"Four myths about sovereign wealth funds"

A good post at VoxEU by Edwin M. Truman seeks to clear up some misconceptions about sovereign wealth funds.

One question is how widely these misconceptions are shared and what difference they make. For instance, #2 on Truman’s list of four myths is that sovereign wealth funds are all equally opaque. I’m not certain that anyone would assume that, and in fact, some SWFs, like Norway’s, are pretty open.

But on a practical level, I’m not certain that transparency is as much of a boon as the public might think. Large equity investments in companies, which is the main source of worry, will wind up being disclosed by public companies (or governments can require that investements over a certain threshold be reported). SWFs can disclose their holdings and policies, swear up and down that they plan to hold only passive stakes, and guess what? A change in regime back home and those policies can change.

But the fear of SWF investments in corporations is way overblown. Why? If you are going to depend on foreign capital, you want the investors to be in illiquid assets. The real danger to an economy dependent on foreign capital is that it might exit suddenly. Of course, the problem is that with foreigners now owning close to 60% of Treasuries. the most liquid instruments in the world, we are already at risk.

I am also not at all certain I agree with Truman’s misconception # 4, “Sovereign wealth funds are not like hedge funds.” Huh? He appears to have overdramatized his point. SWF are accountable to governments. They are not in the business of taking risk (their public position makes them loss averse and therefore rather cautious. China’s investment in Blackstone has been widely criticized because it went south, and quickly too). Indeed, most use conventional asset allocation models similar to those used by international fund managers. Yes, they do invest in private equity funds and hedge funds, the commitments are large in dollar terms but do not (yet) constitute large shares of their portfolios.

From VoxEU:

Sovereign wealth funds are a hot topic, but they’re poorly understood. Four popular myths are that sovereign wealth funds are (1) about “them” not “us”, (2) all the same in their opacity, (3) a net benefit to the international financial system, and (4) not like hedge funds. This column explodes those myths and outlines a framework of reciprocal responsibility for sovereign investors and their investment recipients.

Sovereign wealth fund, a generic description of governmental investment activities, is a term that was coined just three years ago by Andrew Rozanov (2005). I identify sovereign wealth funds (SWFs) as separate pools of government-owned or government-controlled financial assets that include some international assets, which total at least $4 trillion by my latest count. Sovereign wealth funds take many forms and are designed to achieve a variety of economic and financial objectives – from stabilisation to intergenerational wealth transfer. They properly include government pension funds to the extent that they invest in marketable international assets. The very diversity of sovereign wealth funds may be one reason why they are poorly understood.

Myth 1: Sovereign wealth funds are about “them” not “us”

The media and many analysts would have one believe that sovereign wealth funds are entities established by non-Western, often non-democratic governments in pursuit of economic and political objectives that are orthogonal to those of traditional, market-oriented industrial countries. That may be a reasonable characterisation of a few funds but not of the vast majority. Industrial countries hold more than 40% of SWF international assets and about two-thirds of $8 trillion in total SWF assets. The United States leads with at least $800 billion in SWF international assets (second only to the United Arab Emirates). It is followed by Norway with more than $400 billion and the Netherlands and Japan with close to $300 billion. Tiny New Zealand’s Superannuation Fund holds about $8 billion….

Myth 2: Sovereign wealth funds are all the same in their opacity

To many observers, a sovereign wealth fund is synonymous with a lack of transparency. For them, the current IMF-facilitated process to establish a set of generally accepted principles and practices for sovereign wealth funds should aim at increasing their transparency. In fact, the principles and practices primarily should aim at increasing SWF accountability, first, to the citizens of the countries that are the ultimate owners and presumptive beneficiaries of the funds and, second, to the citizens and politicians of countries in which they invest, as well as to all participants in financial markets. As I have established in my scoreboard for 46 pension and non-pension sovereign wealth funds of 38 countries, individual funds differ substantially in their current practices (Truman 2008a and 2008b).

What we observe in the SWF scoreboard is that no fund receives a perfect score. The scores of the funds range from a high of 95% on my 33-element scale to a low of 9%.1…Fourteen funds have scores below 30%, including those of countries with some of the largest funds like the United Arab Emirates and China. (However, it is notable that China’s National Social Security Fund scores in the top group.) …

Figure 1 Sovereign wealth fund scoreboard

Thus, it is grossly misleading to generalise about the practices of sovereign wealth funds…

Myth 3: Sovereign wealth funds are a net benefit to the international financial system

One often reads statements that sovereign wealth funds provide unique benefits to the international financial system because, for example, they make needed capital injections into western financial institutions. No one should doubt that the recipients of those capital injections have benefited from them, and in time the citizens of the countries with the funds may benefit as well. However, sovereign wealth funds are not net providers of capital to western financial markets. For the most part, they are merely recyclers of global financial flows. In this respect, they do not differ from central banks and other government-controlled entities or from private sector investors….

Myth 4: Sovereign wealth funds are not like hedge funds

Another frequently heard refrain from supporters of sovereign wealth funds is that they are patient pools of capital with long-term horizons and are not like hedge or private-equity funds in their short-term speculative activities and use of leverage. Regardless of whether one thinks that patient capital is a net benefit to an economy or financial system, and most economists would argue that it is not, the facts do not support these intended favourable comparisons with hedge and private equity funds. Sovereign wealth funds invest extensively in those types of entities, as well as in other highly leveraged financial institutions such as commercial and investment banks whose activities, including the use of leverage, are indistinguishable today from those of the other two types of financial institutions. In effect, sovereign wealth funds provide the capital to be leveraged to generate the high rates of return.

Thus, those concerned about the accountability and transparency of highly leveraged, private sector institutions should be at least equally concerned about the accountability and transparency of sovereign wealth funds. Moreover, because sovereign wealth funds are owned and ultimately controlled by governments, it is naïve to believe that they can or should be treated as apolitical. The standards applied to sovereign wealth funds should be higher than those applied to private sector institutions precisely because they are governmental institutions that are not subject to the discipline of the market and ultimately are accountable to the citizens of their countries.

A framework of reciprocal responsibility

Having dismissed four myths about sovereign wealth funds, two on each side of the on-going debate, what should policymakers think and do about such funds? Policy makers should establish a framework of reciprocal responsibility for sovereign wealth funds.

Countries with the sovereign wealth funds should embrace a robust set of principles and practices to demystify the activities of their funds and to provide greater confidence to their own citizens that the huge amounts of financial resources involved will be deployed prudently according to the highest ethical and financial standards. Doing so implies setting aside national cultural norms and recognising that the stability of the international financial system requires that sovereignty stop at the water’s edge.

Countries receiving SWF investments should strengthen their openness to foreign investment from whatever source, subject to limited safeguards protecting national security narrowly defined. Moreover, countries receiving SWF investments should be careful what they wish for if they want their own sovereign wealth funds to receive national treatment in their international investments.

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One comment

  1. Anonymous

    someone claimed in the comments of my blog that GIC is 3x leveraged. QIA and a host of smaller gulf funds (a Dubai fund and Bahrain’s fund) are clearly borrowing tho in a more PE style. and I heard a fairly credible rumor from someone in a position to know that a couple of big SWFs were considering in house hedge funds as “talent” was cheap (I strongly argued against this — noting that soveriegns shorting other countries currencies and banks could easily be misinterpreted).

    so i would agree with Ted (who i worked for at one time) on his point that SWFs use leverage to increase their returns — whether by investing in intermediaries that use leverage or more directly.


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