Sovereign wealth funds (SWFs), governmental repositories of wealth, have increased in size, number and scope in the last two decennia, and have become important for a government’s macroeconomic and financial management. Because of their unique structure, funding and horizon, SWFs can become important investment vehicles for alternative investments.
Observations
- SWFs played a prominent role during the Great Financial Crisis by bailing-out of major banks and financial institutions, like Citigroup, Credit Suisse, and Morgan Stanley.
- Assets under management by SWFs have grown 600% between 2000 and 2015, to almost $7.45 trillion in the first quarter of 2017. SWFs are the fastest growing class of asset owners.
- SWFs where politicians are involved in the governance of their investment strategy have a much greater likelihood of investing in their country of origin, than those that are led by external investment managers. Furthermore, SWFs led by external investment managers have better performance.
- Most SWFs don’t give full disclosure of their investment portfolio, performance and investment strategy, which has sparked public fear about foreign SWFs. The transparency of an SWF is negatively correlated with the degree of corruption and positively correlated to the degree of democratization in the country of its origin.
Analysis
Two developments have promoted the growth of SWFs since the beginning of the millennium. The first is the accumulation of foreign reserves, mostly by (East-)Asian countries. These are mostly held net-exporters that run structural trade surpluses, like Singapore, China and South Korea. Furthermore, their central banks have held on to large (mostly dollar-dominated) foreign exchange surpluses as a response to the depletion of the foreign exchange reserves, and the following 1997-98 Asian Financial Crisis. Some of these (excess) reserves are used for funding their SWFs and the search for higher-yielding assets. The second driver was the rise of the oil price, from around $15 per barrel in 1998 to around $120 a decade later. Although the oil price has tumbled in recent years, it still provides oil-exporting countries sufficient liquidity that can be reallocated to SWFs. These countries consist mostly of Middle Eastern oil exporters, Russia, and former Soviet states, and the world’s largest SWF: the Norwegian Government Pension Fund.
By using the future real economic growth rate as their discount rate, SWFs have an incentive to invest and increase the earnings power and long-term productivity of their home economies
SWFs can be distinguished on the basis of their objectives. Some SWFs have a stabilizing function, by facilitating fiscal stability or by stabilizing the exchange rate. Chile’s Economic and Social Stabilization Fund is used as a counter-cyclical fiscal tool to smooth consumption and reduce Chile’s dependency on global business cycles, and Mexico Oil Income Stabilization Fund is used for keeping up the Mexican peso. Another set of objectives is capital maximization, by building a risk-adjusted capital base for preserving and ensuring future wealth. Norway’s Government Pension Fund redistributes wealth in order to maintain intergenerational equality, while the China Investment Corporation invests excess reserves in the reduction of negative carry costs and aims for higher long-term returns. A last set of objectives is using SWFs as investment vehicles for economic development, in order to boost a country’s long-term productivity: like the Nigeria Infrastructure Fund or Temasek to diversify the Singaporean economy.
What distinguishes the last set of SWFs from other institutional investors, is their long-term investment horizon and that they have virtually no liquidity restraints. This provides these SWFs with an interesting possibility for aligning their financial management to real economic fundamentals. Most institutional investors. like pension funds for example, use the risk-free interest rate as their discount rate, which makes their investment scope largely dependent on financial markets. The volatility of financial markets makes these funds less able to invest in illiquid assets and other opportunities with a (very) long investment horizon. Because of their structure and objectives, SWFs can use the real economic growth forecast (corrected for demographic changes) as their discount rate, instead of the financial interest yield curve. In this way, SWFs have an incentive to invest and increase the earnings power and long-term productivity of their home economies.. By doing so, they create a sustainable and public business environment that directly serves their main purpose, and reinforces their own business model.
