Understanding SWFs
Sovereign wealth funds (SWFs) are some of the highest profile and more interesting institutions in the investment landscape. They are also some of the most diverse, and sometimes most colourful.
The Sovereign Wealth Fund Institute (SWFI) ranks some 80 SWFs from countries as disparate in size and resources as China and Kiribati, with assets under management (AUM) ranging from over US$1 trillion in Norway’s Government Pension Fund Global (GPFG) to just $80 million in Equatorial Guinea’s Fund for Future Generations.
Norms are hard to find across such a diverse landscape, but there are some significant trends, and issues, in the SWF community.
What are SWFs?
The question of what an SWF is, is less trivial than it might appear. There are many major institutions that exhibit SWF-like characteristics but are, strictly speaking, different. The SWFI’s widely accepted definition excludes, among other things, foreign currency reserves held by monetary authorities for balance of payments or monetary policy purposes; traditional state-owned enterprises; government-employee pension funds that are funded by contributions from both employers and employees; or assets managed for the benefit of individuals.
Some significant institutions with a semi-sovereign character – Canada’s C$337 billion ($260 billion) Canada Pension Plan Investment Board comes to mind – are hence excluded, even though they often behave like SWFs.
The SWFI’s rankings, meanwhile, include some very less-than-sovereign entities, such as the investment funds of many US states. Obviously, the diversity of SWFs is partly a consequence of a somewhat loose definition.
How significant are they, though? As of September 2017, the SWFI calculated total AUM of SWFs worldwide at $7.4 trillion. In comparison, BlackRock Inc, the world’s largest money manager, alone had an AUM of $6.32 trillion as of the first quarter of 2018.
The Boston Consulting Group estimated that total global AUM was at $71.4 trillion as of mid-2016, which means SWFs account for about 10% share. Even so, as a group, they are cast well into the shade by their most important private sector peers, at least in value terms.
SWFs do, however, tend to punch above their weight in some asset classes, and also often in brand value, prestige and influence. According to Elliot Hentov, head of policy and research in the official institutions group at State Street Global Advisors, although SWFs account for a fairly small share of global assets in overall investor size, this isn’t true in certain assets classes.
“By year end 2016 we estimated that they made up about 6.3% of global equities,” he says. “But more importantly, the alternative parts that are accessible to institutional investors, we think they own roughly 15%. In that segment they are very significant.”
Asset choices and market role
The role of SWFs in alternative investment, or especially certain classes within alternatives, has often been remarked on, and comes with some clear reasons and consequences.
“They are not significant bondholders, but in the equities space they are noticeable, and in the alternatives space, they are very significant,” Mr. Hentov notes.
This is partly an issue of capacity in traditional asset classes.
McKinsey, in its Global Private Markets Review 2018, states that SWFs “are looking to increase their exposure to private markets, increasingly using co-investments and direct investing to boost their ability to deploy capital”.
As for why SWFs would prefer private markets, the report notes that consistency of returns is one driver, not least for those exposed to the energy markets through their parent country or other structural issues. “SWFs’ desire for persistent performance has been increasing along with volatility in energy markets over the past several years,” it says.
Since roughly $4.2 trillion of SWFs’ total $7.4 trillion worldwide is held by petrochemicals-related funds, according to the SWFI, this concern about energy markets’ volatility is very understandable.
The McKinsey report says SWFs have also been a key group in the development of separately managed accounts or special relationships with select leading private investors “seeking a streamlined way to deploy capital at scale, and to develop or extend their internal capabilities”, including through access to general partners or regional experts, detailed market views, and sometimes in-depth bespoke research.
“They are key clientele for boutique or niche specialists,” Mr. Hentov says. “If you are active in the area of real estate or private equity in particular, this clientele is very important to you, particularly if you think of large commercial real estate in prime global cities.”
A joint study in 2016 between academics at the UK’s London School of Economics and the University of Reading concluded that policymakers in the West and elsewhere are increasingly positive towards SWFs “as an attractive international source of patient capital that can offset declines in traditional sources of patient capital”.
“A lot is changing in this space,” Mr. Hentov says. “A few years ago, I would have said they were very important asset owners and providers of capital. But this is not only what I see today.”
SWFs are stepping up more and more as “direct investors, increasingly cutting out intermediaries and investing directly in projects, either in the private equity or the infrastructure space, often in partnership with other SWFs or investors” he adds.
Mandate matters
Why and how a particular SWF invests is a function of its mandate and mission, and given the wide variety of these institutions, there is not likely to be much consistency.
As Mr. Hentov observes: “The SWF universe is very wide: there’s a range of different funds and different mandates.”
There are broad guidelines for how an SWF should behave and what its investment approach should be. The Santiago Principles of the International Forum of Sovereign Wealth Funds (IFSWF), promulgated in 2008, sets out generally accepted principles and practices for SWFs.
The 24 principles provide “practical items of guidance on appropriate governance and accountability arrangements, and the conduct of investment practices necessary for sound long-term investment procedures”.
Principle 19 declares that “the SWF’s investment decisions should aim to maximise risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial ground”, with the sub-principle that “if investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed”.
That said, the IFSWF is a voluntary organisation of global SWFs and it and its 30-plus members by no means constitute the entire SWF universe. Norway’s GPFG and Singapore’s Temasek are conspicuously absent from its member list.
According to Mr. Hentov, an SWFs investment strategy is a function of the mission. “If the mission is to generate the highest return or the highest risk-adjusted return, then the investment strategy will reflect that. When the mission is to promote industrial development, or sector-specific development, then the strategy will reflect that mission,” he says.
Where they do score, he feels, is autonomy. “By and large, these funds have been set up to do this more effectively than governments, and that is because they are genuinely more autonomous. One consistent theme is that by and large business decisions are made autonomously on the merits of the investment proposition,” he says.
Certainly, the Santiago Principle 6 states that “the governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives”.
Principle 9, meanwhile, declares that “the operational management of the SWF should implement the SWF’s strategies in an independent manner and in accordance with clearly defined responsibilities”.
This is not to say that these principles and guidelines have always been well implemented, even by IFSWF members.
“Many funds have dual and triple mandates, and that’s where the confusion stems from. Mr. Hentov says. “Are you investing for developmental reasons, or to maximise returns, or simply as a savings measure?”
He notes that policymaking in the construction of SWFs has now recognised “that a lot of these funds need to have a very crisp and clear mandate”, which avoids “muddle in the portfolio, when you get confusion over why you’re doing things”.
Santiago Principle 2 that “the policy purpose of the SWF should be clearly defined and publicly disclosed” is very germane to this.
The influence of SWFs
SWFs do appear to enjoy an influence disproportionate to their size - whether as a function of their semi-sovereign status, or for other reasons. For the power of SWFs to shift markets, one only need refer back to November 2017, when it emerged that Norway’s GPFG might remove oil and gas companies from its benchmark index, on concerns over potential future downgrading of the sector. The news triggered a share slide across oil and gas stocks worldwide.
The GPFG exercises broad influence on many other types of markets and propositions. In May 2018, Sheikh Mohammed bin Essa Al Khalifa, chairman of Bahrain’s semi-autonomous private sector development agency Tamkeen, cited the GPFG as a model for investment of oil wealth.
“I’m trying to promote the Norway story. Norway discovered oil after they industrialised and started to use oil as capital. That’s what we need to look for,” he said.
“Norway is an obvious example,” Mr. Hentov agrees. “It’s the largest, it’s the pioneer of certain investment techniques, and it’s also a standard setter in terms of certain ideas about investment.”
Singapore’s Temasek and GIC have a similar standing in Asia, while in China, the CIC is increasingly innovating and starting to transform the market, he says. “That’s another one where I can see in a few years everyone talking about the footprint that they’ve left.”
But opinions differ about GPFG. A December 2017 Bloomberg report in the wake of the fund’s decision to pull out of petrochemicals assets took the position that “poor governance has meant Norway’s oil fund has squandered its advantages”.
The report noted the fund’s annual net real return of just 4.06% since inception in 1996, while conceding that the figure had risen to 7.86% over the past five years. Specifically, it pointed to the GPFG’s governance structure, with heavy oversight from the finance ministry and a near-total restriction on investing outside listed stocks and bonds.
Statements by the Norwegian finance ministry in April 2018 that it would consider some pre-initial public offering investments in private companies, and investment in some green infrastructure propositions, can only look positive if these criticisms hold true.