Sovereign wealth funds are today experiencing a heady but challenging time. While these entities, where a fund owned by a state invests in various financial assets, are growing in size and sophistication, two new challenges will demand much strategic attention in the years to come.
The good news is clear: sovereign wealth funds are growing rapidly. Depending on how one counts, there are between 40 and 60 different funds, in nations as disparate as Canada, Kazakhstan, and the UAE, with several more having recently been announced.
Their size is difficult to determine because they often lack transparency. But as of early 2008, the US Securities and Exchange Commission estimated that total fund assets were nearly $2.5 trillion (Dh9.1 trn). To place this figure in a broad investment context, the amount sovereign funds currently manage exceeds the $1.4trn managed by hedge funds, but it is just more than one per cent of global financial assets.
Most of their growth has occurred recently. In 1990, for example, fund assets were estimated at only $500 billion. Estimates suggest that these funds could grow to $12trn of assets by 2015. Much of this growth has been driven, not surprisingly, by the rising price of petroleum, and has been concentrating in producing nations such as Norway, the UAE and Kuwait. But other important players include nations who are piling up foreign currencies because they are running up persistent, large trade surpluses, such as China. These countries are increasingly moving beyond putting these funds "under a mattress"– that is, holding safe but low-return Treasury bonds – and are instead seeking to hold broader portfolios.
In another sense as well, these are the best of times for sovereign funds: they also growing in sophistication. In a number of cases, the size and experience of the investment teams employed have grown substantially. A number of these groups have abandoned their initial conservative strategies, and adopted allocations more consistent with "best practices": for instance, Norway's Government Pension Fund increased its allocation to emerging markets and real estate in May 2008.
But at the same time, sovereign funds face a raft of challenges. Many of these are common to other government schemes, such as efforts to support new ventures: for instance, the temptation to invest too locally without considering the broader perspective, a failure to assess performance, and pressures to invest in the "pet projects" of political leaders and their associates. But they also face two additional pressures, which make the challenge of leading such an organisation particularly challenging.
The first of these is the increased political scrutiny of these organisations in many Western nations. The controversies surrounding investments by sovereign funds are not new– witness the 1987 row over the Kuwait Investment Office's purchase of a 20 per cent stake in British Petroleum – but the intensity of scrutiny around these funds in the past year has been unprecedented. Nor is it likely to subside, at least if the growth of these funds continues unabated.
What is behind this fear of sovereign funds? In part, it can be attributed to intense anxiety in many established economies about globalisation in general and the changing global balance of economics power more specifically.
It is far easier to blame an institution than vaguely understood economic forces. But at the same time, sovereign funds have not helped themselves with the intense secrecy that surrounds many groups' activities.
Valuable lessons may be drawn from the experiences of the private equity industry, which after decades of operating in the shadows, have been singled out for scrutiny in many Western nations in recent years. Many of the charges levelled against the industry – such as claims that buyouts are typically associated with massive job losses or short-term time horizons – do not appear to be valid. But despite the dubious foundation of many criticisms, they have attracted attention from the media, politicians, and voters alike. Once again, fear of the economic disruption and the secrecy of the industry seem to have exacerbated this reaction.
Like the private equity industry, it is important for sovereign funds to pro-actively address these concerns. Doing as much as possible to insure transparency about story behind the funds, the way they operate, and the consequences of these investments is important. Encouraging objective research that can better document the funds' roles can also help alleviate concerns.
The second worry relates to the challenge of ensuring attractive investment returns. Strategies that may work for a modest-sized institution – for instance, a university endowment with a few billion dollars under management – may be difficult to scale up in a larger organisation. Indeed, many of the endowments themselves have struggled with maintaining their success as they have become ever larger.
This is particularly true as sovereign funds put more emphasis on alternative investments, such as private equity and real estate. These sectors have been critical to the extraordinary investment success that many university endowments have enjoyed. But academic research suggests that these sectors are particularly vulnerable to influxes of new capital. Because there are often a limited number of opportunities in a given sector, additional capital tends to be associated with the purchase of securities at higher prices and ultimately lower returns.
Thus, sovereign funds have to figure out how to grow rapidly while generating attractive investment returns. The task is not an easy one, but two avenues seem clear. First, it probably does not make sense to emulate exactly the asset classes and approaches that have been successful for others in the past. Markets that may have generated extraordinary returns in earlier years are unlikely to continue to do so. Instead, looking at what the undiscovered investment classes are today seems far more rewarding.
Second, it is important to understand that unless one can identify and implement a successful investment strategy, one is probably better off simply putting capital in index funds.
Building a successful investment programme is a major investment, which requires a long-run investment strategy, a willingness to invest in recruiting and retaining top managers and advisors, and a process of careful evaluation and strategic fine-tuning. This is an area where enduring success comes not to the lucky, but rather to those who take a thoughtful, careful approach.
- Josh Lerner is the Jacob H Schiff Professor of Investment Banking at Harvard Business School