Sovereign Wealth Funds: Hidden Riches
Sovereign wealth funds (SWFs) hold more assets under management than either private equity funds or hedge funds. Yet it’s tough to pinpoint what, exactly, they are. In October, Patrick Bolton, the Barbara and David Zalaznick Professor of Business at Columbia Business School and a Chazen Senior Scholar, organized a two-day multidisciplinary conference on SWFs that featured Nobel Prize laureates Al Gore and Joseph Stiglitz, and scholars and researchers from around the world. Among the questions debated: what distinguishes SWFs from other investment vehicles?
Broadly speaking, SWFs are funds created and owned by a government to hold reserves and other assets for long-term investment. SWFs differ from other types of investment funds in that the money being managed is state-owned and generally comes from either commodity and manufacturing exports or the accumulation of foreign exchange reserves. Well known examples are Norway’s Government Pension Fund (NBIM), which is funded out of Norway’s oil and natural gas export revenues, and the China Investment Corporation, which is funded out of China’s foreign exchange reserves.
SWFs, as state-sponsored investment vehicles, differ from other types of asset-management firms in their policy objectives. With a much longer time horizon — their mandate being the preservation of wealth for future generations — these funds have fundamentally different objectives than other, more short-term institutional investments. As state-owned funds, they also have (or ought to have) greater concerns for socially responsible and sustainable investment.
Chazen Global Insights
Chazen Global Insightscaught up with Bolton after the conference to get his take on the challenges SWFs will face in the coming years — and why anyone involved in public policy or investing should give them a second look.
Chazen Global Insights: Why would a nation need to have a sovereign wealth fund?
Patrick Bolton: The best and simplest case you can make for SWFs is that they are a way to transform natural resources into financial wealth. Say you’re an oil-producing country and the price of oil goes up. There’s all this money flowing in. The big concern then is what people refer to as the “Dutch disease” [the negative consequences of a large cash influx into a country, usually sparked by discovery of a natural resource: the value of the currency goes up, making its manufactured goods more expensive for other countries to buy]. This money gets spent and crowds out all other economic activity. So where you see SWFs is primarily in commodity-producing countries. One way of counteracting this Dutch disease is making sure that revenues that flow in don’t get spent. They get parked in a fund that becomes an important financial asset for future generations.
CGI: Al Gore was arguing in his speech that SWFs can also stem global warming. That seems like a lofty claim.
PB: Right. The point is, you have these assets to manage. Your horizon is 50, 80, 100 years — really long term. So you have to look down the road. Which assets are going to have a return 50 years from now? If climate change is headed where a lot of evidence suggests it is, at some point there will be a price on carbon emissions. When that happens, oil-producing companies, and electric utilities that run on gas and coal, will be a lot less profitable than utilities that rely on wind or solar power. If you invest in solar energy today, you may lose money. But 50 years from now you may be sitting on a huge return. So because SWFs are long term, they have to factor into their asset allocation what they can do to hedge that risk or profit from it. So they invest in renewable energy, which helps these companies grow and drives down costs.
CGI: That sounds pretty straightforward. Why, then, are SWFs so controversial?
PB: A couple of reasons. As Antoinette Schoar [of the Sloan School of Management at the Massachusetts Institute of Technology] pointed out in her presentation, the people who run these funds have competing pressures. Do they maximize returns? Or do they bolster struggling industries by investing in them but possibly dampen the fund’s returns?
And there are questions about how these funds are managed. Research shows that when politicians are involved in the decision making, that strongly negatively impacts returns.
CGI: That ties into another issue that was discussed a lot at the conference: transparency.
PB: Right. The best way for fund managers to shield themselves against potential accusations of political favoritism in investment choices is to be transparent, saying, “This is what we do, this is how we invest, these are our returns.” But if you ask them to be more transparent, the first thing they will say is, “That’s like stealing intellectual property. We’ve worked on an investment strategy to figure out how we can build returns. We don’t want other people to just take that and run with it.”
CGI: But aren’t there different degrees of transparency?
PB: From the point of view of SWFs, transparency is more about how they deal with the sponsor government. They’re more ambivalent about transparency vis-à-vis the rest of the world. That’s an important distinction.
CGI: If I’m a business leader or policy maker, why should I care about what’s going on with SWFs?
PB: If you’re looking to fund a long-term project — California, for example, has now decided to build the biggest wind farm in the world — SWFs are a very important class of investors. There are so many infrastructure investments that need to be made. Where’s the money going to come from? SWFs are a very good source.
CGI: But the typical solution would be to simply float a bond issue.
PB: But who’s going to buy the bonds? SWFs. And if you want equity stakes, SWFs are a natural fit. Even when you do pitch a huge bond issue, where’s the road show going to be? You’d better look at SWFs.
We’re talking about an asset class that’s gigantic. Many countries don’t have well-trained managers they can rely on to run these hundreds of billions of dollars in assets. Giving them professional managerial capabilities to run these SWFs will be a big part of the future.