Andrew Ang: Sovereign Wealth Funds

I've been privileged to work in this area both in research and in practice for the last five years I've served as an advisor to the Norwegian sovereign fund and being able to get a practical perspective on many of these issues it is a very under researched area at the moment but these institutions are increasing in importance so what is a sovereign wealth fund well there is no universally accepted definition of a sovereign wealth fund sovereign war funds are part of sovereign or national savings which include everything from central bank reserve stabilization or commodity savings funds pension national pension funds or social security funds and other government holding management companies a working definition of a sovereign wealth fund would be an investment fund controlled by governments and largely if not wholly invested in foreign assets the term sovereign wealth fund was itself first coined by a gentleman andrew rosanoff who was a state street at the time in 2005 and they've grown in importance over the past decade partly due to a number of factors which I'll go through very shortly the larger sovereign wealth funds a number in the hundreds of billions of dollars this data should be interpreted with a little bit of caution these numbers come from a sovereign wealth fund Institute which purports to collect data from many funds however many of these funds are actually extremely secretive so GIC for example has a number there but I think if you talk to GIC they would disclaim that number no one actually would tell you that number officially and even only very high level representatives at that fund actually know what that number is that also goes for aria at the top and many of the other funds here they operate in not very transparent settings and the largest ones are assumed to be Abu Dhabi Norway is this is a good half a trillion dollars now no always natural weight in equities worldwide is 1% so basically all one every single company worldwide should actually be owned by Norway according to their current weighting scheme so these employ massive amounts of capital and they came to attention during the financial crisis because the well I think a lot of the same people that decried sovereign wealth funds just a few years before were exclaiming that sovereign funds could come and ride to the rescue and save our failing Western financial system hey the America has its own sovereign wealth fund it's the Alaska Permanent Fund and that's currently around thirty seven billion dollars these funds some of them are very old the first sovereign wealth fund was Kuwait which was founded in 1953 right sama which is itself actually an account it's basically a central bank was depending on how you look at it was also in the early 1950s there is a blurring between what a sovereign wealth fund is and what a central bank reserve fund is and what a Stabilization Fund is we actually don't have very good data as we said on many sovereign wealth funds we do have very good data though on central bank reserves because central bank reserves are required to be reported to the IMF with some exceptions and you can see that these things these central bank reserves have this very steep upward trajectory starting from the late 1990s going upwards and currently over nine trillion dollars currently China and Taiwan do not report to the IMF so you would actually have to add an additional one point six trillion dollars on there just for China alone Taiwan also holds significant foreign reserves so there's a lot of money sitting in these institutions so what's a central bank versus a sovereign wealth fund I think these sovereign wealth funds are just one vehicle for holding sovereign wealth there is a very blurry distinction between reserves central bank reserves or commodity savings reserves state-owned companies and sovereign wealth funds certain central banks like Switzerland safe which is the state administration of foreign exchange by China and Norway this is not the Norwegian sovereign fund it's actually the Norwegian central bank reserves those central banks actually hold equity making them very much work into risky investors certain sovereign wealth funds on the other hand and they would call themselves sovereign wealth funds like Chile's economic Stabilization Fund Russia's reserve fund hold highly liquid safe instruments very similar to what would be traditionally thought of as central bank reserves so the composition of these and the aims of these is really it's really very blurred there is an institution the international form of sovereign wealth funds and there is a principal 24-point principles called the Santiago principles and there are some members of these these are voluntary membership and there's some some basic standards that these members have agreed to in terms of transparency and reporting and and actions so these are not for the whole list of funds that you would sort of seen two slides earlier but they encompass several of them some countries are more than one fund for example Singapore GIC is a member of the IFS WF but its counterpart to mossack is not so again it depends on what you call yourself if you are sovereign wealth fund or not so where did all this money come from well there are three main sources of this money the first one is commodity prices petroleum prices shot up during the late 1990s they went from us $20 during the late 1990s and reached a high of 147 dollars in 2008 and right now currently they're back over 100 dollars so we looked at that list of funds two slides ago you would have seen that many of these funds are very all rich countries Abu Dhabi Norway Saudi Arabia but at the same time there are countries here that don't have natural resources to China so we'll talk about those so the second sort of source of wealth for these countries has been trade surpluses part of the idea for these trade surpluses is really similar to the idea of holding your reserves from selling your commodities and that is you want to insulate the domestic economy economy from this large source of wealth in the case of commodities there is an effect called the Dutch disease or the natural resource curse so very often when you have a fortuitous discovery of a natural commodity then that can crowd out private investment causing you to under invest in education it shrinks the productive sectors other than the one that's producing all or or copper or whatever other commodity you have and you want to avoid that so you want to isolate or insulate your economy from those effects so similarly if you have trade surpluses your domestic economy might be ill-equipped to absorb all the inflows or your leaders might have precautionary savings motives that they might think that these are these and that these trade surpluses may disappear at some point in time and the country must be prepared associated with these perhaps trade imbalances there is a new form of thinking called the New Britain woods and this is a term that was a that was coined by Dulli focus and landau and gaba and it's really about the fixed US dollar new regime that was very similar to the Britain woods when exchange rates for fixed prior to the 1970s the third source of wealth for these sovereign wealth funds is current government budget surpluses or transfers so some of these countries like Australia have funded sovereign wealth funds through government surpluses other governments notably Island have basically issued debt and put the proceeds of that debt issue into a sovereign wealth fund that hasn't really fed so well the Irish one because the sovereign wealth fund for Ireland was actually used or miss maybe perhaps misuse to bail out some failing Irish financial institutions is it global imbalances I think partly yes but I don't think all these imbalances are bad if you have found oil and you were to not put that money aside you would have actually had very devastating effects for your local economy so that is definitely an imbalance but it's actually a good thing so perhaps some of the trade imbalances are not such a good thing but I think it's it's unfair to call them all an effect of robell imbalances if and global imbalances may not be all bad okay the impact of sovereign wealth funds though I think reflect two main broader geopolitical trends which are totally outside a finance talk but we should mention them nonetheless and the first one is the redistribution of wealth that's been ongoing for the past decade and will continue to do to to go in this direction for the next couple of decades away from the Western world primarily focused on the US Europe and other mature developed economies to the east primarily and other developing countries the second broad trend is an increasing role of governments in managing wealth even the US has not been a totally free market economy so the u.s. itself has had some government intervention in the economy the really relevant question is how much in many of these nascent countries which have large increases in wealth held in sovereign wealth funds the role of governments is much larger than the traditional role of government in in the in developed countries so what is the role appropriate role of governments in managing wealth creating industrial policy and managing the economy so when the policy paper I look at some benchmarks of sovereign wealth funds and they are different from private investment management firms and I talked about for benchmarks grouped into these categories legitimacy policy and liabilities governance structure in equilibrium a governance structure and performance sorry and finally long-run equilibrium and legitimacy is by far the most important of these Libya has a sovereign wealth fund now but I don't think one would describe its government as being legitimate and therefore its sovereign wealth fund is probably illegitimate as well most of that money in the sovereign wealth fund is now under sanctions by the US and other countries so legitimacy is as the the primary most important benchmark a sovereign wealth fund the most important thing though some wealth fund is that it be managed so that you don't touch the money today otherwise you get the Dutch disease you want to gradually disperse this money across present and future generations to do so requires legitimacy and credibility and there are different models for this I don't think transparency is required at all for this Norway is definitely transparent as fits the social outlook of that country but there are very successful funds like GIC and Kuwait and Abu Dhabi which have legitimacy which are not transparent and they would claim that they would not like to be transparent given the type of environment that they live in and the type of neighbors perhaps bellicose neighbors that they face also accountability and regular reporting though are important for these although these countries aren't transparent they do have boards they do report to governments or ministries or to Parliament directly hey the second benchmark is one of integrated policy and liabilities it really recognizes the environment in which these sovereign wealth funds live and their role as only one of perhaps many policy instruments that government can take I want to look at an example here for East Timor East Timor is is an incredible fund East Timor has a population where the GD average GDP per capita is 500 okay we don't have any other zeros 500 US dollars this fund is 10 times GDP right Norway for all its wealth half a trillion dollars worth is approximately 1 times Norwegian GDP so East Timor is a giant it's an absolute giant and you can think about countries like East Timor and other sets in other settings around the world where that amount of wealth would have had severe unfortunate consequences and it hasn't and one of the reasons why is Timor has been so successful as is that it's anchored it's it's fund in a array of policy measures designed to produce development for the country prudent financial management and other macroeconomic effects Reserve or stabilization funds have now also morphed to sovereign wealth funds so for example here we would think of CIC or safe which I have now changed their mandates really from traditional reserve funds to part of macroeconomic savings for the whole country and so that's basically changing your liability struck or the purpose of what these funds are sovereign wealth funds you eventually will want to have that money paid into the country although gradually so the payout rule would delineate how and when that money should be distributed and there should be some flexibility here some sovereign wealth funds like Saudi Arabia and Kuwait have paid after the the Gulf Wars in reconstructing the countries Chile also tapped its sovereign wealth fund after the earthquake in Chile so there should be some flexibility in how this money should be used let me turn to the third benchmark which is governance structure and performance and I don't think this is requirement for sovereign wealth funds if a sovereign wealth fund however should be well managed to choose an optimal risk return trade-off then I think governance structure and performance is is a very important part to do that you need professionalism so remember sovereign wealth funds are owned by governments it's not so easy for bureaucratic institutions to manage money well those funds that have done so Kuwait Singapore Norway are shining examples of this have been fortunate to create professional money management cultures either wins with in central bank or public sector organizations this is actually extremely challenging to do they could have actually been traditional very stodgy traditional bureaucratic institutions but they haven't been so and so they're succeeded in creating a professional culture and minimal to good investment decisions the government's model and also the mandate have to be simultaneously considered so a lot of these funds have mandates that look like something like a real interest rate or a real payout plus some kind of spread on top of that and these mandates depend on the board structure or the governance structure of these plants now one I think what should take into account factors in in doing this and this is a great part of my research is to think about the underlying determinants of asset returns and also the underlying determinants of the of the liabilities and the way to think about this is I think an analogy with nutrients a factor is to an asset what a nutrient is to food and just as we eat different food foods provide us with different types of nutrients so too we hold different assets because they give us different factor exposure these factor exposures could be things like how they Co vary with macro factors like inflation and output to also how they covary with different investment styles like value growth momentum etc but these are all types of factors we need to understand those factors in order to find suitable investments for our liabilities just as we need to understand the nutrients inside our food to create a balanced diet different investors are really different types of people in this analogy so sovereign wealth funds are just one type of asset manager and you have many types of asset managers so a just as a child or woman or man if you're well or sick will have different requirements for nutrients so to a sovereign wealth fund with a particular liability structure will have a different requirement for different factors so factors are important you will really want to look at those factors and that's and that's that's a very important area of research that I as well as many other many other academics are looking at the final benchmark is a benchmark of long-run equilibrium and their existence horizon for long for sovereign wealth funds is meant to be long term here we're talking generations the investment horizon though could be short or long term depending on the makeup of the fund it's risk aversion and its liabilities for sovereign wealth funds with long term investment as well as existence horizons those sovereign in those sovereign wealth funds benefit immensely from efficient capital markets as asset owners they benefit from exercising shareholder rights so I think the picture here is not all scary even though massive amounts of capital easily projected to be 20 to 25 trillion dollars over the next five to ten years are going to be held in these types of vehicles imagine if all of this money now were to be exercised to prudently and appropriately that they actually exercised their shareholder rights they created efficiently managed companies that would be a remarkable transformation that would be the best the first best thing that we could that we could we could look at with all this capital inside these and yusin's here I think the benchmarks help in terms of the political debate of sovereign wealth funds we want to ensure that the legitimate the the fund is legitimate that this fund is governed correct appropriately that this fund sits in an appropriate place inside a co and integrated policy perspective and finally that the fund itself cares about the capital markets and the recipient countries of their capital so sovereign wealth funds have a long investment horizon they should consider this long run external effect that they have so in conclusion there are four benchmarks of sovereign wealth funds I would group them as being legitimacy purpose what their role is in an integrated policy and liability setting performance how to structure that openly in terms of governance and endurance which is the long-run equilibrium thank you very much

Channel: Columbia Business School

Views: 25,681

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Keywords: No Free Lunch 11 1of3, Andrew Ang, Columbia Business School, Financial Studies, Asset Pricing, Sovereign Wealth Funds

Id: 0Y4oly7H3UE

Length: 18min 52sec (1132 seconds)

Published: Fri Jul 15 2011