Sovereign Wealth Fund
What is A Sovereign Wealth Fund
There is an official definition of a sovereign wealth fund, written by sovereign wealth funds themselves in 2008 and published in Appendix I of the Santiago Principles. In short, this defines sovereign wealth funds as having three key characteristics:
- A sovereign wealth fund is owned by the general government, which includes both central government and sub-national governments.
- Includes investments in foreign financial assets.
- They invest for financial objectives.
These key elements exclude:
- Public pension funds, which are ultimately owned by the underlying policy holders.
- Central bank reserve assets, which are not invested.
Savings funds are sometimes referred to as intergenerational savings funds because they have decades-long investment horizons. The world’s oldest SWF, the Kuwait Investment Authority (KIA), is a good example.
Savings funds are sometimes referred to as intergenerational savings funds because they have decades-long investment horizons. The world’s oldest SWF, the Kuwait Investment Authority (KIA), is a good example.
Savings funds are often set up by commodity-rich countries to save a portion of their resource wealth for the future. Oil, gas and precious-metal reserves are finite: one day they will run out. There is also a risk that these resources will become stranded assets as climate-change regulation and the rise of green-energy alternatives render hydrocarbon extraction uneconomic.
But by using their SWFs to convert today’s resource wealth into renewable financial assets, governments can share the windfalls with the generations of tomorrow. By investing overseas, savings funds in commodity-rich countries can also help prevent Dutch Disease, whereby a surge in commodity exports leads to a sharp rise in foreign-exchange inflows, generating in inflationary pressures and damaging the competitiveness of other economic sectors.
Some savings funds are designed to nance future liabilities. Pension reserve funds, such as Australia’s Future Fund, the New Zealand Superannuation Fund and Chile’s Pension Reserve Fund, typically invest to build capital that will help defray their sponsoring government’s future pension obligations. Unlike orthodox pension funds, the assets they manage remain the property of the government and no individual has any claim on them. As a result, these funds can remain, long-term investors, even as they are drawn upon.
Case Study: The New Zealand Superannuation Fund (NZSF)
The New Zealand government created NZSF (also known as NZ Super) in 2001 to build savings to defray future pensions costs. As is the case in many countries, such costs are likely to rise as the population ages; as the number of older citizens increases, the number of taxpayers relative to the number of retirees falls.
The NZSF is managed by the Guardians of New Zealand Superannuation, a Crown entity which is empowered to make investment decisions independent of the government. The Guardians invest government contributions, along with the returns generated by these investments, to grow the capital of the fund. Withdrawals are due to begin in the mid-2030s.
As a long-term investor, NZSF can devote a relatively large proportion of its portfolio to private-market assets, taking advantage of the illiquidity premium available on such investments. For example, the fund invests in global forestry assets, transport infrastructure and real estate.
The Guardians use a reference portfolio as a benchmark against which to measure the performance of NZSF and the value added by its various active investment strategies. The reference portfolio is comprised of passive, low-cost, listed investments, split between global equities (80%) and fixed income (20%).
As of 31 March 2018, the Guardians allocated 66% of the fund’s NZ$37.8 billion ($27.4 billion) portfolio to global equities, 13% to global fixed-income and other public market investments, 4% to domestic equities and 17% to alternative investments such as infrastructure, private debt and property.
Stabilisation funds are designed as pools of capital which governments can draw on to smooth the budget. Often, commodity-rich nations create these funds to manage revenue streams; the fund will save some of the proceeds from large influxes of revenue and pay out when commodity receipts fall below a specified amount.
Stabilisation funds can thus help mitigate the resource curse, an economic phenomenon whereby commodity-rich countries tend to experience slower growth than comparable countries that lack such wealth. The resource curse occurs partly because energy prices are volatile. When prices are high, governments usually increase spending; when they are low, governments must tighten their belts. These fluctuations exacerbate the economic cycle.
By helping to smooth out commodity revenues, stabilisation funds can help governments avoid extreme peaks and troughs in the cycle. These funds are also used to help stabilise the value of the country’s currency during macroeconomic shocks. For this reason, stabilisation funds tend to hold a large proportion of their assets in liquid investments so that they have access to capital at short notice.
Case Study: Economic and Social Stabilisation of Chile (ESSF)
ment established ESSF in 2007. ESSF superseded an older fund called the Copper Stabilisation Fund, which the government had used to save a portion of its revenues from copper exports. The ESSF inherited much of its $2.6 billion in start-up capital from this older vehicle.
The timing was propitious. Only a year after the fund was created, the financial crisis hit, reducing demand for commodities. By drawing on the fund’s capital, the government could support the Chilean economy without issuing more debt. This is one reason Chile fared better than its Latin American peers during the crash (Chile’s GDP growth declined by 1% in 2008; by contrast, Mexico’s fell by 4.7%).
ESSF works in tandem with another SWF, the Pension Reserve Fund, in Chile’s fiscal setup. According to Chile’s Fiscal Responsibility Law, ESSF receives an amount equal to the government’s annual surplus once contributions to the Pension Reserve Fund and the Central Bank of Chile have been deducted. As of end-March 2018, the fund held $14.9 billion in assets.
As a stabilisation fund, ESSF needs to keep the bulk of its portfolio in liquid securities that can be accessed at short notice. As of 31 March 2018, ESSF held 33.4% of its portfolio in money-market assets; 55.2% in sovereign bonds; 8% in developed-market equities; and the rest in inflation-linked bonds.
Since the global financial crisis, there has been a marked change in how governments use their liquid and illiquid assets. With interest rates at record lows and global economic growth sluggish, the appeal of traditional savings and stabilisation funds has diminished. Instead, many states have created development funds that form part of their domestic economic policies.
These funds follow the lead of two well-established South-East Asian SWFs, Singapore’s Temasek Holdings and Malaysia’s Khazanah Nasional. These funds acquire stakes in companies in strategic industries to nurture their development, promoting the growth of the wider economy and realising financial returns. Temasek and Khazanah have also been able to build portfolios of overseas assets from the proceeds of the realisation of some of their major investments, as well as using the dividends and other cash distributions they receive from their portfolio companies.
The Irish Strategic Investment Fund (ISIF) neatly illustrates how these vehicles differ from traditional savings funds. ISIF has a mandate to invest on a commercial basis to support economic activity and employment in Ireland in targeted economic sectors. The fund’s recent activity includes the launch of an infrastructure development plan to finance student accommodation across Ireland and a €100 million ($107 million) fund that will offer loans to Irish milk producers.
Strategic funds can promote the domestic economy in a variety of ways. They may provide financing to early-stage companies in strategic industries, or buy long-term stakes to facilitate the development of more mature firms. Some, like Kazakhstan’s Samruk-Kazyna, are active managers of their portfolio companies, aiming to upgrade their operations and profitability with a view to privatisation.
Some strategic funds will make direct investments in critical infrastructure projects, occasionally using their local expertise to leverage co-investments from peer institutions.
Case Study: Investment Corporation of Dubai (ICD)
Established in 2006, ICD manages a broad portfolio of local and international assets across the various sectors supporting Dubai’s growing economy. ICD’s mandate is to consolidate and manage the Government’s portfolio of commercial companies and investments. The fund also provides strategic oversight by developing and implementing an investment strategy and corporate governance policies that maximise value for the long-term benefit of the Emirate of Dubai.
ICD focused on consolidating the state-owned enterprises entrusted to it in its early years. Since then, the composition of the core portfolio has remained relatively stable, with the portfolio companies growing and performing well over cycles. For some time now, ICD’s focus has been on portfolio management and capital deployment, both critical to successfully implementing its mandate. As a natural evolution of the strategy, ICD has recently emphasised a gradual repositioning of the portfolio to achieve a greater level of diversification and enhance its long-term risk-adjusted return potential.
ICD does not typically direct the day-to-day operations of its portfolio companies. Each portfolio company is managed by its management team and guided and supervised by its Board of Directors. However, in its capacity as a shareholder, ICD can actively engage various stakeholders, including the boards and management teams of its portfolio companies, either directly or through designated board members. Shareholder activity is carried out to promote sound business practices, consistent with ICD’s mandate to supervise and monitor its portfolio companies.
When required or justified by circumstances, ICD also provides assistance to its portfolio companies to support their development. This support may take various forms, including advice on strategy, funding, ESG, HR and legal matters. Occasionally, ICD also facilitates cooperation between portfolio companies, as appropriate.
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