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An Alternative Way to Hold Sovereign Debt

PERSPECTIVES: Sovereign wealth funds face many short-term challenges but offer long-term promises

Patrick Bolton, Joseph Stiglitz, 2 February, 2012 | 12:59PM

From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Columbia Business School's Patrick Bolton discusses a new book, co-edited with Joseph Stiglitz, on sovereign wealth fund investment and the unique position of these increasingly common funds. If you are interested in Morningstar featuring your content, please find further details here.

Not so long ago sovereign wealth funds (SWFs) were viewed with a good deal of mistrust. Today, while not without challenges, they are considered potential saviors for a rattled global economy. What changed?

Better communication between fund managers, the investor community, and governments. Many funds have embraced the Santiago principles — the code of best practices developed by the IMF and the International Forum of Sovereign Wealth Funds that address legal issues and transparency, which has led to greater comfort on the part of countries in which SWFs have investments. Also, we have seen very prominent funds apply very professional standards to their investments, allaying fears that their governments are guiding the funds.

The crisis of 2007–08 was also quite influential. Major financial institutions, banks, and insurance companies badly needed recapitalisation, and they began to seek out SWFs, which were often the only funds willing to contemplate such investments. While the funds have lost money to date as large, long-term investors, they are no longer unappreciated as a natural source of capital for large institutions.

Can SWFs play the same role with the eurozone crisis?

If you are a reserve fund, as SWFs are, government debt is a very attractive investment because it’s safe. But the eurozone crisis makes these investments less liquid and less safe, and SWFs have been holding a lot of eurozone debt. Many SWFs are outside the Eurozone, and it’s a big and natural clientele: they have a very long investment horizon and are naturally placed to absorb these shocks. So if you want insurers for global capital markets, that’s a very natural place to be — although those investments don’t look great in the short run, and the fund managers have begun to understand that they should not invest quite so much in government debt.

The book reflects the proceedings of a conference held last year, Sovereign Wealth Funds and Other Long-Term Investors: A New Form of Capitalism, a joint effort between the Commitee on Global Thought at Columbia and the Sovereign Wealth Fund Research Initiative of University Paris Dauphine. What does “a new form of capitalism” mean?

Capitalism has been associated with capital and financial markets where the primary sources of capital have been private rather than public. New players — they are few but large — are public entities with different time horizons, capabilities, and objectives. The Norwegian fund’s objective, for example, is wealth preservation for future generations of Norwegian citizens. Its managers have to ask: what risks is a typical Norwegian in a future generation exposed to? How do you hedge against those risks? How do we invest to maximise wealth in the long-term? That’s the financial dimension.

There is also the social dimension: to the extent that the representative Norwegian citizen is concerned with, for example, climate change, that concern must be also taken into account in the funds’ investment choices.

I use Norway as an example because among critics of SWFs, who would be afraid of Norway? Yet the objectives of the Government Investment Corporation (GIC), the Chinese fund, like Norway’s, include socially responsible investing and avoiding armaments and tobacco. I would not say it is consistent across funds — and we don’t know the composition of many SWF portfolios — but even if we look at just a handful of funds, the total assets under management are enormous. If a large fund shies away from stocks it views as socially irresponsible, that has an effect.

SWFs are known for passive investing and what some have characterised as “excessive prudence.” Is this attributable to the double standards and regulatory hurdles that the funds face?

Some of it is. If a fund wants to conduct long-term investment and potentially increase risk, it must have staffing, which remains quite small [at most SWFs], though they are growing larger quickly. That is probably as important an obstacle as regulatory challenges. Consider one older example involving GIC: when GIC took a position in Morgan Stanley, they took up to 6% of equity. It was nonvoting and it was only on that basis that they could take a stake. Who else would agree to take 6% stake in an investment bank without having voting power or board representation?

But you can make the case that the responsible thing for a large investor to do is be an active investor. Norway is aware that it is holding big chunks of publicly traded corporations and that doing active governance would effect their investments. Whether that translates into active voting in proxy battles in takeovers and so on is another matter.

What other challenges and obstacles do SWFs face?

The European debt crisis has made SWFs look for other long-term, lower-risk investments. One naturally attractive alternative with huge potential is infrastructure investment. We’ve seen, for example, the GIC invest in U.K. infrastructure. Anything you can do to match long-term funds with long-term investments like infrastructure would be a big improvement.

But that brings us back to the regulatory obstacles and lack of expertise on the part of the fund managers. You need infrastructure banks or platforms that would help bring investments to the SWFs and allow them to co-invest. And SWFs want large investments and don’t have staff to review a lot of smaller investments — they need intermediaries that would work as aggregators. So instead of showing an SWF a low-carbon electric utility one plant at a time as a long-term investment, you bundle many plants. That saves time in terms of due diligence, is more efficient, and spreads risk through large aggregated investments.

What about political risk associated with SWFs?

Political risk rests on both sides. On the investor side if you let in an SWF, your may carry risk with respect to political developments by the sponsor of the fund. When Gaddafi was leading Libya, you would have thought twice about what it meant for Libya’s fund to invest in your firm or your government bonds. This is where governance comes in. Over time, the fund has to develop an independence from the government — much like central banks are independent, which reduces the political risk.

The broader question is who should carry what type of risk? At which level do they hold bonds? Do they hold equity tranches of these infrastructure investments? If they hold equity, should they insure out political risk? And if they insure it out, who should hold that political risk? These are all questions that have to be resolved.

Given their size and potential influence, how might SWFs influence climate change and sustainability?

One of the biggest risks the very large funds face is uncertainty over the future price of carbon. Investors working on a 50-year horizon know that carbon pricing is coming their way, but they don’t know when, and they take a very different view from the typical investor who works on a five- or 10-year horizon who just takes a bet that carbon prices aren’t going to rise much in the next five years. The long-term investor has to think today what it means to be exposed to that risk and how it can reduce the costs of the future price of carbon — and has more to gain by investing more in renewable energy than in carbon-dependent industries like oil, automobile production, or airlines.

One last thing — until the financial crisis, the difference between long-term and short-term investing was underappreciated. We are now seeing research emerge that emphasises that difference, with implications for portfolio composition, risk analysis, and so on. There is an opportunity for SWF fund managers to tap into that research and gain a better understanding of how to think about portfolio management.

Patrick Bolton is the Barbara and David Zalaznick Professor of Business in the Finance and Economics Division and a senior scholar at the Jerome A. Chazen Institute of International Business at Columbia Business School.

Joseph E. Stiglitz is University Professor, co-chair of Columbia University's Committee on Global Thought, co-founder and co-president of the Initiative for Policy Dialogue and Columbia University.

Columbia Ideas at Work is a bridge between business research and practice, offering key insights from Columbia Business School’s faculty members in a format that is easily accessible to busy executives and practitioners.

The views contained herein are those of the author(s) and not necessarily those of Morningstar.

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