The SWF world

In the 1966 Norman Jewison movie The Russians are Coming, The Russians are Coming, Soviet submariners run unwittingly aground off New England and go ashore to find a towboat, triggering village rumours of an invasion. You may be excused for harbouring similar feelings toward sovereign wealth funds (affectionately known as SWFs), the new, massive investment pools seeking a good investment in a town near you.

Indeed, you may remember that Four Seasons Hotels and Fairmont Hotels were snapped up by Saudi-based SWFs, and that Chinese and Gulf attempts to buy U.S. oil concerns were to no avail.

It seems SWFs are a whole new ballgame, and they have upped the ante somewhat.

But what are they? To explain, I shall enlist the help of Michala Marcussen, Head of Strategy and Economic Research at Société Générale Asset Management, who recently toured Canada to speak on the topic. There is no universally accepted definition, but let’s try. Essentially, a SWF is a savings pool wholly owned by a national entity, with limited liabilities and primarily invested in foreign assets. Its actual structure is typically that of a private equity-like investment fund, and its raison d’etre is the management of large commercial surpluses (such as Norwegian oil revenues and Norway’s Government Pension Fund or GPF) or foreign exchange surpluses. It’s no surprise Norwegians want to manage their USD $375 billion of accumulated oil revenues or that China may want to invest some of the money made while manufacturing for the world.

How important are SWFs? According to Marcussen, current assets are in the US$3 trillion range, and will reach around US$8 trillion in the next five years. To put this in context, compare this to the roughly US$26 trillion in pension funds worldwide, $27 trillion in mutual funds, or $2 trillion in hedge funds. If you think about how influential hedge funds may be with that kind of money, you can see how SWFs can be a very significant marginal player. Think of them as a new generation of private capital players, with the world as their playground.

SWFs matter because they invest massively in developed economies. More precisely, they invest in government debt such as Treasuries, for instance. Marcussen explains that SWFs are a byproduct of a world order in which developed economies (and none more so than the U.S.) borrow to consume, and borrow from the very nations they consume from. This creates a very interesting monetary cycle in which the U.S. borrows – in U.S. dollars, as the greenback still remains the reserve currency par excellence. This is highly unusual, and according to Marcussen, rests upon what she calls the U.S. bond yield conundrum: relatively high U.S. interest rates coexist with a strong U.S. dollar, in the midst of huge current account imbalances by which emerging economies are essentially financing advanced economies.

Just another Ph.D. dissertation? Not quite. All this matters to you and me inasmuch as SWFs are, well, sovereign. They are controlled by a government that may have its own goals. Marcussen gives the example of the Norwegian GPF purporting to impose stricter environmental requirements on Exxon Mobil, in which it had significantly invested, than on its own national oil company, Statoil. This raises the issues of ulterior motive and the bounds of sovereign control: can SWFs do indirectly – through investing, what governments can’t do directly through negotiation, diplomacy, or war?

An even bigger issue is that of outside control of debt levels. If outside nations hold significant amounts of a country’s debt, they can start managing it, to the potential chagrin of the issuer nation. Marcussen presents a recent study that shows potential reallocations of SWF foreign exchange reserves. Most of these reserves are currently invested in developed economy bond markets. However, a reallocation to a reasonable stock and bond mix would entail lower bond investments in the trillions (more than USD $1 trillion in the U.S. alone). At the same time, it is estimated foreign central bank holdings of U.S. Treasuries prop yields up by between 50 and 200 basis points, depending on the source. Put these together: it means SWFs have the potential to significantly impact bond yields and, indirectly affect monetary policy, in the states they invest in, especially since they are much more inclined to invest in equity than in bonds.

The other issue is transparency. As with other private equity investment pools, transparency can be spotty at best. The most transparent SWFs are of U.S. and European origins; the worst are from – let me be diplomatic – “high-growth” nations.

So should you embrace or despise SWFs? They do represent a true source of long-term, patient funding, and are supported by their home governments as a key activity. Indirectly, they also help companies access new markets. But we cannot abstract from matters of national purpose, uncertain motives and sometimes, poor transparency and governance.

Pierre Saint-Laurent, M.Sc, CFA, CAIA is president of AssetCounsel Inc.