The Triple Threat Facing Sovereign Wealth Funds

September 15, 2015 by Loch Adamson

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The combination of collapsing crude oil prices, wild currency swings and heightened governance scrutiny has created a challenging environment for many of the world’s largest sovereign wealth funds.

From the Mendenhall Glacier in Juneau to Prudhoe Bay above the Arctic Circle, Alaskans by the thousands will soon tear open crisp white envelopes containing the dividend checks they receive each year from the Alaska Department of Revenue Permanent Fund Dividend Division, which doles out money from the state’s $52.8 billion sovereign wealth fund. 

They may be happily surprised. Despite the 60 percent drop in crude prices since June 2014, each oil-fueled check should top $2,000, by our estimates. That’s up from the $1,884 each of Alaska’s approved recipients got last year and just may be the highest total since the fund began paying such dividends in 1982.

With oil near its lowest price since the 2008–’09 financial crisis, the payout is testimony to discipline — and to the power of diversification. To tame the roller-coaster effects of hydrocarbon prices on its portfolio, the Alaska Permanent Fund Corp. (APFC), like the managers of many  sovereign wealth funds, spreads its money across myriad asset classes. Today the fund is invested in areas as varied as infrastructure, private equity and plain old U.S. Treasury bonds, using strategies that range from so-called smart beta to arbitrage. 

Alaskans’ annual payout is based on the average earnings the fund generated over the previous five years. The key determinant is not the price of crude but profits. "Realized earnings are tied to activity in the portfolio — not the price of oil," says Valerie Mertz, the APFC’s acting executive director and its chief financial officer. The fund, which has saved more than half its earnings for future generations and dispensed the rest to citizens, has generated impressive returns given its conservative guidelines, gaining some 10 percent annualized, for the five years through June 2015. For the fiscal year ended June 30, 2015, the fund posted a preliminary 4.9 percent return, following a 15.5 percent return for fiscal 2014.

Sifting through minutes of APFC board meetings, which are posted online, one can see that the subject of oil prices barely arises.  Alaskans have not voiced concerns to management. "We have had no communication from the citizens of Alaska regarding the decline in oil prices," Mertz says.

Armageddon is not upon the Alaska Permanent Fund or the world’s sovereign wealth funds — at least, not yet. Still, the oil sell-off is putting hydrocarbon-based pools of capital through a grueling test. Many, like Alaska’s fund, are notching passing grades, particularly those with longer histories, big portfolios and well-executed diversification strategies.

Undoubtedly, the situation will change for the worse if today’s low oil prices continue for several more years. But there is little or no panic selling of illiquid assets and, with a couple of notable exceptions, like Russia’s pension fund, few blatant violations of the rules on disbursements of funds to governments, even as jurisdictions like Alaska and Norway are depleting their oil reserves. 

The meltdown in oil prices isn’t the only challenge facing sovereign wealth funds. In a corner of the financial world known for gradual, almost glacier-like change, the state-owned investors are suddenly being forced to grapple with a host of what may prove to be transformational developments. These include a spell of wild currency swings, including a 13 percent drop in the euro vis-à-vis the dollar over the 12 months through late August. The Norwegian krone is down 25 percent and the Russian ruble 48 percent. "Sovereign wealth funds are increasingly focused on the impact that currency moves can have on their investment portfolios," says Joseph Konzelmann, senior sovereign strategist at Goldman Sachs Asset Management in New York. "As long-term investors, sovereign funds have taken these moves in stride." A June survey by Invesco found that 57 percent of sovereign funds now use foreign exchange hedges to either safeguard their portfolios or try to turn a profit. 

Read the full story at Institutional Investor’s website.

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