assets appearing in the financial statements of the state or central bank. This is the case for the SWFs of Norway, Saudi Arabia, Chile and Mexico. As a rule, they are under the supervision of the finance ministry, which directly defines investment policy.

Each state must therefore strike a balance between the SWFs’ accountability to government and its strategic and operational independence from government. This freedom of action varies among different funds, and remains entirely dependent on the will of the State and on government strategy.

Investment committee and decisions
SWFs may be very large and often have a structure and internal organisation enabling them to manage their own portfolios. On the other hand, many funds, some of lesser size, outsource management of their assets to a large number of external asset managers.
Even though mainly major Western banks have managed these assets for many years, SWFs today are increasingly selecting independent management companies with recognised investment processes.

Even so, the allocation of the assets placed in the hands of the asset managers selected is still decided by the funds’ senior managers, through an investment committee. That investment committee must consist of representatives of government, the central bank, international financial organisations and risk managers.

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Some 75 percent of the assets under the management of the Abu Dhabi Investment Authority (ADIA) for example, are outsourced to external asset managers, while its board of directors, drawn exclusively from members of government, develops the strategy and investment policy on the basis of statutory objectives, and also supervises the fund’s management.

A recent study shows that over 35 percent of SWFs invest through hedge funds, each one investing close to nine percent of its assets in them. The decisions of the investment committee, whether affecting internal or outsourced investment, should serve three types of objective:
– To seek a conservative management style to allow virtually immediate availability of assets in the event of budgetary contingencies.
– To seek an attractive performance – the objective is to invest in asset classes with a long-term horizon to achieve an expected return.
– To seek a strategic result beneficial to the owner country’s economic and social development – on similar lines to a private equity fund, the objective is to support the development of private companies in order to contribute to the development of the country’s industrial and commercial companies.

In all three cases the internal or external asset managers must always be sought for their specific expertise, transparent investment processes and consistently good previous performance.

Asset allocation and risk management
When defining precise objectives, the investment committee automatically adopts an asset-allocation strategy providing the framework for management of the funds outsourced to external or internal asset managers, identifying perception of risk and financial-return expectations.

Stabilisation funds should, however, be distinguished from the other types of fund: the chief concern of stabilisation funds is risk management, for instance with the aim of protecting a State’s budget against commodities price volatility, whereas with the other types of fund, the overriding concern is maximising wealth and long-term profitability.
For these other funds, the asset-allocation strategy and management processes will be totally different. For example, a portfolio diversified into several sectors and several countries with a predominant share of risky assets, namely listed equities and bonds with varied credit ratings.

These funds are evidently managed with a long-term investment outlook, assigning a precise overall risk-premium target in order to increase the potential total return. With regards to risk management, the closer the possible or probable dates when the fund’s capital may be utilised, the lower the fund’s flexibility in seeking performance; it will then have to reduce its risk in order to guarantee the capital potentially required.

It is also essential for risk supervision to be performed by a committee that is dedicated, independent and totally transparent. SWFs therefore face a number of challenges that will inevitably slow their expansion. The major issues confronting SWFs are the lack of transparency and accountability, particularly in Africa and the Middle East. Ultimately, lack of transparency leads to continual political disagreements and is liable to result in misuse or even corruption.

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