Not so long ago sovereign wealth funds (SWFs) were viewed with a good deal of mistrust. Today, while not without challenges, they are considered potential saviors for a rattled global economy. What changed?
Better communication between fund managers, the investor community, and governments. Many funds have embraced the Santiago Principles — the code of best practices developed by the IMF and the International Forum of Sovereign Wealth Funds that addresses legal issues and transparency, which has led to greater comfort on the part of countries in which SWFs have investments. Also, we have seen very prominent funds apply very professional standards to their investments, allaying fears that their governments are guiding the funds.
The crisis of 2007–08 was also a major game changer. Major financial institutions, banks, and insurance companies badly needed recapitalization, and they began to seek out SWFs, which were often the only funds willing to contemplate such investments. Although some of the investments the SWFs made have lost money to date, the SWFs are no longer unappreciated as a natural source of capital for large institutions.
Can SWFs play the same role with the Eurozone crisis?
If you are a reserve fund, as SWFs are, government debt is an attractive investment because it’s meant to be safe and liquid. But the Eurozone crisis has underlined that even sovereign debt issued by some of the wealthiest countries in the world can be subject to default risk. The problem is that SWFs have been holding a lot of Eurozone debt. They are beginning to understand that these holdings no longer serve the role of liquid, marketable securities, and they have produced very poor returns. So it may be time to diversify into other, hopefully more profitable and sustainable, asset classes. This is why I don’t see SWFs loading up on much more Eurozone debt until Europe has resolved its debt crisis.
At the same time, SWFs with a long investment horizon are naturally placed to absorb the Eurozone crisis shock. Their long-term horizon puts them in a good position to serve the role of insurers for global capital markets, and to the extent that sovereign debt markets may be over-reacting to the risk of a possible breakup of the Eurozone, SWFs may be able to profit substantially by buying more or holding onto their positions in Eurozone debt for the long run. That is why I don’t expect to see major unwinding of Eurozone debt positions by SWFs.
The book reflects the proceedings of a conference held last year, Sovereign Wealth Funds and Other Long-Term Investors: A New Form of Capitalism, a joint effort between the Commitee on Global Thought at Columbia and the Sovereign Wealth Fund Research Initiative of University Paris Dauphine. What does “a new form of capitalism” mean?
Capitalism has been associated with capital markets, where the primary sources of capital have been private rather than public. The new players — they are few but large — are public entities with different time horizons, capabilities, and objectives. This is why we are seeing a shift toward a new form of capitalism, in which the state both relies on and enhances capital markets, which is a departure from both the classical private property form and the state-capitalism form based on central planning. The Norwegian fund’s objective, for example, is wealth preservation for future generations of Norwegian citizens. Its managers have to ask: what risks is a typical Norwegian in a future generation exposed to? How do you hedge against those risks? How do you invest to maximize wealth in the long term? That’s the financial dimension.
There is also the social dimension: to the extent that the representative Norwegian citizen is concerned with, for example, climate change, that concern must also be taken into account in the fund’s investment choices.
I use Norway as an example because among critics of SWFs, who would be afraid of Norway? Yet the objectives of the China Investment Corporation (CIC), the main Chinese SWF, like Norway’s, also include socially responsible investing, favoring low carbon-footprint corporations and avoiding armaments and tobacco investments. I would not say, though, that this SRI dimension is equally well developed across all funds — this is difficult to establish for a fact, of course, as we don’t know the composition of many SWF portfolios — but even if we look at just a handful of funds with enormous total assets under management, if they are known to shy away from stocks they view as socially irresponsible, that will have an effect.
SWFs are known for passive investing and what some have characterized as “excessive prudence.” Is this attributable to the double standards and regulatory hurdles that the funds face?
Some of it is. But also, if a fund wants to conduct long-term investment and potentially increase risk, it must have staffing, which remains quite small at most SWFs, though it has been growing larger recently. That is probably as important an obstacle as regulatory obstacles. Let me mention another example involving CIC: when CIC took a position in Morgan Stanley, it was a non-voting minority stake and it was only on that basis that they were allowed to invest. Who else would agree to take a minority stake in an investment bank without having voting power or board representation? The responsible thing for a large investor to do is to be an active investor. Norway is aware that it is holding big chunks of publicly traded corporations and that doing active governance would affect the value of these investments. Accordingly, it is spending more and more resources on due diligence and screening. Whether these efforts translate into board representation or active voting in proxy battles in takeovers, however, is another matter.
What other challenges and obstacles do SWFs face?
The European debt crisis has pushed SWFs to look for other long-term, lower-risk investments. One naturally attractive alternative with huge potential is infrastructure investment, as these are long-term investments that are suited for SWFs’ long horizons. Anything you can do to match long-term funds with long-term investments like infrastructure would be a big improvement in the allocation of global capital to investments.
But that brings us back to the regulatory obstacles and lack of expertise on the part of the fund managers. You need something like infrastructure banks or platforms that would help bring investments to the SWFs and allow them to co-invest. SWFs seek out large investments and don’t have staff to review a lot of smaller investments — they need intermediaries that would work as aggregators. So, instead of showing an SWF a low-carbon electricity generating facility, one plant at a time, you bundle many plants. That saves time in terms of due diligence, is more efficient, and spreads risk through large aggregated investments. This is in my view one of the biggest opportunities and challenges in the near future.
What about political risk associated with SWFs?
Political risk rests on both sides. On the recipient side if you let in an SWF, you may carry risk with respect to political developments with the sponsor of the fund. When Gaddafi was leading Libya, you would or should have thought twice about what it meant for Libya’s fund to invest in your firm or your government bonds. This is where governance comes in. Over time, an SWF has to develop independence from the government and professionalism — much like central banks are independent, which reduces the political risk.
The other side of political risk for investors in recipient countries raises another question, which is who should carry that risk? Who is best placed to take on this political risk, SWFs or other entities? If SWFs hold equity or junior debt in infrastructure projects, say, should they insure out political risk? And if they insure it out, who should hold that political risk? This is an important question that still needs to be resolved.
Given their size and potential influence, how might SWFs influence climate change and sustainability?
One of the biggest risks the very large funds in oil- and gas-exporting countries face is uncertainty over the future price of carbon and the transition to a low-carbon economy. Investors working with a 50-year horizon know that carbon pricing is coming their way, but they don’t know exactly when. They should take a very different view from the typical investor who works with a five- or 10-year horizon, say, who just takes a bet that carbon prices aren’t going to rise much in the next decade. The long-term investor has to think today what it means to be exposed to that risk and how it can reduce the exposure with respect to the future price of carbon. Such an investor has a lot to gain both in terms of higher long-run returns and lower risk by investing more in renewable energy ahead of the introduction of carbon prices. SWFs are therefore natural and important actors in facilitating the transition to a more sustainable, low carbon, global economy.
One last thing: until the financial crisis, the difference between long-term and short-term investing was underappreciated. We are now seeing research emerge that emphasizes that difference, with implications for portfolio composition, risk analysis, and so on. There is an opportunity for SWF fund managers to tap into that research and gain a better understanding of how to manage portfolios with a long-term perspective.
Patrick Bolton is the Barbara and David Zalaznick Professor of Business in the Finance and Economics Division and a senior scholar at the Jerome A. Chazen Institute of International Business at Columbia Business School.
Joseph E. Stiglitz is University Professor, co-chair of Columbia University's Committee on Global Thought, and co-founder and co-president of the Initiative for Policy Dialogue at Columbia University.
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"Sovereign Wealth Funds and Long-Term Investing"