Don’t fear SWFs, say consultants

Consultants last week defended the reputation of sovereign wealth funds (SWFs), which are among the last remaining sizeable pools of liquidity in the markets, and decried the political suspicion that surrounded the sector.

Speaking at a State Street briefing on SWFs, John Nugee, head of State Street’s global institutions group, said that SWFs had never shown an intention to pose any threat to the financial system of which they are a net beneficiary.

Away from that event, Richard McManus, a member of the management group at PA Consulting in London, echoed Nugee’s sentiments, dismissing Western protectionism of “strategic assets” as tantamount to xenophobia.

But others, such as Pars Purewal, UK investment management and alternatives leader at PricewaterhouseCoopers in London, said it was a natural (if misguided) response to the easterly shift of global economic power.

Nugee said that instead of calling for increased regulation and transparency, Western parties should be engaging SWFs in dialogue to reassure themselves of their long-term objectives.

“SWFs owe us nothing,” he said. “They are market participants and their only duties are to their own people.”

However, SWFs’ determination to appease Western fears about their growing influence – by not taking seats on the boards of companies they invest in, for example – might itself be having a detrimental impact on corporate governance globally.

“Corporate governance may be suffering,” said Nugee. “Passive investment is the friend of poor management. It is better to have an involved investor than a disinterested one.”

This is likely to change in the near future, as faltering performance prompts SWFs to become more activist to protect their investments, added McManus.

The effective nationalisation of Western assets by foreign governments – which has been a major concern for some Western governments – may prove a positive development, offsetting the short-termism of many Western investors and allowing managers to take a longer-term view, said McManus.

SWFs currently manage about US$3trn in assets globally, a figure that will grow by 17%–20% per year over the coming years, to about US$20trn by 2020, predicted Nugee. In the last year, SWFs have grown by about 25%, fuelled by the commodities bull market, with 14 of the 20 largest SWFs being commodity-export based.

State Street projects that the proportion of SWF wealth invested in equities will eventually grow from just under 50% now to 60%, with a commensurate growth in alternative investments such as hedge funds and private equity, as well as in direct equity investment.

Correspondingly, the proportion invested in fixed income – especially US Treasuries – will fall, pushing up real yields and putting significant downward pressure on the US dollar, Nugee said.

But Purewal said SWFs were a long way off reaching the size of pension funds, when they might have a significant impact on such big markets.

There is little prospect of SWF growth being arrested. In some commodity-rich economies, the wealth being accumulated is “beyond the ability of the domestic market to absorb it”, Nugee said. Asian central banks are also keen to accumulate reserves that will enable them to manage their currency movements if markets enter a period of stress similar to 1997.

SWFs will also see growing diversity in their investments and strategies and a lengthening of their investment horizons – notwithstanding their already considerable differences in age, size, structure, approach to corporate governance and liabilities.

SWFs backed by oil money have very different investment targets to those funded by excess FX reserves. Norway’s oil-backed fund, for example, achieved an annual return of 6.5% between 1996 and 2006, beating its benchmark every year.

For the China Investment Corporation (CIC), which has US$200bn in assets, there is an implicit hurdle approaching 10%: a 4%–5% interest rate on its government bonds and a 5% structural appreciation of its currency. Returns of 6.5% would, therefore, be inadequate for this debt-backed SWF.