Massive, mysterious and misunderstood

Move over hedge funds. Sovereign Wealth Funds (SWFs) are bigger investors now. Massive, mysterious – and possibly misunderstood – SWFs have the world financial markets in a tizzy. Concerns abound over the heated debate sparked by SWFs at the World Economic Forum in Davos, Switzerland, and the embers continue to smolder.

On the surface, demands for SWF transparency and governance are fueling global outcries. However, subliminal issues such as fear and apprehension of outsiders also may be stoking the flames. The fact is that SWFs, with holdings estimated at about $2.5 trillion and growing, represent the investments of governments. Since SWF investments may include holdings in public companies based on another country’s turf, it is difficult to separate politics, protectionism and even xenophobia from concerns about what investors really need to know.

This complex story unfolds as the pendulum swings bringing wealth to emerging countries. Concurrently, the established investment community is coming to grips with ‘emerging markets’ reaching critical mass. As countries ‘emerge’ with pockets full of foreign exchange reserves, they are forming SWFs to channel some money into higher-yielding investment vehicles. 

‘You have a big relative shift in wealth from the traditional investor countries towards the emerging market and commodity-producing countries and that gives them a lot more financial weight,’ says Edwin (Ted) Truman, senior fellow at the Peterson Institute for International Economics.

‘Ownership of much of that wealth is in the hands of the government rather than in the private sector and that implies a much different way of thinking about the world,’ continues Truman. ‘Normally we think about international investment being managed by private individuals. Now you have governments [doing it.]’

Historically, emerging countries kept their reserves in relatively safe, liquid short-term investments such as foreign treasury bills. Now for various reasons, some undisclosed, they’re forming SWFs to make bolder investments in riskier vehicles such as equities.

Truman believes SWFs are challenging traditional concepts of globalization. ‘Large cross border holdings in official hands are at sharp variance with today’s market-based global economy and financial system,’ he writes in a policy brief entitled, Sovereign wealth funds: The need for greater transparency and accountability. Truman says SWFs have become a major focus ‘because of their size, their lack of transparency, their potential to disrupt foreign markets and the risk that political objectives might influence their management.’

Some SWFs have been around for many years. For example, the Abu Dhabi Investment Authority and Corporation (ADIA) is a United Arab Emirates’ SWF that was formed in 1976. China and Russia are among the larger more recent SWF entrants. According to the Sovereign Wealth Fund Institute, a non-partisan, non-profit organization formed in January 2008, 12 SWFs have been created since 2005. SWFs are also growing in scale. Experts widely agree that, as a group, SWF holdings have already surpassed the size of hedge funds.

Stephen Jen, global currency strategist at Morgan Stanley, predicts the rapid growth of SWFs will continue. In his research Jen says, ‘The total size of the SWFs could reach $12 trillion by 2015, and surpass the size of the world’s total official reserves within five years (before 2011).’ Jen also believes that non-oil Asian exporters will become as important as oil exporters. He predicts that ‘by 2015, the two groups will be roughly about the same size – at around $6 trillion each – with China’s Huei Lian Company being the single largest SWF.’

Although Norway’s SWF, which was formed in 1970, receives praise for its transparency, other SWFs have come under fire. Overall, lack of transparency is one of the hottest issues in the smoke that surrounds the issue of SWFs. ‘At present, SWFs are seen as secretive and threatening by some,’ Jen commented. ‘However, if they (the SWFs) achieve a level of transparency similar to SPFs [Sovereign Pension Funds], there should, in theory, be much less angst about them.’

Fighting the disclosure tide
Despite the efforts that are underway to develop an international code of behavior for SWFs, not everyone expects to see changes soon. ‘Many companies in China and other parts of Asia are not transparent,’ explains Daniel Chow, who holds the Joseph Platt-Porter Wright Morris and Arthur Professorship of Law at Ohio State University. ‘They don’t have public information which is available in any detail about what they do. I would be surprised if we would find more transparency in [Chinese] entities anytime in the near future because it is part of Chinese corporate culture and China, in general, to keep things less than transparent.’

One argument levied against calls for SWF transparency is, ‘Why should SWFs have to provide disclosure when hedge funds don’t?’ Still others point out that SWFs shouldn’t be pointing fingers at hedge funds because they have positions in hedge funds, too.

Ironically, SWFs may be doing themselves a disservice by not providing more disclosure. Truman says international standards of transparency and accountability ‘will make the world safer’ for SWFs. As he explains, ‘There is a great deal of apprehension about them, partly because many of them, [although] not all of them, are quite mysterious about what they do. If you had more accountability of their actions to their own citizens, as well as other countries’ citizens, then some of this misunderstanding and mystery would be removed.’

Christopher Balding, a research analyst at The Milken Institute, a non-profit, economic think tank, is noticing some patterns in SWF behavior. ‘[SWFs] act as any large investor would, whether it’s a high net worth individual or a pension plan,’ observes Balding. ‘They have money in stocks. They have money in bonds. They take small percentages of their overall portfolio and place them with private equity groups and they take small percentages of their portfolios and place them with hedge fund groups. We see them acting as most other investors do – trying to diversify their risk and increase their return.’

Balding says that the people who manage the funds are ‘incredibly well-educated’ and ‘sophisticated’ investors. They’ve gone to the ‘best business schools’ and worked for ‘top quality investment and law firms.’ John Rutledge, chairman of the private equity firm Rutledge Capital, says many fund advisors are ex-pats from places such as the UK, India, Pakistan and America.

‘If I’m sitting with the Chinese fund or the Dubai fund, or with any large American investor, I’m going through exactly the same analysis of the risks and returns of different kinds of assets around the world,’ says Rutledge who does advisory work in China and the Gulf Region. ‘Why should you expect a knowledgeable foreign investor, with the same people sitting in the room, by the way, who advise the US investors, guys like me, to reach a different conclusion about what their portfolios should look like?’

Understanding the ‘other’
One observer believes over time public companies might come to like SWFs. ‘I think that CEOs and management will actually like sovereign wealth funds because they tend to be long-term investors,’ says Michael Maduell, founder of the SWF Institute. ‘Historically, they have taken a non-voting position and, if it seems to be a sensitive investment to the host country, they will take non-voting shares. For example, Temasek [an SWF from Singapore] took non-voting shares when it infused Merrill Lynch with some cash.’ Maduell says that SWFs have tended not to be aggressive investors. ‘However, as they grow in size, they might be inclined to take more of an activist approach much like the public pension funds,’ he speculates.

While we have to be ‘cautious’ because SWFs are foreign government funds, we also need to keep an open mind according to Seung Kim, director of the Boeing Institute of International Business and professor of international business at St Louis University’s John Cook School of Business. ‘We have to be very open-minded rather than protectionistic or nationalistic,’ says Kim. ‘The fundamental question is, Do we believe in the globalization process or do we want to have a nationalistic system? If you say that globalization is not good for the US, then we don’t want any foreign governments or foreign companies, investing in the US,’ Kim says.

Some suggest that what is really generating the heat stems from who the counties are, how democratic their governments are and whether they’re allies or market competitors. Professor Chow says some people have concerns when non-European investors take stakes in US companies. ‘There seems to be more concern about foreign ownership of US assets now that China seems to be investing more in the United States,’ he comments.

‘The whole notion that there are foreign investors in the US purchasing US assets, whether it’s a sovereign wealth fund or any other type of foreign investor shouldn’t surprise anyone,’ Chow says. ‘The US maintains a trade imbalance with many countries and countries are using revenue that they earned from trading with the US to purchase US assets because they have a surplus. Now that you have a government entity which is actually making decisions on what assets to purchase, that seems to ratchet up the fear and anxiety.’

Ignorance and misunderstanding may be adding even more fuel to the fire. ‘People don’t understand [SWFs] and people tend to fear what they don’t understand.’ Similarly, Rutledge says, ‘People also don’t understand people in the Gulf Region and China. We don’t, as a society, know very much about those places, or about those people or those cultures.’

‘The danger that these funds are somehow secret fronts for foreign government political strategies is vanishingly small,’ continues Rutledge. ‘But the danger of foreign investors, including the sovereign funds, deciding that it’s not worth it, that the dollar is not good to hold, that danger is very real. To the extent that these large holders of global assets decide to reduce their allocations in the dollar that would result in a big drop in the dollar and in the value of US assets.’

Rutledge says that discouraging funds from making investments presents yet another danger. ‘If they can’t spend their dollars to buy things that have long-term value, they will be asking themselves then, Why do we hold them?’

Similarly, Professor Kim believes that globalization and foreign investment provide stability in the financial markets. ‘If the foreign sovereign funds and foreign direct investment is withdrawn all of a sudden, the impact on financial markets [would be] just devastating.’

‘We just don’t see the evidence to warrant the level of worry and potential protectionism that we see,’ adds  Balding. ‘Aside from some very headline grabbing deals like Citigroup, UBS, Merrill Lynch and a couple of others, we don’t see evidence to support the idea that sovereign wealth fund money is flooding into the United States more than any other country. The Middle East oil exporters actually have a relatively small investment position in the United States. Singapore, likewise, is not even in the top ten investors in the US.’

However, Balding also admits that China and Middle East oil exporters are accumulating dollar reserves so rapidly that they have massive amounts of dollars that they need to invest. ‘They’re making large investments in industries that they know well ... and also moving ahead into new areas like alternative energy, financial services and tourism in an effort to diversify their economy.’ Adds Balding, ‘The US capital markets will continue to be a vital investment outlet for those countries simply because they have dollars that have to go somewhere.’

Follow the money
Increasing SWF investment in the US is ‘inevitable’ according to Chow. ‘We can’t keep spending money we don’t have. What happens is that other people wind up lending money to you, which is in essence what these foreign governments are doing, and propping up your economy.’

The eyes of the world are focusing on the sovereign investor nations of the world. How these nations manage their investments in parts of the world in which they are not sovereign likely will be an ongoing subject of debate. Will they manage their portfolios like other long-term investors? Or, will they use their SWF holdings to political advantage? Will SWFs swoop into the US and other countries and buy controlling stakes in strategic industries?

Some experts suggest SWFs are hurting themselves by not providing more disclosure and establishing universally accepted governance standards. Others say that fear and misunderstanding are really what is fueling the debate. Developing global guidelines for wealth fund transparency and governance eventually may squelch the flames.

Ultimately, the investment community and citizens of the world will judge SWFs by their actions and track record in global financial markets. ‘We can pass laws to make people write things down,’ concludes Rutledge. ‘But I don’t know what a foreign investor can say, or show, that will make a material difference in what Americans think about it, other than behave decently over a long enough time.’