Can Sovereign Wealth Funds Learn to Zig When Markets Zag?

April 21, 2015 by Loch Adamson

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One advantage of sovereign wealth funds is their multi-generational investment horizons, which should enable them to adopt a countercyclical stance in their investments: buy low, sell high. But Sovereign Wealth Center data shows they are more likely to follow the pack.

On a sunny day in Rome last week, Norway’s central bank Governor Øystein Olsen addressed the Italian Banking, Insurance and Finance Federation (FeBAF). The subject: the $890 billion Government Pension Fund Global (GPFG). He told the trade group audience that the fund’s long-term horizon puts it "in a position to be a countercyclical investor on a systematic basis." Norges Bank Investment Management (NBIM), which runs the fund, did so by frequently "rebalancing the share of the portfolio allocated to equities."

Such rebalancing — which requires the the sale of appreciated securities and the purchase of lagging ones — is inherently countercyclical and even contrarian. The practice has proven profitable, said Olsen, increasing returns by about 0.5 percentage points annualized since NBIM initiated the strategy in 2001.

Net monthly equity purchases, in billions of NOK and equity index, Jan. 2004 = 100

Source: Norges Bank Investment Management

NBIM has a strict rebalancing rule, ensuring the fund’s stock allocation remains between 56 percent and 64 percent. Other sovereign investors seem to be less disciplined in tacking against the prevalent market direction. Taking such contrarian-like positions often results in short-term losses, especially during times of market volatility and sovereign wealth funds need to have the backing and trust of various stakeholders — governments, parliaments or emirs — to execute such a strategy. Support can be difficult to come by.

But by avoiding short-term losses, sovereign wealth funds are not maximizing their ability to make long-term returns, according to experts. "Asset allocation rebalancing is widely used by liability-driven investors, and smart individuals," wrote Michel Meert, Director of Investment Advisory for professional services firm PwC in an opinion piece for Sovereign Wealth Center last week. Sovereign wealth funds, however, have generally been slow to employ the practice in a disciplined fashion. "It is not given sufficient emphasis," Meert wrote.

"Patient Investors"

Sovereign Wealth Center’s transaction database (which excludes NBIM’s open-market stock trades that are part of its indexed strategies) backs Meert up. Sovereign wealth funds could be far better at investing countercyclically. An analysis of our investment data from 2005 to the first quarter of 2015 shows that there is a strong correlation between upward swings in the market cycle and sovereign funds’ increased willingness to take on risk — and vice versa.

This trend suggests that although these funds are supposed to invest for the long term and theoretically be indifferent to cyclical market movements. Instead, they tend to follow trends like other investors — piling in as markets rise and selling when they tumble. That’s a surefire recipe for underperformance.

The 2008–’09 financial crisis was a case in point. When the chips were down, sovereign wealth funds drew back from the market: Their annual investment abroad fell by nearly half, to $44.8 billion in 2009 from $86.9 billion in 2008, even as they continued to pump cash into the financial services sector. Foreign investment declined further in 2010, to $37.7 billion. As a consultant in 2009, I pointed out that the retreat from the markets was ill-advised and was particularly surprising to see among the more experienced of these funds. "It would be short—sighted to forego opportunities to invest when they have available cash," I wrote at the time. "Moreover, for the first time in years, the current environment offers abundant opportunities for patient investors."

But pull back they did. Even relatively experienced investors like Singapore’s $315 billion GIC chose to sit on its hands. In 2007 GIC made $7.4 billion of direct investments abroad, in 2009 and 2010 the fund invested less than half that amount annually according to Sovereign Wealth Center data. While some of this drop may be accounted for by plummeting asset prices, the number of deals Singapore’s sovereign fund closed also dropped by nearly half, to 24 in 2009 from 42 two years earlier.

Rising Prices

To be sure, the trauma of the financial crisis was extreme and it might be asking too much of sovereign wealth funds, or any individual or institution to invest at the bottom of that cataclysmic market bust — although firms from Appaloosa Management to Berkshire Hathaway certainly did.

But in 2013, macroeconomic conditions were certainly less dire — though debate over the U.S. tapering of quantitative easing was raising investor concerns. State-owned investors’ investment abroad plunged to near-2010 levels: just$39.3 billion.

For NBIM, which is only permitted to invest in publicly listed securities outside of real estate, investing against the ebb and flow of stock markets does not entail inordinate risks, particularly given its almost unlimited investment horizon. But for those sovereign wealth funds that do invest in unlisted companies and other non—traded assets, the financial crisis provided a chance to act as purveyors of liquidity, providing equity or even debt funding to cash starved companies. They didn’t.

The chart below suggests that between 2008 and 2010 sovereign wealth funds favored buying publicly listed securities to unlisted assets as their appetite for risk plummeted with investor sentiment. Liquidity risk, or the likelihood that an asset may not be easily tradeable, is a concern for investors with liabilities to fund, but should not be for most sovereign wealth funds that are supposedly free from such obligations.

Sovereign Wealth Fund Direct Investments in Public and Private Assets Abroad 2005–’15

Source: Sovereign Wealth Center

After 2010, sovereign wealth funds took advantage of the opportunities in infrastructure, private equity and real estate. From 2011 — the height of the euro zone debt crisis — sovereign funds were able to purchase these assets at comparatively low valuations. With bond yields low, state-owned investors are allocating more of their portfolios to non-tradable assets as a way to generate higher returns. Prices now are rising sharply, increasing the chances of a bust.

Silk Road Fund

Most sovereign wealth funds invest to meet their risk-return mandates. We’re now a long way from the days of 2006 and 2007 when sovereign wealth funds were shrouded in mystery, largely thanks to the formation of the International Forum of Sovereign Wealth Funds and its members’ adoption of the Generally Accepted Principles and Practices (the so-called Santiago Principles), which guide their governance and investment behavior. The markets are now largely satisfied that these state-owned investors are not bent on manipulating the markets for economic or political purposes. But while this is true abroad, it is less the case in many of their home markets.

The wisdom of sovereign wealth funds investing in their domestic markets is a hot topic (see here and here) — too large to be tackled here — but it is obvious from Sovereign Wealth Center data that while on the whole sovereign wealth funds without an explicit domestic mandate tend to stay off their home turf, in extremis they do just that.

The chart below shows a spike in domestic spending in 2009, when it rose to $42.5 billion — almost half of their total expenditure — up from $23.9 billion the previous year, and just $5.3 billion in 2007. During the crisis, governments called on their sovereign wealth funds to rescue their economies, primarily supporting struggling local banks and real estate developers, as well as helping fund new infrastructure projects. Such largesse helped assuage local discontent with funds experiencing vast paper losses in Western bank bailouts and helped replace foreign capital, which fled Middle Eastern countries during the worst of the recession. 

Sovereign Wealth Fund Foreign and Domestic Investments 2005–’15

Source: Sovereign Wealth Center

Sovereign wealth fund investment in domestic markets crept up again in 2014 as oil prices tumbled in the second half of the year and the Chinese economy slowed to lowest levels of growth since the financial crisis. The People’s Republic of China’s sovereign wealth funds allocated a total of $8 billion to the State Council’s new Silk Road Fund, which was launched in December to finance an ambitious plan to expand infrastructure, resource development, industrial and financial cooperation with China across the Eastern hemisphere.

Chasing Bubbles?

Lastly. sovereign wealth funds have a habit of fueling asset price increases to unsustainable levels. Over the past year, Sovereign Wealth Center has identified three potential bubbles into which state—owned investors have poured cash.

Consumer Technology: The level of dealmaking in the consumer technology sector — particularly in the U.S. and Asia — is flirting with dotcom-era levels and sovereign wealth funds have been in the thick of it. Whether it is the Qatar Investment Authority, with an estimated $304 billion in assets under management, backing car-hailing app Uber Technologies at a $45 billion valuation, GIC supporting India’s rival to, Flipkart, twice in 2014, at a valuation of $7 billion in July and $11 billion in December, or Singapore’s $177 billion Temasek Holdings pouring money into Chinese firms like car-hailing app Didi Dache or online restaurant review service, sovereign wealth funds now see consumer technology as a growing sector in which they want to play.

But with technology companies seeking to avoid a replay of the 2000 dotcom bubble and shunning public listings, whether these investments will prove to have been unwisely overpriced won’t be known for years. Some funds have already made a killing. The Abu Dhabi Investment Council invested in messaging service WhatsApp in 2013. Whatever the valuation then, you can be sure that the Council reaped a mighty return on its investment when Facebook bought the company for $22 billion in October 2014.

Healthcare and Biotechnology: In 2014 health care and biotechnology stocks soared in the U.S. Buoyed by new drug developments, an aging population and industry-wide consolidation, the S&P 500 health care index advanced 24 percent in 2014. Sovereign wealth funds have, again, been prominent players. Temasek has been particularly active, buying stakes in Gilead Sciences, the $51.1 billion Alaska Permanent Fund Corp.–backed cancer treatment start-up Juno Therapeutics and Thermo Fisher Scientific. Even the Kuwait Investment Authority (KIA), got in on the game with a rare direct investment in NantHealth, a cloud-based healthcare information technology company.

Real Estate and Infrastructure: Sovereign wealth funds’ appetite for property and established infrastructure assets seems insatiable. But they are now facing growing competition for prime assets. This has either encouraged them to search for better yields in other types of properties — such as industrial, retail and logistics — or forced them to increase their offers. In particular NBIM announced last year that it will attempt to invest 1 percent of its $890 billion fund into core real estate in developed markets each year from 2014 to 2016. Last year it managed to deploy $5.4 billion. With yields now heading toward record lows, even NBIM is having to look outside gateway cities in Europe and the U.S. for reasonable returns.

Scary Place

Despite protestations to the contrary, sovereign wealth funds struggle to take advantage of one of their greatest endowments — their intergenerational investment horizon — by investing against the direction of the market. Paying greater attention to portfolio rebalancing might seem like a simple solution, but in truth it’s more complicated.

Achieving consensus among stakeholders for pursuing such a strategy is challenging in a political context. Governments, and particularly parliamentarians, hate to see even short-term or unrealized losses on a sovereign wealth fund’s balance sheet at the end of the year. Consequently they often seek to minimize losses at times of market volatility rather than using the opportunity to seek out longer-term gains. They want to avoid being taken to task for short-term red ink, as the $548 billion KIA is only too aware of as a result of its now annual public beratings in parliament.

One sovereign wealth fund that has actively sought to address this challenge by gaining the support and trust of its government owner is the $21.5 billion New Zealand Superannuation Fund. Matt Whineray, the fund’s CIO, told Sovereign Wealth Center last month that the difficult part of the fund’s strategic tilting strategy, which enables it to take short-term contrarian positions, is "to create the discipline to put the positions on notwithstanding volatility." To do so, the fund structured the strategy so that it makes such moves reflexively, rather than after deliberation. "Our default is to put something on and only in exceptional circumstances depart from the model, which really aids the countercyclicality of the strategy," Whineray says.

But such exemplars are scarce. Whineray concedes those contrarian bets are "a scary place to be" even for investment professionals. The challenge that all sovereign wealth funds face is to make their stakeholders less afraid of the short-term losses and incentivize their staff to take the long-term outlook. Both are easier said than done.

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