from Follow the Money

Bonfire of sovereign wealth funds?

November 25, 2008

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Only a few sovereign funds disclose their performance. But it reasonable to think that many sovereign wealth funds – particularly the well-established funds that invested heavily in equities – have had a bad year. Any sovereign fund overweight emerging economy equities – say those who were seduced by talk of a new Silk Road linking the Gulf to Asia – would have done worse. Ask some prominent US institutional investors.

Indeed, the United States Social Security Trust Fund likely has outperformed most sovereign funds over the past few years. The Social Security Trust Fund invests in nothing other than US Treasuries. That currently looks to have been a good choice. An enterprising Norwegian journalist supposedly has calculated that Norway would be better off now if it had just put all its spare oil revenue in the bank.

The fall in equity markets this fall implies that sovereign wealth funds now likely manage far less than $2 trillion in foreign assets. We don’t know how much sovereign funds had at their peak -- in part because there isn’t a consensus on what constitutes a sovereign fund and in part because key funds don’t disclose much. And we don’t know how much they have now. But if funds that have been managed by central banks and invested fairly conservatively (Russia’s future fund as well as the non-reserve foreign assets of the Saudi Monetary Agency) are excluded, the size of the external portfolio managed by sovereign funds likely fell this year. Sovereign funds received large inflows in 2006, 2007 and the first half of 2008 – high oil prices increased inflows into many existing funds and new countries created funds.

Norway offers a case in point. I think it had around $380 billion in assets earlier this year. It now has around $300 billion. Norway has more exposure to Europe than most funds, so it has been hurt by the euro’s fall against the dollar. But it also has a relatively high share of its assets in bonds, which helped. It probably isn’t atypical.

The confluence of four trends suggests that the sovereign wealth fund moment has passed – at least for the time being.

-- One, sovereign funds are fundamentally vehicles for investing government funds in equities and equity markets have not performed well. Nor for that matter have many “alternative investments.” Hedge fund returns have been not been great – and have been correlated with the equity market. Private equity is still “equity.” I would guess that London real estate isn’t doing that well these days.

Some countries with sovereign funds are subject to democratic pressure and it isn’t clear that there is still consensus in those countries to put public money at risk of (further) large losses. Korea is the most obvious example. Norway’s fund argues that the fall in equity markets provides an ideal time to rebalance Norway’s portfolio toward equities. Perhaps. I will be interested to see if the formal release of Norway’s third quarter results triggers a debate inside Norway over the wisdom of adding to Norway’s equity exposure. My guess is that Norway hasn’t been able to rebalance its portfolio fast enough to offset the market’s fall, and its “equity’ share is now well below target.

-- Two, lower oil prices will dramatically reduce new inflows into sovereign funds. The biggest inflows into sovereign funds generally have come from the oil funds – not from the reallocation of Asian central bank reserves toward sovereign funds. But as long as oil stays at $50-55, only Norway will be adding large sums to its sovereign fund. Abu Dhabi, Libya and Kuwait might still be adding to their funds. But not at the same pace as in recent years. And not if they have to bail out domestic banks and prop up domestic stock markets. Reports suggest that Kuwait is now selling foreign assets. if true, that is a rather large change. Indeed, with oil at $55, several countries may need to draw on their existing funds to support their spending plans. Russia now plans to tap its reserve fund.

-- Three, several external funds will turn into domestic funds. See Reuters’ Steven Johnson. If a country taps its sovereign fund to bailout domestic banks and firms and gets domestic stakes in the process, it no longer is a sovereign fund in the conventional sense. Its external assets will have been used to pay off the external debts of private (or quaisi-private) firms. Russia’s sovereign fund seems likely to become a vehicle for supporting Russian firms rather than a vehicle for investing abroad. And once a fund becomes the custodian of the country’s stakes in strategic domestic sectors, it will be viewed differently in the rest of the world.*

-- Recent events have underscored the value of a traditional, liquid reserve portfolio. Not only have central bank reserve managers performed better than higher-priced sovereign wealth fund managers over the past five years, but liquid central bank reserves have proved more valuable than illiquid sovereign wealth funds during the recent crisis. The Korea Investment Corporation cannot sell its stake in Merrill to finance its intervention in the foreign exchange market – at least not easily. Indeed, Korea is now considering issuing a bond to raise additional foreign currency cash – cash that is currently tied up in the KIC.

The foreign exchange needs of large emerging economies in the recent crisis have been enormous – Brazil has committed $50 billion of its reserves to a set of currency swaps to help address a dollar shortage, Korea has committed $100 billion to backstop its banks and Russia’s commitments add up to something like $200 billion. They likely will want to hold more, not fewer, liquid reserve assets going forward.

So may Abu Dhabi. It may have to write a large check to help out Dubai. Dubai’s domestic state firms relied heavily on borrowed money. Abu Dhabi has more than enough foreign assets to cover all of Dubai’s debts, but it may not have all the liquid foreign assets it now thinks it needs.

Throw it all together and I now expect sovereign funds to fall well short of earlier high end estimates of their growth.

Those pitching sovereign wealth funds to emerging market governments timed the market poorly: they encouraged sovereigns to take additional risk when risky assets were already over-valued and they encouraged sovereigns to sacrifice liquidity for returns when it turns out emerging economies still needed liquid assets. A lot of sovereign funds effectively bought into a host of markets at close to their recent peaks.

Sebastian Mallaby now says that sovereign funds now look like a bull market luxury.

Korea, Brazil, India and Russia aren’t going to have big funds in the near future.

Setting SAMA aside, the Gulf funds almost certainly shrunk in 2008 – despite high oil prices. If oil stays at its current levels, the future pace of their growth will likely slow sharply. My guess is that combined foreign assets of the large gulf funds now are under a trillion dollars.

The big wildcard? China. Its reserves are not just large but still growing. And it isn’t clear if the CIC’s visible losses (and SAFE’s hidden losses – its roughly $100 billion equity portfolio must have fallen in value substantially) will deter China’s top leaders from taking on additional risk. The signs are mixed. SAFE doesn’t seem to be able to buy anything other than Treasuries right now - and the CIC is trumpeting its large cash position. But the CIC also at least considered adding to its large stake in Morgan Stanley.

If oil stays at its current levels, the only real way growth in sovereign funds could come close to matching the investment banks revised projections (see Morgan Stanley and Merrill) is if China effectively channels all the foreign exchange it is buying to support its currency into a sovereign fund ...

* The US is in some sense going in the opposite direction. It has taken large stakes in domestic US firms with extensive operations abroad. As a result, it is acquiring foreign assets as a result of its domestic bailouts rather than shedding foreign assets to cover the foreign debts of domestic firms.

AIG is the most obvious example.

Note: I have drawn on work I am doing with Rachel Ziemba of RGE in this blog post

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