Gaurav’s Weblog

How do governments invest their own wealth and why is it such a controversial area, asks Don Brownlow

Source: IBSJ Wealth Management Supplement – November 08

Middle Eastern and Chinese investment into the US banking system has been widely reported. How have those investments faired during the current banking turmoil, where did the money come from and who are behind this type of government investments?

Back in 1960, when Kuwait placed some of its newly found oil-wealth into an investment fund and called it the Kuwait Investment Authority, it didn’t know that it had just created one of the first international Sovereign Wealth Funds. Depending on how they are counted and which are included, there are now around 40 of these state investment vehicles. By conservative estimates, at the end of 2007, they controlled $3.3 trillion – more than the total amounts in hedge funds and private equity combined. Of the 40 or so funds out there, twelve have been formed since 2005. Governments are now controlling an increasing share of international wealth.

Although some of these funds are new, many of these state investment vehicles have been around for a lot longer than the term Sovereign Wealth Funds (SWF) which was coined to describe them. There are still on-going scholarly debates as to a definition of exactly what constitutes an SWF, but John Nugée, managing director, State Street Global Advisors, offers a simple working definition: ‘SWFs are sovereign-owned asset pools that are neither traditional public pension funds nor reserve assets supporting national currencies’. There are many other definitions but most allude generally to ‘special purpose investment funds owned by governments’. Nugée told a briefing earlier this year that ‘some funds don’t want to be known’ as an SWF ‘because of the bad press’.

If these government investment funds, or SWFs, have been around for so long what has caused the recent handwringing and emotional outbursts from (mostly) western governments in a debate described by the Financial Times as ‘generating more heat than light’? The reason for the apparent concern may relate not only upon the growing number of these funds and their explosive increase in size, but in the fact that the investor is not simply a wealthy fund but is actually a foreign state.

One commonly expressed fear is that the combined size of these foreign statecontrolled funds could exceed the size of the US economy within just a few years. Part of the reason for the surge in the size of these funds is the recent rapid rise in commodity prices – particularly oil and gas. There is also the trend of some countries to reduce their investments in US treasury securities and repatriate funds. Another reason is that some governments may be putting more of their assets into an SWF rather than simply keeping them as central bank reserves because an SWF is able to invest in a wider range of asset classes than would normally be associated with central banks. For some countries, particularly the smaller oil-rich ones, it may be that a government does not want current revenues to directly enter its economy and cause overheating. By putting excess earnings in an SWF off-shore, it can accumulate funds for the future without introducing significant inflation into the economy.

‘SWFs are probably keeping their powder dry and cheering from the sidelines as governments try to put things right’ – John Nugée, State Street Global Advisors

Although sheer size may concern some observers, the issue is aggravated by the lack of transparency of some SWFs’ investment strategies and the individual investments that they make. While the SWFs themselves argue that other investment groups, including hedge funds and private equity, are also secretive about their investments, some observers fear that SWFs may take positions for reasons that are not purely commercial. The nervousness seems to be increased by the fact that the trend is for the developing world to buy private companies in the developed world. The secretive nature of some of these funds does little to ease the geopolitical worries of the western economies. Nugée comments that, ‘some SWFs don’t want people to know’ about their investment strategies.

Not all SWFs are shrouded in secrecy. One of the most transparent is the Norwegian fund. This is still often referred to as the Petroleum Fund, although its name was changed in 2006 to the Government Pension Fund, even though it continues to obtain its funds from oil revenues and not pensions. This fund is quite open about its investments and its holdings. The fund is also known for its principles of ethical investments, which excludes firms worldwide that are involved in arms or defence projects as well as those associated with exploitation or child labour abuses.

The US-based Sovereign Wealth Fund Institute has created a scoring model, the Linaburg-Maduell Transparency Index, which attempts to allocate a ‘score’ to the degree of transparency of an SWF. Using this index the Norwegian fund mentioned above obtains the highest score of ten, whereas a ‘secretive’ SWF such as Nigeria’s Excess Crude Account or UEA’s Emirates Investment Authority has a score of one, the index’s lowest score.