Sovereign Wealth Funds

Introduction:

This subject first attracted our attention in the early summer of 2007. Given the intricacies of international finance, we proceeded slowly and with some reluctance in creating this research note. Since the interest in, and the influence of, sovereign wealth funds (SWF) has continued to grow and since the subject can be difficult to research, we have decided to offer basic information and provide some bibliographic suggestions. Although there are related books on such things as sovereign debt, there are not, as far as we can tell, any monographs on the topic at this time. At this point the student of sovereign funds has to rely on articles, analysts' reports and academic working papers and it is our intention to direct you to them while providing some rudimentary observations that we trust will not surpass the level of our expertise.

Update 2010: Although most people are more concerned about Soverign Debt as opposed to Sovereign Wealth, "The Brave New World of Sovereign Wealth Funds," conducted by Wharton MBA students and sponsored by the Wharton Leadership Center and the Joseph H. Lauder Institute of Management & International Studies looks at SWF in this new financial climate.

Additional documents include:

Definition:

Although sovereign or government reserve funds have been around for a long time, the new SWFs are essentially government-run investment pools. They are described this way by Mr. Clay Lowery, who, at the time was the U.S. Under Secretary for International Affairs: A sovereign wealth fund is "a government investment vehicle which is funded by foreign exchange assets, and which manages these assets separately from official reserves". For more details see: " The Definition of a Sovereign Wealth Fund," by Stephen Jen, in the Global Economic Forum, October 26, 2007. This article is found on the web site of Morgan Stanley (http://www.morganstanley.com/) In fact, it is on their web site that you will find the study which in many ways was responsible for the initial surge of interest in this subject. See: " How Big Could Sovereign Wealth Funds Be by 2015?" also by Mr. Jen, Global Economic Forum, May 4, 2007. See as well: "The Rise of Sovereign Wealth Funds: We Don't Know Much About these State-Owned Players", by Simon Johnson in F&D: A Quarterly Magazine of the IMF, Vol.44, No.3, Sept. 2007.

Size and Scope:

As the sub-title of the article above indicates, details about SWFs can be difficult to uncover since, unlike public companies, they do not typically file annual reports. It is estimated that there are around 25 SWFs controlling an also estimated $1.5 to $2.5 Trillion( US). To put that number in some perspective, it represents "more than the assets of all hedge funds worldwide taken together". It is anticipated that they will grow in number and size and some forecasts are: $10T by 2012 and $12T by 2015. Many of the new SWFs are in countries in the Far East that have accumulated large reserves of foreign currencies and some are found in the resource and commodity producing countries in the Middle East where vast sums are now available for investment opportunities. Two lists of SWFs are provided below for your convenience.

The Issues:

So far none of this is too startling, except perhaps for the depth of the money pools. What has changed is the way governments are choosing to manage the funds which contain far more than the amount required for such things as currency stabilization. Originally reserve funds were invested in long term bonds and U.S treasuries and there was a philosophy of "buy and hold". Now, SWFs are often seeking greater returns and they are making short term investments in the riskier equity arena. The magnitude of the money involved and the mystery surrounding how and where much of it is being invested have led to international concerns. Like hedge funds, sovereign ones are now viewed with some suspicion in many quarters.

In part, as mentioned, some are worried about the lack of transparency and information involving massive investments across borders. As well, there is some concern about the expertise and investment skills of government bureaucrats. More importantly, many are worried that the motives behind the investments have changed, or may change. The hedge fund is simply trying to earn more money. That may be a goal or one goal of a SWF, but the government may have others as well. This problem is recognized in an article by Lawrence Summers in the Financial Times: "What has received less attention are the particular risks associated with ownership by government controlled entities, particularly where the ownership stake is taken through direct investments. The logic of the capitalist system depends on shareholders causing companies to act so as to maximize the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders. They may want to see their national companies compete effectively, or to extract technology or to achieve influence." ("Successful Funds Shake the Logic of Capitalism," July 30, 2007 - we realize that Mr. Summers has made some questionable comments, but we don't believe this is one of them!)

In short, there is concern that capital flows are becoming politicized to a dangerous degree. There have been some who have objected when a foreign company or private investor has taken over an important company for speculative reasons, or a football club, for personal ones. There are now many who object when a foreign country moves to acquire a resource-based firm or a financial one, or one that possesses valuable intellectual property, particularly if the objective appears to have more to do with politics than profit. The issue is magnified when the takeover target is in a defense-related industry or one that manufactures technologically advanced products.

A case which indicates the problems involved and which led to a great deal of controversy occurred in 2006 when Dubai purchased 6 U.S. ports from the Peninsular & Oriental Steam Navigation Company. Although the deal was approved, there was considerable opposition – having an Arab country controlling U.S. ports in a post 9/11 world was not something that many were willing to accept. (They were later sold back. See: “Dubal Sells U.S. Port to Americans: Political Storm Passes,” Dayan Candappa, National Post, Dec.12, 2006.)

Interestingly enough, when the Dubai Group purchased a 20% stake in the NASDAQ exchange in Sep. 2007, there was less publicity and apparent concern. For the reasons why see: “Why No Outrage from Washington: To Fend Off Fiascos Like Last Year’s Failed Dubai Ports World Deal: the Emirate Called in the Big Guns – Lobbyists,” E. Javers and D. Kopecki, Business Week, Oct. 8, 2007. Apparently Dubai and Qatar are vying to become the financial hub of the Middle East and both have interests in the Nordic exchange and the LSE.

Although the actions of SWFs have become a significant political issue in the United States (imagine if the "axis of evil" had one), they are not limited to that country and political problems have arisen elsewhere. See, for example, the case of Temasek (a Singapore SWF) which became the major mobile phone operator in Thailand. This episode caused quite a controversy and, as a result, Temasek is reportedly taking a less aggressive approach (see: “Temasek to Take a Lower Profile,” by John Burton, Financial Times, Nov.24, 2007.) For an account of Temasek’s approach at the time see: " Singapore Accelerates Overseas Acquisitions - Temasek Holdings, Owned By The Singapore Finance Ministry, Is Spreading Its Wings In Asia, Expanding Its Portfolio Of Financial Services And Banking Assets," by Simon Montlake, The Banker, Sept.1, 2006.

Apart from the lack of information about SWFs and their investment strategies, the situation is likely to grow murkier if they quietly invest in private equity firms whose positions in industries and firms are also generally nebulous. Recently it was announced that China took a stake in Blackstone and Dubai acquired a 7.5% stake in the Carlyle Group.

The politicians and pessimists tend to view these developments with trepidation and we count ourselves in the latter group and that is perhaps reflected in this document. The result is likely to be a growth in financial protectionism and a move by a body such at the IMF to take some regulatory steps.

There are some who feel more positively about SWFs. It is generally pointed out that the SWF for Norway has been around for years and provides a good model for how such funds should operate. Many in the investment industry see a business opportunity. It is anticipated that some SWFs will hire capable investment managers or outsource some of the action and that the fees involved will be enormous.

Sample Sovereign Wealth Funds

Table I.

In billions of U.S. dollars – estimates for 2006-2007

Notes: Japan has announced plans to create an SWF.
The U.S. SWF refers to the Alaska Permanent Reserves Fund
nk = not known

Table I is taken from: Source: "Sovereign Wealth Funds: Threat to Financial Security," Quarterly Bulletin, De Nederlandsche Bank, September 2007.p.27. (www.dnb.nl/dnb/home.) It is also the source for the hedge fund quote, p.26.

Table II.

Table II is taken from: “The Overflowing Bathtub, The Running Tap and SWFs”, Global Economics, Merrill Lynch, October 5, 2007, p. 10. Note the existence of the Alberta Fund above. Although this fund is not based on foreign currency holdings, it provides a good example of a type of SWF and the site is very interesting. See: http://www.finance.alberta.ca/business/ahstf/index.html. For an interesting report comparing the Alberta Fund with the Alaska Fund mentioned in Table I. see: “Alberta Heritage Fund vs. Alaska Permanent Fund: A Comparative Analysis,” Allan A. Warrack & Russell R. Keddie.
In some discussions, Quebec’s Fond des Generations is mentioned as a SWF.

Bibliography:

For more details we suggest you use our suite of Economist Intelligence Unit resources. The subject has been discussed often in their Risk Briefing (e.g. “World Risk: Alert – Sovereign Wealth Funds: The New Bogeyman of International Finance?” July 4, 2007). See as well, The Economist, which is available through the EIU suite. We also provide access to the publications of the World Bank and the IMF. Articles are easily found by using Factiva and Lexis/Nexis. For your convenience, we provide below some recent articles located on ProQuest.

"Comment: Hypocrisy Over Sovereign Wealth Funds - Given Current Regulations regarding SWFs, the US and EU have no Right to Attack Emerging Economies on how they Invest." The Banker (2007): 1.
Abstract:
The growing influence of sovereign wealth funds (SWFs) and their increased willingness to flex their investment muscle has led to much gnashing of teeth among politicians, pundits and economists. Whether it be Clay Lowery, acting undersecretary for international affairs at the US treasury, or German chancellor Angela Merkel calling for greater regulation governing what sovereign wealth funds are able to buy, the response to this increasingly visible phenomenon has been negative.

Diana Choyleva, Lombard Street Research. "Sovereign Wealth Funds." FT.com (2007): 1.

"The Dollars 2,500bn Question how Sovereign Wealth Funds are Muscling in on Global Markets." Financial Times May 25 2007: 7.
Abstract:
The growing role of the SWFs in markets is beginning to attract criticism, particularly over a lack of transparency. Few SWFs give details of their operations, with exceptions such as Norway's GPF. "Monitoring the currency and asset compositions of official reserves is difficult, but tracking the sovereign wealth funds would be nearly impossible, as these funds are blended with the massive pool of privatecapital," says one investment banker.
Some of the newer SWFs appear to be following a similar path to the Abu Dhabi Investment Authority, one of the first SWFs, which has for 30 years acted as a savings fund for the emirate's future generations. It is rated highly as a professional manager with a diversified portfolio and a cadre of talented managers. But there are few public details on its operations, with no official figures released for Adia's investments. Morgan Stanley estimates it is the world's largest SWF, managing as much as Dollars 875bn. But where this money is deployed is a matter of conjecture.
This raises issues about potential systemic problems if SWFs assume a greater role in markets. Many of the newer SWFs, more- over, lack the management experience and systems of a fund such as Adia. "Many governments do not have the wherewithal to manage risk (in SWFs)," says Ms [Jennifer Johnson-Calari].

"Finance and Economics: The New Rothschilds; Sovereign-Wealth Funds." The Economist 384.8548 (2007): 98.
Abstract:
Sovereign-wealth funds, a loose term to describe state-run investment pools, have an estimated $2 trillion-3 trillion under management and are playing an increasingly muscular - and controversial - role in cross-border investment. Middle Eastern money has been particularly active.

Finance and Economics: The World's most Expensive Club; Sovereign-Wealth Funds." The Economist 383.8530 (2007): 94.
Abstract:
The announcement on May 21st that China would invest $3 billion of its reserves in Blackstone, a New York-based private-equity firm soon to issue shares, shows that it is prepared to barge into murky private markets as well as liquid public ones. It is not the only inscrutable country to be cosying up to the inscrutable private-equity industry. Like China, whose proposed Blackstone stake is part of $300 billion that the government plans to set aside this year for investment purposes, dozens of countries have set up what are now commonly referred to as sovereign-wealth funds. They manage money drawn from reserves, natural-resource payments and the like. China is chiefly concerned to diversify its foreign reserves, but other sovereign-wealth funds own national, as well as international, assets. Recently, central bankers have also begun wondering whether they have a fiduciary duty to make higher returns from the public wealth under their supervision, which could mean placing at least some part of foreign-exchange reserves in high-yielding, if less liquid, investments. In Asia this question has become increasingly pertinent in the past two years, as reserves have mushroomed. The result has been a torrent of money into a finite pool of assets.

Javier, B.L.A.S. "Sovereign Wealth Funds Move into Commodity Investment." Financial Times Nov 13 2007: 12.
Abstract:
"While macro data on sovereign money is elusive, anecdotally we see meaningful flows into commodities from the Middle East, Europe and Asia," said Katherine Spector, head of energy strategy at JPMorgan in New York.
"They want to use commodities, and particularly gold, as a hedge against the US dollar's weakness," said a senior banker, who added that the investments were mainly coming from the Middle East and Asia.
"They want commodities exposure exactly for the same reason as other institutional investors - diversification," said a banker at a large Wall Street institution.

Larson, Stuart E. Eizenstat and Alan. "The Sovereign Wealth Explosion." Wall Street Journal Nov 1 2007: A.19.
Abstract:
The good news is that following last year's outcry over Dubai Ports World's proposed acquisition of U.S. port terminals, cooler heads have prevailed. Recently adopted reforms, passed with large bipartisan majorities in Congress, clarify the national-security review process for foreign mergers and acquisitions administered by the Committee on Foreign Investment in the United States (CFIUS). The new law provides greater transparency and certainty both to Congress and investors. The law also improves the political environment for investors, with great benefits for the U.S. economy. Along with the administration's statement on open investment issued last May, the new CFIUS reforms effectively recognize that FDI is critical to the health of the American economy.
Such concerns are not entirely without merit, especially when sovereign wealth funds or state-owned enterprises (SOEs) seek control of companies that have a bearing on national security. For example, the prospect that oil and gas companies controlled by the Russian government would advance state-driven, as opposed to commercial, objectives must be taken seriously. Investments in certain sectors (telecom, IT, energy and defense) by Chinese state-owned companies might raise legitimate national-security considerations. More broadly, transparency, preservation of free markets and fair competition are all legitimate issues for policy makers to take up in assessing investments by sovereign wealth funds and SOEs.
The environment in the U.S. today is better for foreign investment than it was a year ago, precisely because the recently enacted reforms have enhanced an already mature review process. The U.S. government and leaders on Capitol Hill must maintain this momentum by remaining open to sovereign wealth, while also working with partners to develop confidence-enhancing measures in which wealth funds and SOEs can participate.

"Leaders: Governments Go Shopping; Sovereign-Wealth Funds." The Economist 384.8539 (2007): 14.

"Sovereign Wealth Funds: The $2 Trillion Investor." Euromoney (2007): 1.
Abstract:
Not a week goes by without a sovereign wealth fund grabbing the headlines. These vehicles, which are government run, are not new. Adia, for example, was set up more than 30 years ago. What is new is the number of these funds and their sheer size and influence. They have assets, built either through commodity exports or foreign exchange reserves, of between $1.5 trillion and $2.5 trillion, according to analysts. As such they are among the most important investors in the international financial markets. The speed at which these funds are accumulating assets is providing much food for thought.

Vail, John F. "A Passage to the West for Sovereign Wealth Funds." Financial Times Oct 31 2007: 24.
Abstract:
Many voices in the US government now say that this accumulation of reserves is illegitimate as it was caused by currency intervention, and that Asian governments should not be allowed to buy large portions of the US. While there are justifiable concerns about a communist country such as China owning controlling stakes in many "national interest" industries in the US, the general fear of Asian equity ownership is unfair and impractical. The US allowed this unbalanced system to develop and the natural consequence is for Asians, whether citizens or their governments, to own large portions of US assets, and not just Treasuries. With appreciating currencies, the Asian SWFs must seek higher risk assets such as high-yield bonds, equities and real estate in order to achieve acceptable returns.
If this is not achieved, Asian SWFs may rapidly diversify away from the dollar, with the euro bearing the greatest brunt of appreciation, and also likely causing a sharp rise in commodity prices. Trade protectionism and acrimony would certainly follow. While this has not yet occurred, China's recent creation of its massive SWF and its growing influence in the world changes the rules. This trend will gain momentum very quickly, so it would be best to seek agreements on the above items as core principles of "SWF best practices" rather than wait for a long negotiation over a complete set of such principles.