• Wed
  • Oct 22, 2014
  • Updated: 9:07am

A passive solution for sovereign wealth funds

PUBLISHED : Wednesday, 03 September, 2008, 12:00am
UPDATED : Wednesday, 03 September, 2008, 12:00am
 

The representatives of the world's sovereign wealth funds, some of the most powerful but least accountable financial institutions on the planet, are meeting in the Chilean capital Santiago in an attempt to agree a voluntary code of practice.

While they are blathering, the answer should be staring them in the face.

Unlike central bank reserve managers, who prize minimum risk and maximum liquidity and so tend to buy low-yielding but uncontroversial government bonds, sovereign wealth funds or SWFs typically have a mandate to invest aggressively in pursuit of higher returns.

This is a problem. For one thing, SWFs are big and growing bigger. According to the International Monetary Fund, they control assets worth about US$3 trillion today that are likely to grow to US$10 trillion over the next five years. With the entire capitalisation of all the world's stock markets worth about US$42 trillion, SWFs will clearly have an enormous influence on world financial markets.

More to the point, many of the biggest are almost completely opaque and run by governments that are themselves undemocratic and unaccountable. As a result, observers around the world fret that the real objectives of some funds may not be to generate decent risk-adjusted investment returns over the long run but rather to flex dictatorial regimes' financial muscles in support of their political aims.

Whether or not their aims are mischievous, SWFs' lack of transparency inevitably will attract criticism and some of it will be deserved. Edwin Truman at the Peterson Institute in Washington has devised a scorecard ranking SWFs for factors such as governance, accountability and investment strategy and has found many of the biggest sorely deficient (please see charts below).

Wharton business school professor Olivia Mitchell has compiled a similar test, with similar results. 'As SWFs have grown, they appear to be demonstrating an increasing risk appetite, very little transparency and virtually no clarity of objectives,' she wrote in a paper published in July.

Such behaviour is not only going to feed opposition - Germany last month passed a law restricting SWF investment - but it could also lead to heavy losses. The China Investment Corp's most high-profile investment, in US private equity group Blackstone, is currently under water by 40 per cent.

If they were smart, SWF bosses would realise they can kill both birds with one stone. Not only could they silence their critics in a single move, they could also go a long way to ensuring acceptable long-term returns if they ditched the idea of actively managing their portfolios. Instead, they should become passive investors, merely replicating and tracking stock and bond indices.

This would be a deeply uncontroversial move. With the world's equity and debt markets together capitalised at about US$100 trillion, passively managed SWFs would jointly own no more than 3 per cent of each outstanding issue - a small enough stake to reassure even the jumpy Germans.

Not only that, adopting a passive investment style could well yield better returns in the long run. That's because active management is all about exploiting market inefficiencies. An active manager spots a security he believes is underpriced, and buys lots in the hope of beating the market.

That's relatively easy to do if you manage a fund of US$1 billion. A US$100 million investment which appreciates 50 per cent lifts your portfolio by 5 per cent. But if you manage US$100 billion, it adds only a negligible 0.5 per cent to your overall return.

In other words, the bigger your fund, the harder it gets to generate market-beating returns through active management. The only way you can do it is through taking massive punts by buying huge stakes in big companies. As we've seen, that's not only controversial but highly risky.

In the long run, SWFs would be better off saving themselves money and choosing the far cheaper option of indexation. They won't, of course; that would be far to dull.

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