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Growing Sovereign Wealth?

by rziemba
August 27, 2008

Note: this post is by Rachel Ziemba of RGE Monitor, where this post also appears. Many thanks to Brad for letting me fill in again.

Today (August 26) two of the most transparent sovereign investors, the Norwegian Pension fund- Global and Singapore’s state holding company, Temasek reported their most recent investment returns. In Temasek’s case, these were for the year ending in March 2008 and for Norway from the second quarter of 2008. Both reported lower returns than in 2006/7 – which is not surprising given asset price moves in this period.

Reports from these two model funds, which represent two ends of the sovereign wealth spectrum give us some clues as to how other, less transparent sovereign investors might be faring in the current market. In fact, since many such funds appear to have suffered losses, despite the inflow of capital received by oil funds (Brad and I have been working on a paper that presents some new forecasts) might call into question the expected rate of growth of such funds. Furthermore they raise the question of whether the risk management operations of these funds are up to the challenge. Both funds note that they have been beefing up such operations as they expect the credit crisis to persist for some time to come.

How are they faring?

Temasek, which primarily takes large stakes that it manages actively – still reported a fairly significant profit – asset sales offset equity market declines. Yet, it sees the year(s) ahead as more complicated. Temasek’s report noted that 2007 was the first year in the last five in which its returns failed to clear the cost of capital hurdle. And that may only get more difficult in the rest of 2008 and 2009 given that credit costs remain elevated and profit expectations are being revised down in many markets.

Furthermore, it may have become more exposed to riskier assets – ranging from investments in Merrill to other forays into distressed assets. These may have absorbed much of the new capital injected. By increasing its holdings in the financial sector (which now makes up 40% of its portfolio- up from 38% last year), it may be less diversified. Given large investments in Merrill and Standard Chartered, one might actually be surprised that the exposure to financial institutions is so low. Its new purchases were offset by sales of Chinese and other banks in which it booked profits. And its 19% stake in Standard Chartered, one of the best performing global banks- in part because of its exposure to corporate banking in Asia and the Middle East, has been profitable.

Singapore’s holdings in the OECD actually rose in 2007/8, though it continues to up its allocation to Asia ex Singapore and Japan. In this way, like GCC funds it may have actually increased not decreased exposure to the U.S. in light of the crisis. And it may do so in the future.

Temasek is a model for many other countries, particularly in Asia and the Middle East who seek both to diversify their economies and improve the returns on their state companies and to increase profits. The Temasek model, if there is one, is to invest in state companies, improve the governance to extract better returns. The next step is (partial) privatization whose proceeds free up capital to be invested elsewhere in corporate stakes. In those investments Temasek also takes on a direct role if not necessarily controlling stakes.

Norway’s assets under management on the other hand are actually lower than they were six months ago at least in Norwegian Krone. (See the link for some of my past analysis on the GPF at RGE Monitor). In fact, despite almost $63 billion in new capital, transferred from Norway’s oil revenues, the funds market value increased by only about $10 billion. In part, Norway, which approved an increase in its equity allocation last year, may have diversified either too late or two soon. When equity markets (especially in Europe and Asia) were booming in 2003-2007, their bond- heavy asset allocation, meant they had to keep buying bonds, depressing returns. They began implementing the asset allocation shift about a year ago. While they may have been able to purchase some of their new equities at cheaper prices, they may have bought well above the bottom. Norway’s equity portfolio exceeded half of the total portfolio for the first time in its history in Q2..

Yet, Norway’s purchases – stemming from its need to place $6 billion a month at current oil prices, may have modestly helped support European equities. Norway, which has been the largest holder of European equities for some time, now holds more than 1%. Norway’s managers did manage to provide a small return in excess of the benchmark portfolio and losses were 1.9%, less than the 5.6% in losses in Q1.

Norway’s recently approved asset allocation shift to branch into real estate and add several new emerging markets is not yet evident, but it has already laid the groundwork to take larger stakes. Its new risk strategies and capital strategies groups can take larger stakes in the market and across asset classes. Furthermore, todays report also takes a sanguine look at the risk management model, which assumed a normal return curve – and “has underestimated the actual risk in the portfolio” Something they are now supplementing with more analysis.

With the big caveat that its impossible to generalize across the spectrum of sovereign investors, it does seem likely that Norway and Temasek are not alone in suffering losses in their portfolios. If key sovereign wealth funds like those of Kuwait and Abu Dhabi held benchmark indices, their assets under management might actually be lower now than they were a year ago – despite large inflows from a near 50% jump in the oil price. Of course such index based returns may understate (or overstate) returns and assets under management. And if they did suffer such losses, that would put them in the company of many private sector counterparts. In fact, of the GCC funds, the Saudi Monetary Agency, with its bond-heavy portfolio and large inflows, likely saw the largest increase in assets.

Recent accounts have been critical of the investment strategies of sovereign wealth funds, noting the sharp losses sustained thusfar, in their most visible investments – the investments in US and European financial institutions. Many have lost well over 50% – losses which are only partly offset by high interest payments on the preferred shares. But these aren’t the whole portfolio. The more we know about these funds, the more many of them seem to have asset allocations similar to private sector counterparts, whether they be private equity style funds, scaling up capital with leverage (and increasingly costly thing to do even for cash-rich funds) or more classic endowment like funds. Increasingly a vast array of pension funds, endowment funds, sovereign funds all seem to be coalescing to a similar asset allocation – high equity, more exposure to alternatives, real assets like commodities and less exposure to bonds. And everyone wants more emerging market exposure.

Recent research by Olivia Mitchell of Wharton and two co-authors suggests that sovereign funds have a long way to go before they are models of transparency, risk control and optimal asset allocation. In many ways the three go together – and it is possible to have the last two without the first. However without transparency, it is harder to grasp how funds might respond in the future – particularly if they incur losses that could become politically unpopular. Furthermore, a better understanding of the overall liabilities against which these long-term assets are implicitly if not explicitly measured, is needed. While by definition most sovereign funds have no explicit liabilities like a pension fund or a social security trust fund, most are assumed to offset fiscal fluctuation or long-term financing needs. But the sophistication and investment expertise of funds varies. Hopefully such governance and risk control ‘good practices’ are among those being discussed in the IMF’s working group on sovereign funds.

24 Comments

  • Posted by Twofish

    bsetser: Recent research by Olivia Mitchell of Wharton and two co-authors suggests that sovereign funds have a long way to go before they are models of transparency, risk control and optimal asset allocation.

    I’m wondering what they are using as the benchmark for transparency, risk control, and optimal asset allocation. Also, I think that far too much emphasis has been placed on the value of transparency. Most portfolio managers are quite non-transparent since anyone with a transparent portfolio is going to find themselves at a huge advantage when they actually start to buy and sell assets. Knowing that a big fund is even interested in a company is going to drive the asset price sky high.

    Also the benefits of transparency are also overrated when it comes to funds. For public companies and mutual funds, if you think the managers are being crazy idiots, you sell your shares and get out. For funds, there is nothing that the average person can really do if they think it is badly run.

    It’s also funny when you have the IMF talk about the benefits of transparency in governance.

    bsetser: Hopefully such governance and risk control ‘good practices’ are among those being discussed in the IMF’s working group on sovereign funds.

    I think that the IMF’s working group on sovereign funds looks to me like a committee designed make sure that the IMF takes no effective action with respect to SWF. Spending years and years coming up with a set of voluntary principles is your classic “lets look busy so nothing gets done” routine.

  • Posted by bsetser

    2fish — i suspect your comments should be directed at rachel ziemba. I am not writing on the blog this week. detox.

  • Posted by fatbrick

    It all depends on who you are compared with. If you compare SWFs with BS, or Citi, LEH…you will find that SWFs probably beat those IBs, which have the most brilliant MBAs with the highest wages in the world.

  • Posted by Twofish

    fatbrick: you will find that SWFs probably beat those IBs, which have the most brilliant MBAs with the highest wages in the world.

    Not necessarily. There are people in IB’s that make extremely high wages, but most people make high but not shockingly high wages. A physics Ph.D. is also usually a better route into investment banking than an MBA. It depends on the bank, but people in IB’s aren’t exclusively Ivy Leaguers. You do have very serious problems if you have a market in which talent is on one side of the deal. Investment bankers are basically salesman and if you rely on salesmen for your main source of information, you are going to get into trouble.

    Also, I really doubt that there was ethnic discrimination. More likely is that the criteria that universities use to evaluate students aren’t the ones that Asian parents think are important. In particular, once you reach some thresholds standardized tests are given very low weight. Things like social activities and sports are looked at very highly by American universities. In any case, unlike most Asian countries, not getting into the school of your first choice doesn’t impact the rest of your life.

  • Posted by Dave Chiang

    Hey shrek,

    Gee, Brad Setser’s blog now attracted so many China haters, amazing. I highly recommend those Americans who are worrying about China first look in the mirror at themselves, and worry about yourselves! Yes, China has many problems, so does the US! My guess is that the US will FALL before China!! The United States is no longer a meritocracy but kleptocracy where self-proclaimed C students with 1100 SAT scores go to Ivy League Universities and become the President.

  • Posted by bsetser

    i checked into the comments from the beach and wasn’t too happy with what i saw; just because i am on vacation doesn’t mean that the comments are a place to raise your pet concerns. the comments need to be directed at the issues raised in rachel’s post. thanks.

  • Posted by Beau Butts

    At this time of currency uncertainty, it is suprising that none of the big SWF’s have taken advantage of the ability of their central banks to invest in SDR denomintated accounts at the BIS. Norway, for example could have placed used their central bank as a conduit to place a term account that would have protected them from currency volatility as well as from the market risk. While the returns may not be as high as with some other investments, during this time of economic uncertainty it is suprising that such low risk options are not being explored.

  • Posted by pswartz

    Rachel – I’d be interested to understanding how fund think about the base currency that they are measuring returns in. In the case of fund that have explicit liabilities then it is clear that the measuring stick should be what they need to pay in (even if that is a mix). In these long term funds with real purchasing power goals, although not entirely clear what those purchase are, it is not clear to me what the base should be. Thought? Although it not a economic issue, are they concerned (for those who dollar base) that they are masking bad real purchasing power returns with fx gains on foreign assets? How do you think about this problem?

  • Posted by Twofish

    Butts: At this time of currency uncertainty, it is surprising that none of the big SWF’s have taken advantage of the ability of their central banks to invest in SDR denominated accounts at the BIS.

    It’s actually not. The problem is that in order to use a currency for storage anything there needs to be an active market for financial assets that is traded in that currency, and that isn’t true for SDR’s.

    There are only two currencies that SWF’s can denominate their bulk of their assets in, dollars and euro, and the problem with the euro is that the EU has absolutely nothing like US Treasury bonds that you can as a fail-safe storage for wealth.

    Part of this is what I call the elephant problem. If you want to create a storage space for your pet hamster, that’s easy. You find a shoebox or buy a cage that you can tuck away in your apartment. If you want to store an elephant or 10,000 hamsters, then it gets harder.

    So stuffing a SWF’s assets into SDR accounts is like trying to push an elephant into a hamster cage. There’s just not enough room.

  • Posted by Rien Huizer

    Amazing that people continue to classify Temasek under SWFs (does it mean that a SWF is any entity involved in cross border investment owned by a state and not being a central bank)

    Anyway, Temasek is a conglomerate of mainly majority-owned companies, ultimately owned by a Singaporean entity entity called “The Minister for Finance Inc. Temasek is not the only asset of said Inc.

    Including entities like Temasek would expand the scope if “SWF” too much, oe even make it pretty meaningless.

    This is not to say that Temasek is an ordinary private company. If it was not government owned, and subject to strategic objectives the Spore gvt may have, it might have a different structure and asset management criteria. As it is, it seems to be pretty unique and highly specific to the political economic regime of Singapore.

    I have many problems with calling something which is clearly a conglomerate, hence not a “fund”, invested to a very large extent in large local companies, and not funded from either FX intervention residuals, nor resource revenues, a “sovereign wealth fund” because it is entirely different from both the Norwegian fund and entities like Adia. and its sibling GIC (in my opinion a proper “fund”, investing (almost?) entirely abroad and in general in a passive quality.

  • Posted by RebelEconomist

    Twofish,

    Do you know about the services that the BIS offers? Do you know about euro government bond markets? If not, you should be more circumspect about giving your view.

    I know a little about the BIS, and I dare say that they would accept an SDR deposit from a central bank in the order of a few billion dollars worth – enough for some diversification, but not a major allocation. I would expect settlement to be in the dollar, euro, yen and sterling constituents of the SDR though. Whether an SDR holding would represent a low risk strategy depends on what currency the central bank has a need for and therefore provides its benchmark for reserve management. There are enough AAA euro government bonds, plus supranationals etc to absorb as large an allocation to the euro as most central banks or SWFs would like to make. In my view, German bunds and French OATs/BTANs are as “fail safe” as US Treasuries these days.

  • Posted by Cedric Regula

    There does seem to be a shortage of quality investments in world, especially of the fixed income variety.

    It’s frustrating that you can have a global credit crunch, 4% or less long term government bonds in the entire developed world, and more than 4% inflation everywhere, all at the same time.

    But demographics would explain part of it. The aging population in the developed world should have lots of retirement assets accumulated.

    It’s amazing to think what it would be like if the US was one of them? What if we really had a SWF instead of a social security fund full of non-marketable IOUs from Congress?

  • Posted by bsetser

    2fish “There are only two currencies that SWF’s can denominate their bulk of their assets in, dollars and euro, and the problem with the euro is that the EU has absolutely nothing like US Treasury bonds that you can as a fail-safe storage for wealth.”

    Two points:

    one: as Rebel notes, German bunds and French OATs are as good as treasuries, setting the issue of currency risk aside.

    two: Bunds and OATS are better than Agencies, and Agencies have absorbed about 1/2 the central bank inflow into the US market over the last year.

  • Posted by Beau Butts

    Actually, if you go to the BIs website you will find that they do offer SDR denominated accounts that are filled by depositing an SDR currency and that are paid out in an SDR currency but while they are dpeosited with the BIS are denominated in SDR (thus hedging currency risk and giving you better options for for withdrawing your money when the time comes). The reason to do this through the BIS is that actual SDRs are so limted that Twofish is quite correct as to their unavailability.

    I am still curious why SWF’s are taking the risks that Ms. Ziemba describes for such miserable returns. Is it an effort to avoid questions about the value of the experts and their salaries if they are going to go with safe simple investments instead of Norway’s stock portfolio or the actively managed portfolio of Temasek?

  • Posted by Twofish

    Rebel: Do you know about the services that the BIS offers? Do you know about euro government bond markets? If not, you should be more circumspect about giving your view.

    Yes and yes.

    Rebel: I know a little about the BIS, and I dare say that they would accept an SDR deposit from a central bank in the order of a few billion dollars worth.

    That’s fine. However, what if someone wants to deposit US$500 billion instead of US$5 billion? Also what does the BIS do with a US$500 billion deposit. Well it has either absorb currency risk or split them out into the various parts and then invest those funds, but then what’s the point of doing that, since the investor can do currency allocations by themselves.

    Rebel: I would expect settlement to be in the dollar, euro, yen and sterling constituents of the SDR though.

    In which case, what’s the point of buying SDR’s rather than the constituents directly?

    Rebel: There are enough AAA euro government bonds, plus supranationals etc to absorb as large an allocation to the euro as most central banks or SWFs would like to make.

    There are about $4.3 trillion in treasuries and then another $4 trillion in GSE’s. There is about $2.5 trillion in EU national government debt, and EU rules prevent the amount of EU national debt from increasing substantially, so if SWF’s where to suddenly move from US treasuries to French/German treasuries, there isn’t an coordinated way of increasing the supply of EU national treasuries.

  • Posted by Twofish

    Butts: I am still curious why SWF’s are taking the risks that Ms. Ziemba describes for such miserable returns.

    In the case of the China Investment Corporation, investing in financials seemed like a good strategic move at the time, However these were small experimental investments, and when they seem to have blown up there seem to have been a lot of political ramifications back at home.

    One thing about managing a $700 billion fund is that there are just limits to what you can do. If you have $50 million, you can do matress arbitrage which means that if things get bad, you go to the bank, make a $50 million withdrawal in paper money and the stuff it into your matress so that you worst possible return is zero percent.

    You can’t do that with $700 billion. There is only about $900 billion in paper money in circulation, and so getting to the point where you end up with zero percent return is non-trivial.

  • Posted by Judy Yeo

    The question is probably not so much getting 0% return but what happens when that return turns -ve? What type of accountability is there? What kind of consequences await those in executive positions in SWFs if any or are SWFs all that more”patient”?

    Rien

    So what would you see GIC as? Temasek may not have started off as SWF but it has almost definitely been behaving like one. Is it really just the name or the function?

  • Posted by Twofish

    Yeo: What type of accountability is there? What kind of consequences await those in executive positions in SWFs if any or are SWFs all that more”patient”?

    If your performance is absymal then your boss gets annoyed and you lose your job. Also it’s standard in finance to have performance related bonuses so your salary depends on how well you do.

    However, defining performance is very, very tricky. For example, if you define performance as the amount of return then the money manager is under huge pressure to take lots of risks to maximum return since if he wins the lottery, he makes megabucks, but if he loses then it doesn’t matter if he loses $10,000 or $10 billion, he is going to get fired anyhow. And then you have the ‘who watches the watchmen’ problem. You are hiring the money manager because he supposedly is an expert, but then who tells you that he is an expert, and then who tells you that the person that tells you that he is an expert is an expert…. etc…. etc…

    However, these are some well known problems in portfolio management, and people have come up with solutions to these problems. Curiously, I’m not worried about accountability. In most private corporations, senior management is effectively not accountable to anyone. Theoretically they report to the shareholders, but because shareholders are unorganized, there’s pretty much nothing that they can do. If you end up losing a bunch of money in the Russian, Chinese or UAE SWF, someone is going to be very upset, and they are going to have the will and ability to do something to you.

    You actually see this in the case of CIC, in which the bad banking investments it made last year have seriously damaged its political authority.

    The things that worry me are:

    1) small countries. China and Russia can afford experts to manage their SWF’s, but I worry about Upper Volta and Mozambique. This is a huge problem in the US because there are horror stories about small counties and states just not having the right managers and they end up relying on salesman to make investment decisions. The fact that you had all of these salesmen telling people that GSE corporates are the same as agency pass-throughs worries me.

    2) coordination. Country A does something that seems rational. Country B does something that seems rational. Country C does something that seems rational. Put them together and then they end up messing up the world economy. This also happened with quant hedge funds last year. The IMF working group on SWF’s seems like a reasonable forum for SWF’s to talk to each other about what they are doing. The trouble then becomes that no SWF is going to discuss what it is doing if it is going to be in tomorrows Wall Street Journal.

    3) complexity. The world financial system is just getting more complicated, and we are doing things that have never before been done in human history. Unexpected things will happen.

  • Posted by Dave Chiang

    Commodities boom isn’t ending anytime soon. It has just been taking a break from the Beijing Olympics. LOL.

    Chinese skyscraper builders to put up equivalent of 10 New Yorks, says Rio Tinto
    Wednesday August 27 2008
    http://www.guardian.co.uk/business/2008/aug/27/riotinto.commodities

    Rio Tinto yesterday shrugged off talk of an impending collapse in the commodities market, pointing to recent research that suggested China will build up to 50,000 skyscrapers in the next 20 years, the equivalent of 10 New Yorks, creating sustained long-term demand for steel and other raw materials.

    Metal prices have come off their highs after five years of strong growth, but Skinner said the credit crunch had had only a “modest” impact on Rio’s markets.

    The company said that North America and Europe were becoming decreasingly relevant to the setting of metals prices, as demand is driven by China, India and other emerging markets – Chinese imports of iron ore are running 20% ahead of the same point last year. In the first half of the year, Rio lifted prices of iron ore by an average 86% compared with 2007, even as economies in North America and Europe were weakening. The average copper price charged by Rio in the first half was 20% higher than last year, gold was 38% higher and aluminium prices were up 2%. The company said 2009 was likely to be the sixth successive year of higher prices.

    By 2025, the report predicts that China will have 221 cities with more than a million inhabitants, compared with 35 in Europe today. As well as the need for huge spending on infrastructure, McKinsey projects that China will build between 20,000 and 50,000 skyscrapers, many of them in less developed interior provinces far from Beijing and Shanghai.

  • Posted by Dave Chiang

    Chinese Banks cut GSE Agency Debt for US Treasury Bonds
    http://www.nakedcapitalism.com/

    Bank of China has cut its portfolio of securities issued or guaranteed by troubled US mortgage financiers Fannie Mae and Freddie Mac by a quarter since the end of June.

    The sale by China’s fourth largest commercial bank, which reduced its holdings of so-called agency debt by $4.6bn, is a sign of nervousness among foreign buyers of Fannie and Freddie’s bonds and guaranteed securities.

    Foreign investors have been a mainstay of the market for such debt, but uncertainty over the mortgage financiers’ capital positions and the timing and structure of a potential government rescue has made some investors reassess their exposures. Asian investors in particular have become net sellers of agency debt, said analysts.

    Federal Reserve custody data shows that for the year to July, foreign official and private investors bought an average of $20bn of agency debt a month, including debt issued by other government agencies such as Ginnie Mae and the Federal Home Loan Banks. Purchases of US Treasuries averaged $9.25bn.

    From July 16 to August 20, foreign investors sold $14.7bn of agency debt, trimming their overall holdings to $972bn. They purchased $71.1bn of Treasuries in the same period…..

  • Posted by RebelEconomist

    Twofish,

    I think your factbook dates back to the time of Upper Volta. German and French government debt alone amounts to over $2.7bn outstanding, and then there are other reasonably liquid AAA bonds such as Dutch State Loans. There are about $2bn of Italian government bonds, and lots of covered bonds which might be regarded as the equivalent of agencies.

    Central banks may use SDR BIS deposits because they are administratively convenient (like holding an index fund instead of the index) or because their base currency is SDRs.

  • Posted by RebelEconomist

    Sorry, I should have written $tn, not $bn in the above.

  • Posted by Rien Huizer

    Judy,

    GIC is partially a SWF, partilally a CB (remember that GIC also invests on MAS’s behalf. Its funding is GVT o S accumulted budget surpluses, CPF funds (not much these days) and anything else that is not funding Temasek. Temasek should be a stand alone entity, but who knows it may borrow from CIC, or one of its own minority investments like DBS. Perhaps Mr Dhanabalan or mr Qianlong knows. If they spend their time wisely, they will surely set some time aside to read this blog.

    But really, if Temasek is an SWF what are other state conglomerates? Does it matter if state owned conglomerate is owned by a government that calls itself democratic, or a less hypocrite one that calls a spade a spade and simply trie s to delver “good government”. Anyone interested in Singa pore should, of course, like Twofish, familiarize with the Greek classics.

    SWF is simply a term coined by a few salesmen in an investment bank to differentiate certain clients from the genus “central bank”. Same discretion, ;less boring (and unprofitable) product range, and with a little bit of luck managers who consider themselves sophisticated. I have a lot of respect for the people at both GIC (a true SWF and a very experienced and well run one) and at Temasek. It makes me wince what some people write about these entities, but perhaps tthe Spore gvt should stop trying to be an unusually good one and make fewer ennemies among he people who try to make a living off the vain and gullible. Being a staunch ally of the US does not mean that the nation’s wealth must be handed over to the wizards of Wall Street.

    Probably, Judy, you’ve caught my drift. I doubt many others have.

  • Posted by Rien Huizer

    Twofish,

    While Brad is away your widsdom is overwhelming. No critical comments on my part this time. Although, a little shift in the rationality with which I endowed my character could mean a challenge. For instance suppose that politicians in SWF states had good (i.e. selfish) reasons for having SWFs. What about stationary bandits? Autolycus is no Zhuge, but Zhuge never had real power. Figure this one out over the weekend.