Responding to global calls for transparency has left sovereign wealth funds open to local critics, as Richard Lowe reports
The Official Monetary and Financial Institutions Forum (OMFIM) held its inaugural meeting at the beginning of March, ostensibly to facilitate discussions between Western central banks and the ever-growing sovereign wealth fund (SWF) community (estimated to be worth well in excess of US$3trn) over how to mend the global financial system. It has been suggested that this new forum, which is held behind closed doors, is essentially a way of helping Western authorities find buyers for the great volume of government debt they will have to issue over the next few years. But regardless of the real intentions and objectives of this meeting, it illustrates how significantly the perceptions of SWFs have changed since the start of the financial crisis.
The SWF universe, which is continually growing (a number were launched in 2009 and more are being planned) is diverse. It includes the oil-based funds of the Middle East, such as the $627bn Abu Dhabi Investment Authority (ADIA) and non-commodity based funds, such as the $289bn China Investment Corporation (CIC), which are funded mainly from official foreign exchange reserves. Although they all have very different characteristics and objectives, SWFs are becoming increasingly definable as a specific investor community. In May 2008, the International Working Group of Sovereign Wealth Funds (IWG) was established and less than six months later published a set of 24 voluntary principles, otherwise known as the Santiago Principles. An international forum meets at least once a year to discuss, among other things, facilitating ongoing understanding of the principles.
Many countries are less worried about the transparency of SWFs and more hopeful that SWFs will play their role in underwriting the liquidity of the financial markets
Ultimately, the objective of the principles was to increase the transparency of SWFs, and there has been much progress in this area since their inception. In March, for example, ADIA published its first annual report and accounts and launched a new website offering more readily available information on its investments, objectives and processes. The SWF Institute runs a transparency benchmark, known as the Linaberg-Maduell Transparency Index, which scores funds against a number of criteria. However, the Santiago Principles and the drive to transparency were very much borne out of an age when SWFs were eyed with suspicion by Western governments. While increased transparency is a natural progression for these funds, the issue has perhaps lost the urgency it once had.
A new mindset
The financial crisis has brought about a stark change in priorities. In short, governments are today much less concerned about Middle Eastern funds gaining control of strategically important businesses, where investment decisions could potentially be driven by political or national purposes rather than independent commercial ones. Instead, Western authorities are far more focused on ensuring these capital-rich vehicles direct their money towards propping up the developed world’s crumbling financial system.
“Many countries are less worried about the transparency of SWFs and more hopeful that SWFs will play their role in underwriting the liquidity of the financial markets,” said Oxford University professor and leading academic on SWFs Gordon Clark. “I hear much less about worries from nation states about transparency of SWFs than I used to and I think most of that is the reality of the last couple of years, which has served to underline how important SWFs can be for market liquidity, whatever their goals and objectives.”
Mercer’s head of investment consulting for the Middle East and Africa, Mailesh Shah said the financial crisis has enabled SWFs to demonstrate they can act as positive force in the context of the global financial system. He added: “Some of them have relished opportunities to show they can perform a part in the overall financial system in a constructive way. A lot of the funds have themselves become a lot more open and talked more about their processes and how they operate.”
There may be some irony in the way transparency is increasing while concern over SWF’s opacity has actually declined. The Santiago Principles, the publishing of online report and accounts, and other measures that have opened up the workings and investment activity of these funds, have actually enabled a greater degree of scrutiny from commentators and critics within the domestic borders of these funds.
BNP Paribas Investment Partners’ head of central banks, supra-nationals and SWFs Gary Smith said this increased scrutiny from SWFs’ home nations is an unfortunate bi-product of the move towards transparency. Unfortunately, the majority of SWFs do not market themselves well to their local media, he argues. Much of the criticism that SWFs have come under at home during the recent crisis has concerned the headline losses made at the funds. But these criticisms have been made without paying consideration to the wider, global context – i.e. how did a SWF’s losses compare to its peers?
Smith argued that SWFs suffer from an asymmetric relationship between risk and reward. Unlike pension funds, which have very specific long-term investment objectives (i.e. to match their pension liabilities) and measure their performance against benchmarks, the principal influence on SWFs’ investment strategy is the volume of assets under management. “For a lot of these funds, the happiness they get from seeing their assets rise from a 100 to 110 is completely dwarfed by the unhappiness they feel when their assets fall from 100 to 90,” Smith said.
But the significance of this observation is not simply that SWF managers feel the pain more keenly, but rather it has important implications for the investment behaviour of SWFs. Smith believes it goes some way to explain why a large number of funds failed to rebalance their equity portfolios in 2008 and 2009, following months of stock market losses. Pension funds invariably automatically rebalance by buying more equities when values decline, so as to maintain their long-term strategic allocation weightings. But Smith said the majority of SWFs did not do this.
Smith’s assertion is supported by research from the International Financial Services London (IFSL). Its Sovereign Wealth Funds 2010 report, published in March, showed many SWFs are still holding losses on investments made at the outset of the credit crisis – that is, despite the recovery in the equity markets in 2009. Figures show that SWFs were more inactive during the first six months of 2009 than they had been during any other corresponding period since 2005. Activity picked up in the second half of 2009, but this was directed more towards non-financial equity investments (which in previous years had represented roughly 45% of their investments) and alternatives such as infrastructure.
Norway’s SWF was one of the few to rebalance during the downturn and as a result had its best year for performance ever in 2009, posting a return of 25.6%, 4.1 percentage points higher than its benchmark. Despite its name, Norway’s Government Pension Fund is much more a SWF than it is a pension fund, having no specific liabilities and being backed by oil profits (it used to be known as The Petroleum Fund of Norway).
“They have always been good at marketing their strategy to their stakeholders in Norway, from the people who will benefit from the fund to the local media and to people involved in every level of Government. The fund has always said what it is going to do and why it is going to do it.” Smith argued that because many other SWFs do not market their performance in the context of wider global investment performance, it is more tempting to “hunker down and do nothing when things are really uncomfortable”.
Shah admitted that last year was more about “taking stock” than investing aggressively for Middle Eastern SWFs. “Things were moving very quickly,” he said.” Obviously a lot of turbulence had taken place, and it was a question of assessing how best to operate in the environment as it developed. So there wasn’t a lot of activity, but there was a lot of reflection on how best to move forward, and in the last six months or so, there has been more action.”
However, as evidenced by the performance of Norway’s SWF fund in 2009, and figures from IFSL, this increased appetite for risk and investment activity in the second half of 2009 was probably too little, too late. As mentioned previously, Smith believed most SWFs were ill-equipped to cope (and capitalise) on the downturn because of the asymmetry of their risk-reward relationship, combined with a lack of clearly definable liabilities to help drive investment strategy.
But there is another challenge that SWFs face: intervention from their governing authorities. Last year saw Ireland’s Minister of Finance force its National Pension Reserve Fund to help recapitalise Irish banks during the financial crisis. Russia’s Reserve Fund, meanwhile, is estimated to have halved in value following the Kremlin’s decision to tap its assets to help cover the federal budget deficit.
For these reasons, Smith argued it does make sense to impose a traditional pension fund analysis, complete with scientific models, to the SWF space. “It just doesn’t work. The governments move the goal posts,” he said.
Clark says the main challenge for SWFs is to be “genuine long-term investors” and develop a “genuinely disciplined approach to investment that can overcome the temptation to ride the tiger”. He added: “It’s very hard to be a disciplined long term investor when markets are failing around you and political interests are asking genuine questions about how well they are doing.”
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