By Erik L. van Dijk
Introduction
A lot has been written in recent years about the so-called Sovereign Wealth Funds(SWF’s). Wealth Funds are large pools of money, created by governments or governmental institutions. The Western world is not totally unfamiliar with huge government pools of investments, but normally we associate them with state pension funds. Some wealth funds, like the Norwegian one for instance, do indeed have this form. In other cases the wealth funds resemble long-term investments funds or stabilization funds, used to ensure that one or a few dominant sources of income with volatile prices (e.g. oil and gas) don’t disrupt a country’s national income trends through spectacular ups and downs in GDP caused by large price and / or demand-supply fluctuations.
As so often with new trends, market analysts, journalists and governments have expressed fear that the SWF’s might become too big a force in the market. Are these concentrated portfolios really invested with pure investment motives in mind? Or are strategical and political factors incorporated in the investment philosophy as well? Quite a few pundits have expressed doubts concerning the pure investment activities and skills of SWF’s. They rather stressed the political danger of these institutions.
As if Western goverments do always apply pure investment motives when spending their budgets! SWF’s are extremely large and do invest a substantial percentage of their wealth abroad. Now, if they would have been political entities, investing abroad and going against the rules and regulations of the recipient country is risky. Recipient countries could take nasty countermeasures ranging all the way from court cases and penalties to nationalizations.
SWF’s; a powerful but relatively new phenomenon
In this blog entry we study the pool of existing wealth funds a bit more deeply using the database of the SWF Institute. The database contains some 55 wealth funds from developed and developing countries. The SWF’s from developing economies form the majority (41 out of 55, or 74.5%). This might seem strange, but it is not. When income distributions are relatively unequal, it is not uncommon that governments try to get a piece of the action. And especially the goverments of resource-rich nations have a nice opportunity to do so. However, the structuring of those investment pools into wealth funds implies a professionalization that is rather new. The average year of establishment of the 55 funds in our empirical study was 1995, albeit it that one of the most famous wealth funds – the Kuwait Investment Authority with USD 202.8 billion under management- was founded in 1953. And the Foreign Holdings portfolio of the Saudi Arabian Monetary Authority (SAMA)– with USD 431 billion assets under management – was created in 1952. But some of the real big ones aren’t old at all. Here are some of the most remarkable entries since 2005: China Investment Corporation (2007;AUM USD 207 billion), Libyan Investment Authority (2006;AUM USD 65 billion), the Russian National Welfare Fund aka National Wealth Fund (2008;AUM USD 83.6 billion), and the Investment Corporation of Dubai (2006;AUM USD 82 billion)
The SWFs are an enormous force now and we should not underestimate their impact and influence. Total assets under management for the 55 SWFs in the database continue to show an upward long-term trend and the current level of AUM is USD 3,585 billion. When looking at the amounts needed to repair our financial industry and cope with the credit crisis, this implies that Wealth Funds might be able to play an important role in any recovery plan. It is therefore quite remarkable that Western leaders so far seemed to focus on a strategy based on ‘look to each other, and solve together’. Didn’t we basically make the SWFs in the Middle East and Asia richer by buying their oil and gas or cheap products, thereby creating a moneyflow from West to East? Only Gordon Brown and Barack Obama seemed to be willing to concentrate efforts on the Middle East (Saudi Arabia and Gulf States). The opening up to Iran in recent periods can also be seen as an important step. Iran is probably one of the most secretive nations as far as its wealth fund(s) are concerned. The Oil Stabilization fund is well-known, but too small to be the whole story. Currently the US and its Western allies on the one hand, and Iran on the other are going through a serious political chess game with probably just one goal. To find some kind of common ground to get Iran back in the league of ”’acceptable” nations. The Roxana Saberi case illustrates how tensions are orchestrated and reduced in a purely political rhythm. In normal situations it would be unheard to see Ahmedinejad suggest things like this to judges within the Iranian judiciary system.
In terms of goals, we see that the bulk of SWFs start of as stabilization fund, and gradually but slowly moved to a role as state investment funds with long-term investment horizon. A next step is the transition into full-fledge pension system, at least with a substantial part of the assets involved. A growing number of nations understand that the creation of a pension system provides countries with a tremendous source of savings and investment potential that can help stabilize the political situation in a country and fight extremist tendencies while at the same time helping to stabilize the economy.
SWF’s; The New Capitalism?
When comparing the SWFs with other large institutional investors, there are some structural differences. One of the most important ones according to us, and that holds especially for the SWFs that are based on energy- and commodity-related wealth, is their ability to concentrate on (ultra) long-term growth. This will enable them to capture higher returns by locking in the higher risk premiums on riskier investments while working with an asset mix that is more tilted towards riskier asset classes. Obviously, with this type of SWFs often being from countries that did not establish themselves as major financial powerhouses yet, we need to place a caveat. The level of knowledge within the SWFs might be a constraint. In recent years we did indeed see some indications of suboptimal asset management in the SWFs. Some tended to link this to strategic motives, but a closer look at the asset allocation, holdings acquired et cetera indicated that this was not the whole story. Lousy ‘picking’ at the bottom-up level has played a far more important role. The sad investment story of Chinese insurer Ping An that bought a stake in Dutch-Belgian financial conglomerate Fortis at about the worst moment possible is indicative. This is not to say that there aren’t any ultra-professional, well-managed SWFs. But the difference in investment expertise is still striking and far bigger than it is within the institutional investor community in Europe or the US.
Now, with their long-term focus, enormous wealth, and huge size compared to the local economy (which automatically implies that the focus has to be to quite a large extent ‘international’) and top-down, hierarchical decision structure SWFs are definitely not pension plans like the ones we know in Western Europe or the US. Their relative lack of transparency concerning decision taking, performance analysis, compliance et cetera further strengthens the case that this is really a new category of investors entering the stage.
Sure, when looking at total assets under management Western institutional investors are – as a group – still far more important. However, also more fragmented with smaller average sizes and with a much larger focus on low risk, fixed income assets. The impact of SWFs on global stock markets will therefore most likely increase tremendously in the years that lie ahead of us. First of all, because the economic growth rates in the nation mix of SWFs are higher than those in nonSWF-dominated economies. Second, most of the traditional Western institutional investors don’t really grow that fast anymore with the inflow of pension premiums more or less offset by payments to pensioners, with demographic trends making it almost impossible that this will really change.
This implies that we need to take a closer look to what could happen in the future when taking these trends into account.
China will win, but energy-related SWF’s should not be underestimated in the next 10-15 years
Although the Asian SWF’s are gaining in importance, led by the Chinese Wealth Funds that benefit from the country’s growth record, the oil-related wealth funds will be a dominant force to reckon with for quite some time to come.
The energy-related wealth funds represent a bit more than half of the group of 55 when we look at the number of funds (31), and in terms of assets under management their total of USD 2259 billion represents 63 percent of total AUMs of the wealth funds.
So, unless the growth rates in China and some other Asian nations reach record highs, with oil prices remaining sluggish, the Middle Eastern SWFs – actually the group that most people fear because of their lack of transparency – will remain a very important category to take into account. We at Lodewijk Meijer believe that it is not just for this reason important to ensure a dialogue with this group of wealth funds. Also when looking at the political situation in the Middle East and the problems with global terrorism, an open and fair communication, trade and investment relationship with the countries in the Middle East will certainly be beneficial in these areas as well. The West should recognize that quite a bit of the tensions are directly related to flawed drawing of country borders in the Middle East by Western occupiers in the past in combination with giving Western oil companies too large a stake vis-a-vis the revenues left for the energy-rich countries itself. Add to that the fact that quite a few nations were or are led by leaders that do not have the support of the population to the same extent as they have Western support and an important part of the terrorist story is explained.
Development and growth in general have always worked against terrorism. Terrorists thrive in climates with inequality, lack of chances, and poverty. The SWFs and their growth stories will definitely make it less likely that MENA countries themselves – as a group – will witness increased terrorist activity. Skepticists will add that they will have more funds available then to support terrorist activities elsewhere, but we tend to believe that this risk is far more greater when not allowing these nations a dialogue and place within the family world nations, while at the same time helping their SWFs to further professionalize and internationalize their portfolios. This is a win-win situation for all.
SWF’s and the local economy; catalysts for growth….
but local growth can only thrive when economies develop further and governance improves:
The Trinidad Case
SWFs are huge. Often too huge compared to the size of their local economy. They do therefore have to diversify internationally. This implies that their wealth that was often created through Western imports of oil, gas and relatively cheap products will in the end – to quite some extent – flow back to us and other nations via financial market transactions.
That is not to say that SWFs cannot play a fantastic role when developing the local economy of countries. Their potential to be a catalyst of growth is huge. A nice example is the situation in Trinidad and Tobago.In an earlier entry to this blogwe told a bit more about the country, one of the least know oil states in the world. Most people outside the region still believe that the whole Caribbean is about tourism and tropical products, but Trinidad and Tobago is definitely an important exception with attractive growth potential that makes it an interesting Frontier Market.
The country’s Heritage Fund has assets under management of USD 2.9 billion or about 12 percent of GDP. And that percentage will be growing assuming that oil and gas prices will at least stabilize. Trinidad wants to establish itself as a regional financial center and we believe that this strategy could work when undergoing a structured transformation of the economy and upgrading of the financial market system. When taking into account that Cuba will probably be an interesting new entry to CARICOM any time soon (we at Lodewijk Meijer think that it could take approximately 3-5 years for this to happen), that regional financial role could really be of tremendous importance. The ongoing growth in the trust/offshore business in the CARICOM region could also further improve things, with Port-of-Spain then becoming a logical on-shore financial center for the off-shore islands of the region.
When talking to local leaders and international investors, we believe that the opportunities are there.
However, one thing that worries us – and an area where change is needed – is the relatively low country score (3.6 on a scale of 1 to 10 with 10 being the highest) on the Transparency International Corruption Index (CPI). Activities undertaken by institutions like the Caribbean Procurement Institute, Trinidad and Tobago’s chapter of Transparency International and by politicians with large popular support and a willingness to change things could all help. Currently, developments in the ongoing proceedings of the Uff Commission of Enquiry into the Construction Sector of Trinidad and Tobago seem to indicate that – as so often in many nations, even developed ones, – construction and real estate are the areas where lacking corporate governance and fraud have led to a situation in which public funds were misused for personal gain by corrupt politicians/bureaucrats and/or entrepreneurs (e.g. within the construction industry) and/or lost through incompetency, with a political chess game being played in the background. When analyzing the corruption proceedings, we believe that the nepotists seem to have decided to make former minister of Housing Dr Keith Rowley (one of the most popular politicians in the country, with a tremendous track record as far as new housing activity is concerned while he was in charge of that ministry, and one of the architects of the Vision 2020 report in which the transition into a more diversified economy was first introduced) their scapegoat over a negligble malperforming housing project after he left office. And not just that, too much decision power was and still is not in the hands of ministers in the first place, but is concentrated within UDECOTT; the Urban Development Corporation of Trinidad that seems to act like a kind of state within the state.
The Commission will present its final report in September 2009 and we are optimistic that it will unravel a smelly truth about what is a standard nepotism case so often seen in developing economies. Local newspapers help set the stage for a climate in which nepotists are forced into defensive positions. This is a tendency quite often seen in developing nations. When the country develops and corruption fighting grows into a serious countervailing power, the growing independence of the media is not just an important sign of this, but a tremendous catalyst as well. The country’s growth story and transition into a more diversified economy with expanded financial sector will further improve things. Smaller local nepotists will lose out when ‘big finance’ discovers the region. Huge financial institutions will – through the investment opportunities they provide andthrough their larger focus on procurement and ESG strategies (they have too much at stake to be caught in local scandals!)- basically provide the final blow to the nepotists even when the Uff Commission verdict doesn’t already do so in a legal setting.
Along the way the role of the Heritage Fundwill become more important; a) as the largest local investor; and b) as entity attracting the professional skillset of international investors, litigation lawyers, investment bankers, asset managers, investment analysts et cetera. Either directly (to work for the Fund) or indirectly (through provision of services by parties wanting to establish a position for themselves in the country).
This Trinidad example is illustrative for developments in many Emerging economies. And the trends we see developing here have so far shown that in successful growth stories external money and expertise went hand-in-hand with a local willingness to fight corruption from within. And from an investment point of view: it is actually this group of Emerging and Frontier markets where both components are visible, that actually have showed the most attractive return-risk profile.
SWF’s and the international economy; a growing role to play
With total assets under management of USD 3585 billion, it is clear that SWFs can be an important force when leading us out of the current credit crisis. The combined assets of the big Western institutional investors are still far larger, but SWFs are quickly catching up.
We foresee that their role and positive contribution will substantially increase during the next 6 to 12 months, with the beginning of a positive change already under way. Part of the 30+ percent stock market return generated during the first 5 months of 2009 was directly related to SWFs stepping in (finally!) looking for bargains.
Evaluation
SWFs are a relatively new phenomenon. Their large pools of funds are of tremendous importance to the domestic economy and are a great support for the world economic situation as well, because most of the SWFs are too big to concentrate on a home-alone policy. They have to diversify internationally to a larger extent than most other institutional investors a) because the local economy is not big enough; and b) because it is often not diversified enough.
Western nations have often complained that investment behavior by SWFs was to a large extent guided by strategic instead of economic principles. So far evidence in this direction has not been convincing at all. Sure sometimes strategic motives might have player a role, but wasn’t that the same for Western investments in our past?
The attraction that economic development and wealth funds have to international financial instutions that might want to provide services to them will trigger a climate of financial sector dynamics and growth. What could hurt the positive potential effect of this is often a local climate in which nepotism and corruption thrive. Once that threat is neutralized, the upside potential will be tremendous.
Spotlight on Investments and Markets 