Thursday, December 27, 2007

What's the Word on Sovereign Wealth Funds?

Sovereign Wealth Funds (SWF) are saving funds consisting of mostly foreign assets that are controlled by sovereign governments. When central banks or governments accumulate a surplus of reserves (assets), often they transfer the surplus to a managed fund. The International Monetary Fund (IMF) estimates global sovereign wealth to be in excess of $2.5 trillion, which is 5 times greater than it was in 1990, and is expected to grow to $10 trillion by 2012. Many funds were developed following the oil shocks of the 70’s, such as funds in the United Arab Emirates, Singapore, Kuwait, and Canada. Ten of the twenty largest SWFs, though, have been created since 2000. The large increase in demand for commodity-based products and the large saving patterns from several key countries has focused much of the world’s excess reserves in a handful of countries. estimates global sovereign wealth to be in excess of $2.5 trillion, which is 5 times greater than it was in 1990, and is expected to grow to $10 trillion by 2012.

Size of the funds

The exact worth of many SWF (a notable exception is Norway’s fund) is, for all practical purposes, unknown. The top 20 funds are estimated to be worth in excess of $10 billion each. Truman (2007) estimates the largest SWF, Abu Dhabi Investment Authority, to be $500-$875 billion. The next largest is the Singapore fund, Government of Singapore Investment Corporation, which is worth $100-$330 million. Norway’s Government Pension Fund, which is valued at around $362 billion, earns an annual real return of 4.6%. Holding all else constant, expected growth of 4.6% annually implies that the fund will be worth $724 billion in 15 years (2022). Recently, Saudi Arabia announced that it will establish a SWF and is expected to hold wealth in excess of Abu Dhabi Investment Authority’s $875 billion.

Sovereign Wealth Funds derive wealth primarily from two sources: commodity sales such as crude oil and natural gas (United Arab Emirates, Qatar, Nigeria, Russia), and high export growth and saving rates (China). In both cases, governments hold a large surplus of foreign exchange in excess of liquidity needs (to purchase goods and services by citizens and the government).

Where is the money going?

The recent SWFs’ portfolio allocation strategy has been to diversify away from the high levels of liquidity (treasury notes, currency, etc.) and toward nonliquid assets. For several economies, the U.S. Treasury monitors certain flows of assets (e.g., U.S. Treasury bonds and notes, corporate bonds, and equities), but the flow of less-liquid assets, such as commercial real estate or corporate buyouts, is not well known. Several SWF have hired external portfolio managers, such as State Street or PIMCO, but their data is subject to privacy rules and is not publicly available.

The big corporate deals, though, are represented in the media. In November, Abu Dhabi Investment Authority agreed to buy $7.5 billion stake in Citigroup. Singapore Investment Corporation paid almost $10 billion for a stake in UBS. In December, China’s SWF, China Investment Corporation, agreed to pay $5 billion for stake in Morgan Stanley. Not only are the funds moving away from liquid assets, they are buying up the struggling firms; Citigroup, UBS, and Morgan Stanley are suffering greatly due to losses derived from the sub-prime mortgage crisis. In the end, these struggling corporations welcome the flow of funds during times of distress.

Implications for world financial markets

SWFs are not unlike private hedge funds or pension funds and often compete in the same asset markets. The incentives and strategies of the SWF managers, though, may differ greatly when compared to the private funds (pension, hedge, etc.). The extreme secrecy of many of the SWFs, with the exception of Norway’s Government Pension Fund, makes it difficult to assess many SWFs’ management strategies. For example, go to the Abu Dhabi Investment Authorities’ webpage – there you will find a page with no links, let a lone management information.

First, the incentive structure of managers at a government-run SWF may be different from that at a private pension fund or hedge fund. Government employees on fixed salary often manage part or all of many SWFs. A private manager (hedge fund, pension fund) receives bonus income based on the performance of the fund. This leads to a lower cost of management on the part of the SWF, and smaller incentive for its portfolio manager to maximize expected return. Thus, the SWF may be willing to accept a smaller expected return. It is becoming more common for SWFs to hire external private managers; the incentive structure is, at best, mixed.

Second, the risk exposure that the SWF is willing to be subject to may be higher than many private hedge and pension funds due to the relative magnitudes of the funds themselves. Economic theory posits that risk aversion falls as wealth levels rise since the marginal utility of each extra unit of wealth is falling. Thus, when you compare the new Saudi SWF valued at > $900 billion to a private fund worth $50 billion, the $900 billion dollar fund is willing to incur more risk. Thus, the SWF is willing to accept higher risk exposure at a lower expected return.

Third, the SWF appear (in the media, at least) to be long-only investors. They are willing to buy up stake in struggling firms (high risk) at an undervalued price. So, if a pension fund or hedge fund is based on long positions, then it will be in the same market as the SWFs.

In the end, commodity prices are driving much of the wealth. If the price of crude oil continues to rise, the surpluses earned by a few net-saving countries may impact global economic markets. The asset markets will change, global economic investment will change, and the imbalance of global saving rates may be further exacerbated. It is hard to predict the impacts, as the SWFs’ worth are essentially unknown, the investment strategies and asset purchases are essentially unknown, so we must wait to see.

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