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Growing Sovereign Wealth?

August 27, 2008

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Note: this post is by Rachel Ziemba of RGE Monitor, where this post also appears. Many thanks to Brad for letting me fill in again.

Today (August 26) two of the most transparent sovereign investors, the Norwegian Pension fund- Global and Singapore’s state holding company, Temasek reported their most recent investment returns. In Temasek’s case, these were for the year ending in March 2008 and for Norway from the second quarter of 2008. Both reported lower returns than in 2006/7 – which is not surprising given asset price moves in this period.

Reports from these two model funds, which represent two ends of the sovereign wealth spectrum give us some clues as to how other, less transparent sovereign investors might be faring in the current market. In fact, since many such funds appear to have suffered losses, despite the inflow of capital received by oil funds (Brad and I have been working on a paper that presents some new forecasts) might call into question the expected rate of growth of such funds. Furthermore they raise the question of whether the risk management operations of these funds are up to the challenge. Both funds note that they have been beefing up such operations as they expect the credit crisis to persist for some time to come.

How are they faring?

Temasek, which primarily takes large stakes that it manages actively - still reported a fairly significant profit – asset sales offset equity market declines. Yet, it sees the year(s) ahead as more complicated. Temasek’s report noted that 2007 was the first year in the last five in which its returns failed to clear the cost of capital hurdle. And that may only get more difficult in the rest of 2008 and 2009 given that credit costs remain elevated and profit expectations are being revised down in many markets.

Furthermore, it may have become more exposed to riskier assets – ranging from investments in Merrill to other forays into distressed assets. These may have absorbed much of the new capital injected. By increasing its holdings in the financial sector (which now makes up 40% of its portfolio- up from 38% last year), it may be less diversified. Given large investments in Merrill and Standard Chartered, one might actually be surprised that the exposure to financial institutions is so low. Its new purchases were offset by sales of Chinese and other banks in which it booked profits. And its 19% stake in Standard Chartered, one of the best performing global banks- in part because of its exposure to corporate banking in Asia and the Middle East, has been profitable.

Singapore’s holdings in the OECD actually rose in 2007/8, though it continues to up its allocation to Asia ex Singapore and Japan. In this way, like GCC funds it may have actually increased not decreased exposure to the U.S. in light of the crisis. And it may do so in the future.

Temasek is a model for many other countries, particularly in Asia and the Middle East who seek both to diversify their economies and improve the returns on their state companies and to increase profits. The Temasek model, if there is one, is to invest in state companies, improve the governance to extract better returns. The next step is (partial) privatization whose proceeds free up capital to be invested elsewhere in corporate stakes. In those investments Temasek also takes on a direct role if not necessarily controlling stakes.

Norway’s assets under management on the other hand are actually lower than they were six months ago at least in Norwegian Krone. (See the link for some of my past analysis on the GPF at RGE Monitor). In fact, despite almost $63 billion in new capital, transferred from Norway’s oil revenues, the funds market value increased by only about $10 billion. In part, Norway, which approved an increase in its equity allocation last year, may have diversified either too late or two soon. When equity markets (especially in Europe and Asia) were booming in 2003-2007, their bond- heavy asset allocation, meant they had to keep buying bonds, depressing returns. They began implementing the asset allocation shift about a year ago. While they may have been able to purchase some of their new equities at cheaper prices, they may have bought well above the bottom. Norway’s equity portfolio exceeded half of the total portfolio for the first time in its history in Q2..

Yet, Norway’s purchases – stemming from its need to place $6 billion a month at current oil prices, may have modestly helped support European equities. Norway, which has been the largest holder of European equities for some time, now holds more than 1%. Norway’s managers did manage to provide a small return in excess of the benchmark portfolio and losses were 1.9%, less than the 5.6% in losses in Q1.

Norway’s recently approved asset allocation shift to branch into real estate and add several new emerging markets is not yet evident, but it has already laid the groundwork to take larger stakes. Its new risk strategies and capital strategies groups can take larger stakes in the market and across asset classes. Furthermore, todays report also takes a sanguine look at the risk management model, which assumed a normal return curve - and "has underestimated the actual risk in the portfolio" Something they are now supplementing with more analysis.

With the big caveat that its impossible to generalize across the spectrum of sovereign investors, it does seem likely that Norway and Temasek are not alone in suffering losses in their portfolios. If key sovereign wealth funds like those of Kuwait and Abu Dhabi held benchmark indices, their assets under management might actually be lower now than they were a year ago – despite large inflows from a near 50% jump in the oil price. Of course such index based returns may understate (or overstate) returns and assets under management. And if they did suffer such losses, that would put them in the company of many private sector counterparts. In fact, of the GCC funds, the Saudi Monetary Agency, with its bond-heavy portfolio and large inflows, likely saw the largest increase in assets.

Recent accounts have been critical of the investment strategies of sovereign wealth funds, noting the sharp losses sustained thusfar, in their most visible investments – the investments in US and European financial institutions. Many have lost well over 50% - losses which are only partly offset by high interest payments on the preferred shares. But these aren’t the whole portfolio. The more we know about these funds, the more many of them seem to have asset allocations similar to private sector counterparts, whether they be private equity style funds, scaling up capital with leverage (and increasingly costly thing to do even for cash-rich funds) or more classic endowment like funds. Increasingly a vast array of pension funds, endowment funds, sovereign funds all seem to be coalescing to a similar asset allocation – high equity, more exposure to alternatives, real assets like commodities and less exposure to bonds. And everyone wants more emerging market exposure.

Recent research by Olivia Mitchell of Wharton and two co-authors suggests that sovereign funds have a long way to go before they are models of transparency, risk control and optimal asset allocation. In many ways the three go together – and it is possible to have the last two without the first. However without transparency, it is harder to grasp how funds might respond in the future – particularly if they incur losses that could become politically unpopular. Furthermore, a better understanding of the overall liabilities against which these long-term assets are implicitly if not explicitly measured, is needed. While by definition most sovereign funds have no explicit liabilities like a pension fund or a social security trust fund, most are assumed to offset fiscal fluctuation or long-term financing needs. But the sophistication and investment expertise of funds varies. Hopefully such governance and risk control ‘good practices’ are among those being discussed in the IMF’s working group on sovereign funds.

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