Sovereign Funds: The writing on the wall…

Rachel Ziemba

Note: This post is from Rachel Ziemba, not Brad Setser.

"Like private firms, pension funds, and other institutional investors, Abu Dhabi’s investment organizations have always sought solely to maximize risk-adjusted returns. ...The Abu Dhabi Government has never and will never use its investments as a foreign policy tool."

So writes Yousef Al Otaiba, the Director of International Affairs of the Abu Dhabi Government in a letter to Treasury Secretary Paulson, other G7 finance ministries and international institutions. The letter which expresses Abu Dhabi’s investment guidelines is unprecedented as a public response from sovereign funds, the government investment funds of many countries that have been under the spotlight. These funds are large - Brad Setser and I have estimated they manage $2 trillion - and growing - they could add $500 billion this year. In 2000, they managed around $500 billion. The availability of funds (including leverage) has helped them make higher profile purchases in search of higher returns. After all, sovereign funds respond to a desire to diversify assets and make higher returns than those possible with holdings of US and other government bonds. They are increasingly a go-to capital source. Just today, Dealogic suggested that they accounted for $48.5 billion in cross border M&A in 2007 and about $24 billion so far this year. In 2006, it was $19 billion. Their investments in fixed income, smaller equity stakes and alternatives are even larger.

The following graph - which adds the Russian oil stabilization fund and Saudi Arabia’s non-reserve foreign assets to that of dedicated investment funds of Asia, the Gulf and Norway- gives a sense of how quickly these funds have grown. Oil’s surge has fed the growth of sovereign funds 3/4 of the assets managed by sovereign funds are oil funds. About half of the almost 20 funds that we routinely track were created after the year 2000. Sovereign wealth really is a new superpower.

As estimates of SWF assets proliferated, so have concerns from policymakers (summary here) questioning how the prominence of state-directed investors will affect the financial system. Sovereign wealth funds now seem to be responding to concerns. The head of Singapore’s GIC suggested in December that it might increase disclosure. Other funds already disclose more about their holdings, management and investment decisions - Norway, Temasek, the funds of Alberta and Alaska. Even China has been a little more publicly conciliatory to the process. But most are likely wary of having the rules dictated to them. This is the time to play a part in fashioning the rules both at the IMF and in the public domain. Sovereign wealth funds will likely be a big topic at the IMF/WB spring meetings - though systemic risk and a deteriorating global outlook will loom large.

Abu Dhabi’s investment strategies.

- To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi.

- To operate as strictly individual entities, making independent, commercially driven investment decisions.

- To follow meticulously all of the laws, regulations and rules of the countries and exchanges in which investments are made.

- To meet all disclosure requirements of relevant government and regulatory bodies in countries in which they invest.

- To maximize risk-adjusted returns, relative to well-established market indices.

- To recruit and retain world-class financial professionals either as in-house or external managers.

- To invest with a long-term perspective.

- To invest in a well-diversified portfolio across asset classes, geographies, and sectors.

- To maintain appropriate standards of governance and accountability.

All of this seems positive - exactly the sort of actors one seeks in today’s credit crunch. Its also basically consistent with what the funds have been saying; that they are long-term investors, primarily portfolio, with commercial motivations. And its worth noting - none of the officials worrying about sovereign wealth funds can actually find an example of funds acting for political - not commercial - reasons, but they worry that the possibility might arise as funds grow.

Furthermore - these guidelines address some concerns but they likely do not go far enough. A key part of disclosure is knowing the size, asset allocation and currency composition (at least roughly) so that one has a sense of the scale of investments and likely responses. With the size of assets under management, a strategy shift could move markets. Even though it might not be in a funds interests to liquidate, understanding the broad nature of positions helps to assess systemic risks.

As funds grow - a calculation dependent on oil revenues, investment returns and the share of official foreign assets entrusted to sovereign funds. Since the official assets are growing at a fast pace - Saudi Arabia and China alone added over $70 billion (valuation adjusted) in official assets in January- deciding how to respond to these flows in a way that keeps funds investing is necessary. Though some countries are spending more domestically.

The letter is thus significant for several reasons.

1. By all accounts Abu Dhabi’s Investment Authority is the largest sovereign wealth fund. Getting it on board is necessary for the voluntary code to succeed. It may thus want to be seen as a leader - as Singapore does also. While it may not manage as much as the circulating $900 billion estimates, it still likely manages over $600 billion.
2. It is the first significant public statement from the Abu Dhabi government which tends to disclose very little - ADIA for example makes almost no public statements. We tend to draw on press reports (Euromoney and NYT).
3. A broader notion of government investment. It’s not just about sovereign wealth funds - The letter describes the overall investment guidelines of the Emirate. Abu Dhabi, like other emirates has created a set of complementary (and possibly competing) entities to diversify their savings and contribute to economic development. The Abu Dhabi Investment Council seems to be intended to oversee investment. Mubadala, an investment company is a direct investor. Abu Dhabi’s energy companies (IPIC and Taqa) also invest overseas.
4. More predictability from both sovereign funds and the countries in which they invest likely benefits all.

The release of the letter implies that they are recognizing that not all the negotiations can happen behind closed doors, in bilateral or multilateral negotiations. Transparency could go a long way to lessening fears about links with government and risk management. After all, we could use more transparency from a range of private sector actors - if there had been less of an information deficit, we might not be in the current credit crunch. But there are separate issues raised by an opaque government actor than by an opaque, highly leverage private financial institution.

Likening themselves to institutional investors - which many resemble - is an attempt to shift the debate. Many long-standing sovereign wealth funds are surprised to find themselves called sovereign wealth funds. Ultimately there may be too much naming and finger pointing - what’s important is investment strategy and how decisions affect other market participants. Abu Dhabi mentions that its objectives make it is akin to a public pension fund or institutional investor. Where they differ, however is that it is unclear how it is accountable to the ultimate beneficiaries.

But, while this is significant, its not exactly a done deal. Chip Cummins notes that while the emirate’s investments are primarily passive investment with small stakes, it does not rule out increasingly active stakes in the future. Furthermore, it doesn’t express guidelines for voting, management etc. Also - and this may be setting the bar too high - but it focuses on the past but doesn’t rule out anything in the future. Abu Dhabi’s state owned enterprises are more likely to be involved in active management than ADIA.

So what does this all mean - does it give us more indication of changes to the investment regime?

Perhaps not yet.

Ultimately this may be a part of setting the ground rules for more detailed negotiations. The IMF board will discuss its draft paper this week. It also plays a role in educating the public who have been wary about sovereign funds. Current US and European discussions seem geared towards making sure that something usable comes out of the IMF discussions.

Sovereign funds are unlikely to go as far in disclosing information as the Europeans suggested (strategies, source of fund, leverage, holdings etc) but likely provide more detail to back up what ADIA suggests. Sovereign funds might also agree to share more information with the authorities where they do business - and international institutions - than with the general public.

But some people though think transparency and disclosure is insufficient. Proposals (see here for a summary) are starting to emerge on limiting voting rights, restricting sovereign funds to non-controlling shares, changing tax incentives on specific deals and the portfolio investments of government entities.

Entrusting the bulk of assets to external managers (as ADIA has done with 80% of its assets) does seem to answer many of the concerns raised about voting and controlling stakes. Outright restricting sovereign investors (or those voting on their behalf) from investment might just lead to funds being channeled through other vehicles. Stripping voting rights would remove a key and transparent means of influencing corporate governance whilst allowing the public to assume that unofficial influence is granted. But disclosing general principles about whether funds vote and in what cases seems appropriate.

One possible outcome - Differentiation between sovereign entities, with funds that disclose being treated in one way, and those that are more guarded treated another. This already happens in the court of public opinion. With Foreign official institutions investing more abroad - The TIC data as summarized on RGE’s economonitor shows how they financed the US in January- walking the fine line of encouraging investment whilst protecting national security and ways of doing business becomes more important.