From the November 2008 issue of Wealth Manager Web • Subscribe!

NEW FUNDS ON THE BLOCK

Sovereign wealth funds (SWFs) look menacing to some, while others say they're beneficial for the global economy. But no matter what you think of these portfolios, it's hard to overlook them or underestimate their capacity for casting a long shadow on financial markets.

Globally, the value of SWFs exceeds the unlevered assets in hedge funds and private equity shops, the International Monetary Authority reports. But big doesn't always mean transparent. SWFs can be secretive about their operations and strategic objectives, in part because governments oversee a large chunk of this capital, and many of those governments are not democratic.

The combination of size, a potential for making a splash in the capital markets, and a lack of transparency unnerve some investors and policy makers. No matter, say the optimists, since money is money, and more investment is a good thing for the global economy and markets, regardless of the source. All the more so these days, with the credit crunch still biting.

Estimates of SWF assets start at around $2 trillion globally. Sheer size alone ensures that SWFs will be a major force in the world's markets, for good or ill. No wonder, then, that policy makers of late have been calling for establishing global standards for transparency and rules for investing.

In some respects, there's nothing new here. Institutional investors have long been a fixture in global markets, and that includes SWFs proper. The blueprint for establishing an investment portfolio for managing a country's wealth dates to 1953 when the Kuwait Investment Authority was launched to invest the nation's excess oil revenues. Today, the fund is valued at more than $200 billion and the Kuwaiti example has been copied many times over (please see the accompanying table.)

But not all SWFs are created equal. Many have little in common other than the label and a government that calls the shots on how the money is invested. True, oil wealth is behind most of the assets in SWFs, which means that the Middle East is home to a large share of these portfolios. Yet the inspiration behind establishing SWFs is usually basic economics. Oil-exporting countries, for instance, earn excess revenue--far more than can be prudently invested at home. As a result, these portfolios are first and foremost vehicles for recycling petrodollars with an eye on generating income for the country after the natural resources run dry. Other SWFs have more ambitious goals in mind. Chile's Economic and Social Stabilization Fund, for instance, has a mandate to promote kinder, gentler economic cycles in the country.

Ultimately, SWFs are just one more form of recycling capital in the global economy, says economist Edwin Truman, an authority on the vehicles and senior fellow at the Peterson Institute, a Washington think tank. "Over the past five years, the size of the global capital market has doubled, but asset holdings of SWFs have at least tripled," he said earlier this year in testimony on SWFs before the House Committee on Foreign Affairs.

The question is whether all of this is good or bad news for the U.S., investors and the global economy. For one dismal scientist's answer, read on.

Let's start with your definition of a sovereign wealth fund.

I try to emphasize that it's not a well-defined term, and so I use a description rather than a definition. I think of it in terms of a separate pool of international assets that are owned and managed, directly or indirectly, by a government. You can talk of domestic pools, but if the money's invested domestically it doesn't raise the same issues.

How big a pool are SWFs globally?

Something on the order of $4 trillion; I'm including government-managed pension funds that invest in marketable securities. So I'm not including Social Security, but I am including CalPERS [California Public Employees' Retirement System], for instance.

By your standard, the U.S. is a major source of SWFs.

The U.S., by my definition, has collectively the second-largest group of sovereign wealth funds. That's because we have very large government pension systems, and some commodity-based sovereign wealth funds, too, such as the Alaska Permanent Fund. We have at least $800 billion in sovereign wealth funds in the U.S. with assets invested abroad.

Four trillion dollars in SWFs sounds like a lot of money, but that's still fairly small relative to the global capital markets.

Yes, but sovereign wealth funds are bigger than the hedge fund industry and bigger than the private equity industry.

Are SWFs misunderstood?

One myth is that there's a net benefit to the world. I don't mean to say that there are no benefits [from SWFs], but these funds are just one more recycling mechanism. The notion that sovereign wealth funds make the international financial system more stable doesn't make any sense to me. They have to invest and they make choices about how to invest, and they invest in A rather than B, and so A gains and B doesn't. But there's no net gain for the system as a whole because whatever A gains, B loses. Overall, there's no way of proving that they'll always be net providers of stability to the system. For example, there are Russian sovereign wealth funds, but if we're picking a fight with Russia, they could dump all their dollar assets, just like anybody else. There's nothing inherent in SWFs that provides stability.

How, then, should we think about SWFs?

At the macroeconomic level, you can ask: Do we need more saving or more investing? You can argue it both ways. But if you say we need more savings, and SWFs are in some sense a vehicle for more saving, on the micro level it's certainly true that to the extent they go into places where others investors don't, they may provide net stability.

Are there risks associated with a rising pool of global SWF assets?

There are two major concerns. One is that they represent a shift in wealth from developed countries to other countries. The other issue is that this wealth is being managed by governments rather than by individuals, and that raises a host of other questions: Is the government investing wisely? Does the government pursue political motives? Will the rise of SWFs bring on protectionism? Are SWFs an advantage or disadvantage in terms of financial stability? Will there be conflicts of interests? All those things are involved with sovereign wealth funds.

Do those questions reflect valid concerns?

They're all valid potential concerns. If you think about financial protectionism [which has been raised in some circles as a response to SWFs], certainly that's a valid concern. It's also a valid concern that there could be a lot of corruption in the management of this money.

Will the rise of SWFs change the investment game in the U.S. and around the world?

I think it has changed things a bit on the margins because these funds are big players, and they compete on the demand side. I've heard, for example, from people in the investing business that they're concerned that sovereign wealth funds are increasingly investing in hedge funds, private equity and so on, and that's driving down returns in those investments.

The SWFs that attract most of the attention these days--some of it negative--are the commodity-based funds in the Middle East, along with China's portfolios. Is there a reason to see those funds as more threatening than other SWFs?

There are new players, and they're wealthier today than they were five years ago. That makes us feel uneasy because the decisions for those funds are being made directly or indirectly by governments, and some of those governments aren't particularly friendly to us or particularly transparent in their activities. They may be benign, but it's not always easy to tell.

Some of the more pessimistic concerns focus on SWFs taking a large or controlling share of U.S. companies.

There is a narrow national security dimension to this. SWFs are run by governments, and to the extent that one worries about governments and their motives, there are national security implications, although we have processes to deal with that. Then there are the broader issues regarding foreigners buying our crown jewels. I don't consider that a national security concern, but some people may. Thirdly, once SWFs own substantial or controlling stakes, they can essentially employ those ownership interests to our detriment. That's true for any foreign investor, but it would be a foolish foreign investor who does that.

Moreover, people forget that, when talking about direct investments, we have a lot more control. If there's a hot conflict in the Taiwan Strait, you can imagine that U.S. authorities would seize Chinese assets in the United States. I think those kinds of concerns can be exaggerated, though, because it's not in the interests of investors to cause trouble since they'll lose money.

Remember, too, that the U.S. has something like $17 trillion in foreign liabilities--foreign claims on the United States. About 20% of that is foreign governments, although that's probably slightly understated. If you think about all our foreign liabilities, governments are a significant but minor fraction.

To the extent that SWFs recycle foreign earnings in the global economy, is that a good thing?

If you didn't recycle money through official channels, you'd recycle it through private channels. Overall, sovereign wealth funds aren't any different than recycling through other means. SWFs are one more recycling channel.

The question is whether there's more potential for mischief- making with SWFs compared with other channels?

On one level, the answer is "yes," because it involves governments, which, by definition, are different than individuals.

What is your reaction to the call by some for limiting SWF investments?

If it's SWFs today, it may be central banks tomorrow, or individuals. You could easily start a defensive run. Trade moves slowly; finance moves at the speed of light. If the world decides that we have become less friendly to foreign investment in all forms, then that realization will trigger a run on the banks and substantial sales of U.S. assets, and that will drive up interest rates and drive down the dollar. If we say SWFs can't invest in the U.S., then the $800 billion in U.S. SWFs are at risk of being shut out from the rest of the world.

James Picerno (jpicerno@sbmedia.com) is senior writer at Wealth Manager.

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