October 9, 2011

Sovereign Wealth Funds: Big Players with Some Big Problems

As an asset class, sovereign wealth funds total more than either private equity or hedge funds. Here’s how they could affect you and your portfolio in the months ahead.

Betsy Wiesendanger and Christen Marie Soden

If you haven't kept tabs on sovereign wealth funds (SWFs) lately, you might want to start. They're huge players in world markets — as an asset class, they total more than either private equity or hedge funds. They're also a major source of capital for banks. Because SWF portfolio values have been dampened by the European debt crisis, banks could have difficulty getting the recapitalization funds they need.

SWFs are created and owned by a government to hold assets for long-term investment. They differ from other types of investment funds in that the funds being managed are state-owned; they generally come from either commodity exports or the accumulation of foreign exchange reserves. Well known examples are Norway's Government Pension Fund, which is funded from Norway's oil and natural gas export revenues, and the China Investment Corporation, which is funded from China's foreign exchange reserves.

To get an update on SWFs, Chazen Global Insights caught up with Patrick Bolton, the Barbara and David Zalaznick Professor of Business at Columbia Business School and a Chazen Senior Scholar. Bolton is co-chairing a conference on SWFs in Paris October 17–18, 2011 featuring Nobel Laureates Al Gore and Joseph Stiglitz.

CGI: What topics will people be buzzing about at this year's conference?

Bolton: If you look at the typical sovereign wealth fund, how did they do in the past year or six months? Most likely they did not do so well, especially if they have been holding a lot of European debt. Given their mission — to preserve wealth for future generations — they're probably overly focused on traded securities, either fixed income or equity. With what equity and sovereign debt markets have just gone through you wonder if that's really wise. That's likely to be a question that will be debated. A related second question is, how concerned should the SWFs be with the current market movements? Is it a temporary thing?

CGI: Is there an opportunity for SWFs to rebalance after the European debt crisis? You'd think that, because their time horizon is longer than most portfolios, they're likely to sit tight.

Bolton: That's really a sustainability question. When you look at SWF portfolios, it doesn't make much sense to say that current valuations are a reflection of fundamental value. You have to look at equities now in terms of the massive flight to quality we have seen. If you are a fund manager who has to deliver returns on a quarterly basis, you're really in a tough situation right now. But if you are a long-term investor like SWFs, you can look at this environment and say “Well, really I'm investing for future generations. I should be able to pick out now the stocks that seem way undervalued on a long-term basis.”

CGI: At last year's conference, you proposed an international green fund that would help SWFs from different countries coordinate investments in sustainable energy. Has there been any progress on that front?

Bolton: Some of the funds here are really way ahead of others. For example, the Mubadala fund in Abu Dhabi. It has a sustainable coordinated investment strategy with the goal of making Abu Dhabi's economy dependent only on renewable energy by 2030. They are investing in big solar energy plants and have a major collaboration ongoing with General Electric. That's one striking example. The big point is that there are many areas where this kind of infrastructure investment can happen around the world, such as investments in more efficient electricity grids and in electric vehicles. But you need institutions and a process to facilitate the reallocation of sovereign wealth funds' capital to those investments. SWFs cannot take on this major investment reallocation effort on their own. They need access to investment platforms or dedicated green infrastructure funds that still largely need to be developed.

CGI: Not all countries have SWFs. Nigeria and India don't, for example. What are the barriers to starting one?

Bolton: It could just be that they saw other countries do it and they saw the benefits and now they want to do the same. The harder question is: do they have the institutional capabilities? In the case of Nigeria, that would be a question mark. Think about Libya right now, for example. They had a sovereign wealth fund, and what good did it do to Libya? It was basically run by the Gaddafi family and Gaddafi cronies. Thus, the governance issue is very important.

CGI: Why should our readers care about SWFs?

Bolton: A lot of the day-to-day big decisions in capital markets will involve, one way or another, sovereign wealth funds. For example, in the current context, where are banks going to turn to for capitalization? One obvious source is sovereign wealth funds. If you are working in the banking industry you can't ignore sovereign wealth funds. You have to know who they are, what their investment policies are, and whether they may be potential equity holders in your bank. That's true for large corporations too. They are now big players in capital markets.

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