A Lot to Learn: Many Sovereign Wealth Fund Managers Come up Short in Measures of SophisticationPublished: August 06, 2008 in Knowledge@Wharton
Bird dung started the boom in sovereign wealth funds.
The British colonial government of the archipelago nation of Kiribati in the South Pacific created the first such fund in 1956. Back then, Kiribati exported phosphates -- that is, guano -- for use in fertilizer. The government deposited its phosphate royalties in an investment fund on the theory that future generations should share in the profits from this exhaustible resource. Today, the guano is gone, but the fund, with about $500 million in assets, is nearly 10 times as large as the country's gross domestic product.
Sovereign wealth funds and their cousins -- national-pension and currency-stabilization funds -- have lately burgeoned. Like Kiribati's, many of the government-run funds have their roots in their home nations' natural resource wealth, especially oil exports. With crude prices increasing fourfold over the last five years, countries ranging from Russia to Venezuela are now collecting more revenue than they can prudently invest at home. The International Monetary Fund estimates that sovereign wealth funds control about $3 trillion and that figure could grow to $12 trillion by 2012. The biggest of them, the Abu Dhabi Investment Authority and Council, is believed to sit on about $875 billion.
Despite these eye-popping sums, the management sophistication of many of these outfits has hardly reached its adolescence, says Olivia S. Mitchell, a Wharton professor of insurance and risk management and director of the Boettner Center for Pensions and Retirement Research.
In a soon-to be-published paper titled, "Managing Public Investment Funds: Best Practices and New Questions," Mitchell and two co-authors -- John Piggott and Cagri Kumru at Australia's University of New South Wales -- say that many funds don't adhere to basic norms of modern money management. Most don't even appear to make an effort to match their investment strategies with their future financial obligations. "As [sovereign wealth funds] have grown, they appear to be demonstrating an increasing risk appetite, very little transparency and virtually no clarity of objectives," the three scholars write.
Matching Risk with Obligations
That's troubling because, in theory, government-run funds should conduct themselves just as private ones do when it comes to matching their investments with their future payouts, Mitchell says. "Your appetite for risk should depend on the cash flow pattern of your expected liabilities. Until you undertake a good analysis of the liability stream you need to cover, it's impossible to know what you should be invested in. In the majority of cases, these funds don't report enough information to track their future liabilities, so we cannot tell whether their investments are appropriately matched to future promises."
The three scholars devised a system for ranking the management of sovereign wealth funds by tallying indicators of their governance, public accountability and investment practices. They rated Norway's Government Pension Fund and New Zealand's Superannuation Fund as the best managed, while Abu Dhabi's management counts among the worst in terms of transparency and accountability. Norway and Abu Dhabi are investing a portion of their swelling oil wealth, while New Zealand is socking away tax receipts to provide retirement income for its citizens. "New Zealand is charging today's workers while they're young, so the young of the next generation won't be so heavily taxed when today's workers retire," Mitchell notes. Like many developed nations, New Zealand faces an aging populace because of lengthening lives and a falling birth rate.
What sets Norway and New Zealand apart from their peers? Both countries have created operations that function almost like modern U.S. mutual funds.
"The well-managed funds are very explicit about where their money comes from and what their objectives are," Mitchell says. "They're reporting the nature of their investments and the funds' geographic diversification. They issue quarterly reports, and they protect the funds' managers from political interference. New Zealand's plan has even put in place guidelines for corporate responsibility, outlining the way it will intervene, or not, in companies in which it invests, and what types of assets it will or won't seek to hold. It publishes a formal 'responsible investment policy' manual, which takes into account the environmental impacts and employment-rights practices of companies in which it invests."
Just as important, both countries try to insulate their funds from political meddling, which is perhaps the biggest peril for a government-run investor.
They achieve this partly by investing much of their money abroad, thus reducing pressure from elected officials to back friends' and supporters' companies or hometown projects. Norway, for example, holds about 60% of its assets in foreign stocks and 40% in foreign bonds. New Zealand has 40.5% in foreign stocks, 7.5% in domestic stocks, 17% in bonds and 35% in other asset classes, including real estate, timber and private equity.
Both of these funds were created by democratic governments, giving them a legal obligation to operate openly. And, by doing so, they also generate support for their financial mission. In theory, if citizens understand and trust a fund's goals, they should be less likely to clamor for tax cuts or increased benefits. "New Zealand has been explicit that it's building this asset pool now in the hope that it will help to buffer future pension payments," Mitchell says. "It takes resolve to be that unambiguous about intergenerational tradeoffs."
The United States has repeatedly stumbled in its efforts to put financial priorities ahead of political hurly-burly in the administration of its Social Security system. Back when President Franklin Roosevelt championed the national public pension plan, he envisioned an agency that would collect money from workers, invest it and then pay benefits out of those contributions and investment returns, not out of current tax receipts, as occurs today. "What happened was that the pool of assets started to build up, and it was too tempting -- politicians increased benefits and reduced the retirement age," Mitchell says.
Likewise, during the Clinton administration, federal policymakers discussed investing some of Social Security funds in the stock market, which prompted all manner of political carping and caterwauling. "One group didn't want investments in companies that weren't green," Mitchell recalls. "Another was worried about companies that shipped jobs overseas. At the time, it became quite clear that it would be difficult to insulate a U.S. government investment board from these kinds of pressures. This may be one reason that the Australian Future Fund will eventually steer all of its money outside of the country."
Several of the sovereign wealth funds at the bottom of the authors' ranking don't operate in democracies and thus may face less pressure to operate transparently than their counterparts in Norway and New Zealand. Abu Dhabi, for example, is part of the United Arab Emirates and is governed by an emir, or prince, who chairs the board of the country's fund.
Mitchell says she understands the desire of money managers to operate clandestinely. "It is often the case that investors like to keep their strategies close to the vest, so as not to be preempted," she notes. That's how many hedge funds justify their secrecy. But the facts may belie those instincts. Prior research by Mitchell found that "enhanced pension reporting, including making annual reports on financial, actuarial, statistical and investment information to stakeholders, can improve returns by 2.1 percentage points annually," she and her co-authors write.
Keeping Others Out
Politics, in many forms, bedevils sovereign-wealth funds. Simply put, they are controversial and, to some people, even scary. Thus, some governments restrict investments by foreign funds or are considering doing so. "The European Commission is drafting a plan to prohibit non-European Union members from investing in the European energy business," the three scholars write. "German Chancellor Angela Merkel has mentioned designing a system similar to that implemented in the U.S., where a governmental Committee on Foreign Investment must review and approve foreign-based investments that might be deemed a threat to national security. Such financial protectionism might be avoided if these publicly managed investment pools were made more transparent, clearer in their objectives and more accountable to [their] many stakeholders."
Xenophobia and grudges may exacerbate the worries. Several of the fastest-growing funds are controlled either by countries such as China, with ideologies that often conflict with those of Western countries, or others such as Iran and Venezuela, with leaders who rail against the United States and its worldwide influence.
"These public pools of assets managed by governments are growing dramatically, just when financial markets seem particularly fragile," Mitchell explains. "The concern is that they seem to foretell a return to global financial socialism. When governments direct these large pools of money without being transparent about their objectives or their methods, this makes many politicians and financial experts nervous."
Despite these concerns, little evidence has surfaced that governments have tried to use their funds for political manipulation or chicanery. If anything, some of the recent moves by sovereign wealth funds could be deemed more stumbling than sinister. One of China's funds, for example, last year bought $3 billion worth of shares in Blackstone Group, an American private equity company. The value of Blackstone's shares has since fallen, sliding with the rest of the U.S. financial sector. Today, the stake is worth about $2 billion.
Likewise, in November, Abu Dhabi's fund shoveled about $7.5 billion into Citigroup. Like many U.S. banks, Citigroup has been sapped by its bad bets on mortgage securities, and its shares have dropped nearly 40% so far this year.
Other equally ill-timed investments may be plaguing some sovereign wealth funds, but, given their penchant for operating covertly, independent experts such as Mitchell cannot be sure. "We don't know how many of these funds might hold mortgage-backed securities and, if they do, what damage they have done to the public asset pools," she says. "We only see the tip of the iceberg, but there's a feeling that some pain has been inflicted."