Sovereign Wealth Funds and their Impact - Part 1

 

Part 1 – What are Sovereign Wealth Funds

 

“In life’s journey, having the ability to predict the future gives us an unfair advantage. If we can understand the laws of cause and effect, anyone can predict the future. What we do today leads us to tomorrow’s destination. Why does this simple truth seem to be difficult for most people to understand?” ― Celso Cukierkorn

Sovereign Wealth Funds (SWFs) are not understood very widely, although they aren’t new.

Several funds have been operating at a global level for more than fifty years. However, the big thrust came during the early years of this century. The number of funds created during this century represents the majority of the total in existence. Earlier, these funds (state-run), operated under the radar, maintaining a low profile in the public eye. Very broadly, SWFs have been regarded as investment vehicles established in order to manage, in a profit-oriented way, surplus national wealth for future generations. The last financial crisis (2008) brought these funds into public focus. By then they had grown to enormous sizes and they were now seen as an important part of the international safety net. They are today regarded as the most important financial investors in the global financial system.

At present SWFs are managing assets of the order of USD 8-9 trillion. It is also among the class of investors that have grown the fastest during the last two decades. To get an idea of the order of magnitude, one must remember that the total market capitalization of all the listed companies in the United States is of the order of USD 31 trillion and all the world’s stock exchanges have a capitalization of USD 85 trillion (This is an increase of 320% since 2009, when their value was $25 trillion). Of course, all of the SWFs don’t go into stocks, but it does give you a sense of how large the SWFs have become.

The amount of money held by the largest sovereign wealth funds has nearly trebled since September 2007, from around USD 3.3 trillion to over USD 8 trillion today. Their asset holdings are now double that of all hedge funds combined.

These funds are big enough to affect overall markets. For example, they took large stakes in Citigroup, Morgan Stanley, and Merrill Lynch during the financial crisis. They contributed to asset bubbles in London and New York real estate. These funds have increasing influence as investors become more sophisticated.

With size comes influence, and SWFs do end up influencing the direction of investment flows. Of course, they are not the only ones, but they are an important set of entities and as they are growing their influence will continue to increase.

What are Sovereign Wealth Funds (SWFs)?

A sovereign wealth fund is a state-owned investment fund. It is created from money generated by the government, usually from a country's surplus reserves. SWFs provide a benefit for a country's economy and its citizens. Typical SWFs are those that have been created by countries who have created a budget surplus for years and they invest this surplus to derive future benefits for their citizen. However, there are also countries that maintain SWFs even without generating that surplus, and use these funds as an alternative vehicle for generating surplus. However, these are limited to very large economies, since it is not really feasible for smaller economies to do that.

The top five SWFs by assets as of August 2020 were:

• ·         Norway Government Pension Fund Global USD 1 trillion
• ·         China Investment Corporation USD 940 billion   
• ·         Abu Dhabi Investment Authority USD  579 billion
• ·         Kuwait Investment Authority USD 533 billion
• ·         Hong Kong Monetary Authority Investment Portfolio USD 528 billion

As with any type of investment fund, SWFs have their own objectives, terms, risk tolerances, and liquidity concerns. Some funds may prefer returns over liquidity and vice versa. Depending on the assets and objectives, sovereign wealth funds’ risk profile can range from very conservative to a high tolerance for risk, and horizon could be a decade to multiple decades.

The allocation into equity investment varies. For example, Norway Government Pension Fund Global had 71% of its allocation in equities. The Norway fund invests in equities, fixed income, and real estate. In 2019, it reported a return of 19.9%, led by equities with a return of 26.0%. 71% of the fund was in equity, 3% in real estate, and 27% in fixed income.

Sovereign wealth funds have attracted significant attention as more countries open funds and invest in big-name companies and assets—some more transparently than others. This has given way to widespread concern over the influence these funds have on the global economy. For example, if a fund changes its policy (say it decides to pull out of fossil fuel related companies, and decides to reallocate the amount to green technologies), it can impact the stock prices of certain companies in different ways. Thus, in theory it is possible for SWFs to influence key policies of Governments, particularly in smaller countries.

In summary,

• ·         A sovereign wealth fund is a way for countries to invest excess capital into markets or other investments.
• ·         Many nations use sovereign wealth funds as a way to accrue profit for the benefit of the nation's economy and its citizens.
• ·         The primary functions of a sovereign wealth fund are to stabilize the country's economy through diversification and to generate wealth for future generations.
• ·         A sovereign wealth fund is a state-owned pool of money that is invested in various financial assets. The money typically comes from a nation's budgetary surplus. When a nation has excess money, it uses a sovereign wealth fund as a way to funnel it into investments rather than simply keeping it in the central bank or channeling it back into the economy.

 

The emergence of sovereign wealth funds is an important development for international investing. The motives for establishing a sovereign wealth fund vary by country. For example, the United Arab Emirates generates a large portion of its revenue from exporting oil and needs a way to protect the surplus reserves from oil-based risk; thus, it places a portion of that money in a sovereign wealth fund, which in turn is invested in diverse industries/ sectors across different countries. This diversified pool earns investment returns for the citizens. Over a period of time, these funds start generating significant incomes from these investments which helps the country manage the vagaries of its own economy.

A bit of History

The first funds originated in the 1950s. The first sovereign wealth fund was the Kuwait Investment Authority, established in 1953 to invest excess oil revenues. Two years later, Kiribati created a fund to hold its revenue reserves. However, not much happened three major funds were created, twenty years later:

• ·         Abu Dhabi's Investment Authority (1976)
• ·         Singapore's Government Investment Corporation (1981)
• ·         Norway's Government Pension Fund (1990)

Kiribati is an unusual pioneer, but it did show the way very effectively. The Revenue Equalization Reserve Fund (RERF) is the sovereign wealth fund of the Pacific island republic of Kiribati. It’s a tiny place, with a population of 120,000 and a land area of 811 sq kms. The size of the economy is of the order of just USD 180 million. The Fund was established in 1956 when the country was a British colony. The island nation created the fund in order to manage earnings from the country's phosphate mining industry, which accounted for over half of the country's revenue when it was established. It was also the country's largest export at the time. By the late 1970s, the country exhausted its phosphate deposits, and the per capita gross domestic product (GDP) was cut in half between 1979 and 1981. Since that time, Kiribati has largely depended on foreign aid, tourism, and the sale of fishing rights. In 2009 the RERF was valued at A$570.5 million. This, for the small island represented 350 percent of the GDP) in. It was actually higher than that in 2007, but was impacted by the global financial shock. As a result of the Global Financial Crisis (GFC) the RERF was exposed to failed Icelandic banks, and drawdowns were made necessary because of other effects of the crisis and the government of Kiribati needed to finance budgetary shortfalls. However, it is now estimated to have again increased to about USD 608 million. As is obvious, it offsets the lack of activity/ opportunities in the economy in a very significant way, the fund value alone being 3.5 times the annual GDP.

Larger economies are more complex but the basic template and the rationale is no different. Over the last few decades, the size and number of sovereign wealth funds have increased dramatically. According to the SWF Institute, there are more than 91 sovereign wealth funds with cumulated assets amounting to about USD 8 trillion in 2020. The biggest ones are depicted here -

The above list does not include the Japanese pension fund, which is bigger than all of them. That’s because it is not a classical SWF, since a substantial portion of it is invested in Japan itself.

There are others who classify the Japanese fund as SWF, and other pension funds as pension funds. According to them, the SWFs size gets closer to USD 9 trillion (mainly because of this). One such source -

• ·         SWFs -  in numbers, 155 – AUM in USD billions - 9,072
• ·         PPFs -    in numbers, 283 – AUM in USD billions - 18,432
• ·         SWFs+PPFs - in numbers, 438 – AUM in USD billions - 27,504

Source -  https://globalswf.com/

In terms of money flow, the only difference is that SWFs invest abroad, whereas PPFs (Public Pension Funds) invest both domestically and overseas. Bothe are long term capital with certain specified goals in terms of returns and periodic drawdowns. The funds need to balance the two objectives.

It should be noted here that creating and maintaining a sovereign fund takes a long time. It doesn’t happen in a short time frame, and often takes a few decades. If we look closely at the top SWFs, the top 10 account for 77% of the total AUMs, and the top 5 account for 52%. Building an investment fund and ensuring long term income requires discipline and focus, and also prudent risk-management.

Types of SWFs

There are broadly two categories of Sovereign wealth funds - commodity or non-commodity. The difference between the two categories is how the fund itself is generated and financed.

1.       Commodity sovereign wealth funds are financed by exporting commodities. When the price of a commodity rises, nations that export that commodity will see greater surpluses. Conversely, when an export-driven economy experiences a fall in the price of that commodity, a deficit is created that could hurt the economy. A sovereign wealth fund acts as a stabilizer to diversify the country's money by investing in other areas. The biggest example of this are the SWFs of oil producing nations. Norway was the pioneer, but many of the Persian Gulf based Oil producing states have created SWFs of their own during recent years.

2.       Non-commodity funds are typically financed by an excess of foreign currency reserves from current account surpluses. These describe export surplus economies whose exports are much more than their imports. Instead of keeping it as a low earning treasury holding, some countries have created SWFs to invest for better returns. Singapore is a prime example of this. Another example is China Investment Corporation, one of the biggest of these SWFs, which was created in 2007 to channel China’s vast foreign exchange reserves into assets more profitable than government debt.

Lately, a third type has emerged. These have been dubbed by critics as ‘vanity funds’. Their home nations did not enjoy commodity exports or surpluses, and often had poor fiscal discipline. On the surface, there doesn’t seem to be any valid reason for creating a SWF. Some Governments of these so-called vanity funds’ home countries perceived SWFs as vehicles to boost the economy during global slowdowns or to attract international capital. debt levels are either too high or natural resource revenues or future fiscal surpluses [are] too small to justify creating such a fund. Yet countries like Ghana and Uganda, and a few others have established funds. These defy the fundamental logic, and are often attributed to the vanity of the people in power at a given point in time.

Within the categories there are different types of funds. Traditional classifications are:

·         Stabilization funds - fiscal stabilization through excess budgetary reserves. This is particularly useful for countries that exposed to price fluctuations of a few commodities (eg, many oil producers)

·         Savings or future generation funds - wealth preservation, expansion, and inter-generational transfer. It makes the money earned today work to provide for future generations

·         Public benefit pension reserve funds – This is particularly useful for countries when they enter into a phase of aging and declining working-age populations. Many European and East Asian countries are entering this phase and those who created SWFs in the past would have it to draw from.

·         Reserve investment funds - excess reserve management, beyond that required for stabilization or for direct monetary policy support

·         Strategic Development Sovereign Wealth Funds (SDSWF) - strategic asset management, including privatization. This could include investing to secure supplies of strategically important inputs for energy, defense, and other critical areas.

·         Funds targeting specific industries (possibly emerging or distressed) – These are more focused towards very specific industries.

SWFs with stabilization mandates would tend have a short-term horizon in their investments because the need could arise without much of a notice. Savings funds, aimed at inter-generational wealth transfers, will tend to have long-term horizons. Pension funds would also have a long horizon with well-defined outflow requirements at a later stage. This would potentially make them invest not just in equity and real estate, but also in alternate investment funds (AIFs).

 

“At times, we were forced to go through a history of dependence, unable to determine our own destiny. But today, we are at the threshold of a new turning point.” - Roh Moo-hyun

Part 1 – What are Sovereign Wealth Funds

Part 2 - The story of the Norwegian SWF and The SWF of China

Part 3 – Singapore and a few more prominent SWFs 

Part 4 – India as a prominent destination for SWFs