Are Sovereign Wealth Funds Making Good Decisions?
IMF paper argues crisis might have changed them for the worst.
March 16, 2011
The financial crisis caused all investors to rethink their risk exposure – not just to the known risks, but to risks that hitherto had existed only in the background, such as counterparty risk. Even investors with the longest of long-term horizons were wounded – and now may be rethinking their asset allocations.
So say Peter Kunzel, Yinqiu Lu, Iva Petrova and Jukka Pihlma, researchers at the International Monetary Fund. In their paper, "Investment Objectives of Sovereign Wealth Funds—A Shifting Paradigm," they argue "the global crisis may have changed SWFs' asset allocations in ways that may not be ideal or justified in all cases and that a review of investment objectives may be warranted."
To get at this, first they introduce a classification of SWFs. "SWFs are typically categorized as stabilization funds, savings funds, pension reserve funds, or reserve investment corporations. The majority of established SWFs are either savings funds for future generations or fiscal stabilization funds."
Given that diversity, "[t]he type of SWF, its investment horizon and funding source, and other balance sheet characteristics should all affect its strategic asset allocation." While many have long-term horizons, others do not. "Thus investors with short or very uncertain investment horizons, such as stabilization SWFs, would be expected to have a larger share of their investment portfolios in cash and relatively liquid bonds to be able to meet potential and sometimes unexpected outflows without incurring large losses in the process."
But it's hard to match theoretical expectations to what different types of SWFs actually do with their investments. The IMF researchers categorize SWF holdings into four classes: cash, fixed income, equities, and alternative assets. That's not a perfect data fit for each type of SWF, at least so far as the source of revenues is concerned – whether foreign currency reserves or natural resource revenues.
Still, analysis indicates that "[t]he global financial crisis affected SWFs worldwide. The sharp downturn in asset prices, particularly prices for equity and alternative investments, resulted in large losses for many SWFs … In some cases, the losses reached 30 percent of the portfolio values for 2008, thereby impairing SWFs' long-term returns as well."
It's a question of market-timing – buying at peak prices – as well as due diligence. Think Wall Street investment banks that blew up. Some SWFs were heavy investors in historic names that now have only legacy – or memorabilia — value.
A key point in the paper is the equity drag during the financial crisis. "Pension reserve funds and savings funds suffered equity valuation losses during the period September 2008 through March 2009, but have since recovered. ... SWFs with both stabilization and savings objectives—which are mostly invested in fixed-income assets—have weathered the crisis relatively unscathed."
Are the more aggressively oriented funds – aggressive by their definition as long-term funds – changing their ways? Yes and no. "SWFs with previous investment in alternative assets have increased their investments in such assets, presumably with a view to further diversifying their portfolios." That's despite losses due, mostly, to the Great Liquidity Crisis. And it depends on the asset strategy.
"Some SWFs are re-examining the traditional asset class-based approach to SAA [strategic asset allocation] and have started to use, or are considering using, a risk factor-based approach. The Board of the Alaska Permanent Fund, for example, decided to choose an approach to asset allocation 'that is a good fit for the goal of building an all-weather portfolio' and decided to group investments by their risk and return profiles, and by the market condition or liability that each group is intended to address."
A useful step. But only the first of many, the IMF researchers suggest.