Kings of Cash: The Impact of the Global Financial Crisis on Sovereign Wealth FundsPublished: March 11, 2009 in Knowledge@Wharton
The worldwide financial crisis has raised many questions about the efficacy and role of sovereign wealth funds (SWFs), the large, state-controlled investment funds typically carrying a mix of assets. Some of the largest funds, as a proportion of GDP, reside in the Middle East -- a prime example is Abu Dhabi Investment Authority, with $875 billion in assets. In the wake of the financial meltdown, most of the SWFs in the Middle East have either stopped investing or have become very risk-averse. Instead, they are now turning inward to stimulate their own slumping economies -- and thus reducing purchases of foreign assets. The need to expand government spending to moderate the hit on local economies, along with lower oil revenues, is absorbing most, if not all, of any surpluses at home.
Have SWFs in the Middle East been successful in bringing some economic stability and diversification to their domestic economies? Knowledge@Wharton asked Wharton faculty and other experts to weigh in.
A History of Competitive Returns
Generally passive investors with little significant interaction with the management of their investment targets, SWFs in the Middle East have largely followed a long-term, conservative investment strategy.
It is widely accepted that traditional reserve management by central banks, usually heavy on dollar-denominated Treasury bill holdings, generate low returns and sometimes actual losses in real terms over the longer run. Yet a typical pension fund portfolio of 60% stocks and 40% bonds -- at least up until the current crisis -- was expected to provide much higher returns in the long term. SWFs that followed the pension-portfolio investment approach generally saw higher returns, which are more consistent with returns generated by oil investments and much higher than funds that followed the central bank investment model. Now, however, the global crisis has made it clear that conservative SWFs that placed the bulk of their investments in less risky, liquid securities performed better than those that invested aggressively, an approach mostly tied to the recent oil boom. On balance, most Middle Eastern SWFs, like their peers elsewhere, are estimated to have lost up to 30% of their portfolios in the precipitous decline in global equity markets.
Yet, "if they have only lost 30%, they are doing pretty well relative to most other institutional investors," notes Wharton finance professor Franklin Allen. "I think the main lesson is that downside risks are definitely there. The last 30 years have been so good for equities that we have been lulled into thinking they must inevitably go up. This is a stark reminder of how much they can lose."
What are the likely effects going forward? Howard Pack, a Wharton professor of business and public policy, says it is too early to have a firm sense of the impact of the recent oil price decline on capital flows, but "it is certain that many of the governments such as [that of] Dubai have significant problems. Given that there was a substantial commitment of resources to diversify the economies, and that this effort was far from complete before the precipitous decline in crude prices, it is pretty certain that all of the Gulf countries will suffer from a significant slowdown in growth and substantial drawing down of accumulated reserves." He adds that the full effect of the drop in oil prices will not be known for about six months when more data becomes available, "but it would be very surprising if both the slowing of growth, perhaps a significant downturn, and large scale loss of reserves are not occurring."
Not all SFWs suffered equally, however. Libya's SWF investments of $50.6 billion have returned profits of about $2.4 billion since 2006, with 78% of the portfolio invested in short-term financial instruments and only $8 billion in equities, spread mostly across North Africa and Asia. Similarly, the Saudi Arabian Monetary Agency (SAMA), which acts as both the country's central bank and wealth manager, is understood not to have lost as much as others in the financial crisis thanks to its conservative dollar-and-bond-heavy portfolio, with only a 20% percent exposure to equities.
One important risk management lesson in all this is clear. "If your export revenue stream is correlated with global growth, not all of your wealth should be invested in assets that are also likely to be highly correlated with global growth. For funds with a stabilization mission, the value of an asset in bad times matters far more than its value in good times," noted the Council on Foreign Relations in a working paper titled, "GCC Sovereign Funds -- Reversal of Fortune," published in January. (GCC stands for the Gulf Cooperation Council, a group of six Arab nations -- Saudi Arabia, the United Arab Emirates, Oman, Bahrain, Qatar and Kuwait.)
Wharton finance professor Richard Herring notes that since SWFs are long-term investors, the fall in asset values should offer an opportunity to reallocate some assets in a way that will be highly profitable in the long run. At the same time, "I'm sure they will be looking for new and better ways to diversify and hedge their investments, since many of the anticipated diversification measures simply didn't work in a down market. They learned that the only thing that goes up in a falling market is correlations."
Just how Middle East SWFs change their investment patterns in the future "is the key issue," notes Allen. "It depends a lot on the governance in the country whose wealth they are investing. I think they will come under considerable pressure to reduce risk taking and to invest mainly in bonds."
Varying Investment Strategies
Across the world, there are an estimated 53 SWFs of varying sizes and mandates, with an estimated $3.8 trillion in assets as of early 2008. GCC funds are the wealthiest, and according to figures from management consulting firm Booz & Company, they make up about 40% of the total. In the Middle East, SWFs' critical stabilization role came into play in the 1990s when oil prices fell to around $10 a barrel. For example, SAMA, which has been accumulating surplus oil revenues since the 1970s, helped fund expansion in Saudi Arabia throughout a decade of low growth. In the aftermath of the first Gulf War, the Kuwait Investment Authority (KIA) emerged as the main driver for rebuilding the country's war-shattered economy.
Until the 1990s, Middle Eastern SWFs were primarily risk-averse investors of foreign exchange reserves that injected funds back into the local economy only in times of need. But then, several significant, regional political events highlighted the need for the region's economies to diversify revenue streams and reduce their dependence on oil. With fewer immediate possibilities at home, these SWFs started investing in relatively riskier assets abroad, such as equities and real estate. The trend gained strength as oil prices started to rise at the beginning of the new century, and ran up further support through the expansion of globalization, spurred on by institutions like the World Trade Organization.
Given the condition of world financial markets, it is not surprising that SWFs might be more wary today of making investments abroad, Don DeMarino, co-chairman of the National U.S.-Arab Chamber of Commerce, notes. "The sovereign funds are financed from retained earnings. At $40-per-barrel oil, there are other, more pressing local calls on those retained earnings. But I think of equal if not greater importance in explaining the inactivity of the funds during the meltdown is the treacherous political environment for them in the West. All the Gulf funds vividly remember the Dubai Port World debacle. The prospect that the funds might again encounter another firestorm -- this time of 'Arabs buying up assets too cheaply' -- is a real concern."
With oil prices rising, the number of SWFs grew and new entrants sought not just to serve as ballast for economic stability and investment diversification, but also to maximize returns. That drove most of them to even riskier investments. Even some of the older, more conservative institutions were sucked into the general shift of national savings from bonds, which had been the traditional style of reserve management by central banks, to value- and return-driven equity investments, once thought to be the appropriate domain of private equity and hedge funds. Examples of aggressive investors among Middle Eastern SWFs would include the Abu Dhabi Investment Authority, Kuwait Investment Authority and Qatar Investment Authority (QIA).
QIA, however, also belongs to the club of SWFs that emerged during the oil boom with a mandate to complement ambitious domestic socioeconomic development plans. These proactive SWFs seek investments at home and abroad will underpin economic development, boost knowledge and technology transfers and leverage cost advantages. These more proactive SFWs also seek more involvement in managing the companies they invest in. Other examples of proactive investors include the U.A.E.'s Mubadala Development Company and Dubai Investment Corp.
Taking the lead from Asian SWFs like Singapore's Temasek Holdings and Malaysia's Khazanah Nasional Berhad, Mubadala is probably the most successful of the proactive SWFs in the Middle East. Its 5% stake in Ferrari brought with it the potential for increased tourism to Abu Dhabi in the form of the Ferrari theme park. More recently, Mubadala has invested $8 billion in an R&D partnership with General Electric, which in turn has committed to increasing its investments and technology transfers to the U.A.E.
Whatever investment strategy GCC SWFs ultimately adopt, economists agree that the region will have to look beyond its oil wealth for future growth. Herring notes that many of these economies have a finite pool of natural resources which they are converting to better diversified assets. Over the long term, those assets can continue to produce income once the natural resources have been exhausted. "Some of the opportunities may be within their own economies, but generally they are so small relative to the world economy that it's unlikely a very large share should be devoted to domestic investments."