What’s All the Fuss? A Primer on Sovereign Wealth Funds

What is the purpose of these funds?
Unlike foreign reserves, which are used by countries to stabilize their currencies, the primary goal of most SWFs is to maximize returns. If a country depends on commodity exports such as oil, an SWF can help mitigate some of the boom-bust cycle, such as Alberta’s Heritage fund intended. SWFs can help to build up national savings for future generations, such as the Government Pension Fund of Norway. There may be other strategic or economic reasons for creating SWFs such as the Government of Singapore Investment Corporation which has attempted to create an international financial centre, with a network of offices in financial capitals worldwide.

How large are the funds?
It is estimated that the funds control up to US$3 trillion, which, to put it in perspective, is almost double the estimated size of hedge funds at about $1.6 trillion. The largest is Abu Dhabi at $1.3 trillion followed by Norway’s Pension Fund $350 billion and Singapore’s at $330 billion. There are eight funds each with more than $100 billion in assets.

What have they invested in recently?
In June 2007, while the new $200 billion China Investment Corporation was being formed, it bought a $3 billion stake in Blackstone Group’s IPO, and in December 2007 bought a 9.9% stake in Morgan Stanley for $5 billion. In November 2007 the Abu Dhabi fund bought a 4.9% stake in Citigroup for $7.5 billion. And in December 2007 the Singapore fund and a large investor bought a 10.8% stake in UBS for $11.5 billion. These recent major financial institution investments helped the firms shore up their capital in the face of large subprime mortgage losses. Over the past year there have been SWF investments in other major financial firms such as Barclays, Bear Stearns, Citigroup, HSBC Holdings and Merrill Lynch, bringing the total SWF investments in this sector to an estimated $70 billion. In general, these investments have been received favourably by the markets.

What concerns have been expressed?
At one level, these types of investments are nothing more than foreign investments, albeit by foreign governments. But there are certain industries and certain country funds that cause concerns. For example, in 2005 there was a major controversy when China National Offshore Oil Corporation (technically not an SWF but a state-owned oil company with 70% of the shares owned by the government of the People’s Republic of China) made an $18.5 billion all-cash offer to buy U.S. oil giant Unocal, outbidding Chevron. A group in the United States Congress argued that the Chinese government had questionable motives and that there could be an economic or security risk related to some of the drilling technology. Given the delays and threat to the deal, the bid was withdrawn and Unocal was acquired by Chevron.

Another example, in 2006 was a deal by a government-owned business in the United Arab Emirates, Dubai Ports World, which would give it control of U.S. ports, that was met with fierce resistance and protests in Congress, with concerns over homeland security. Yet despite much rhetoric, it was never shown to be a meaningful threat. (Eventually management of the ports was transferred to a U.S. company.) With many of these SWFs based in oil-rich Middle Eastern countries, and given recent high oil prices, these funds have grown tremendously and are projected to increase at a staggering rate as oil revenues climb. The concern is that at some point the power of these funds may be used for political or non-investment purposes.

Why have they been in the news lately?
The topic of SWFs was raised at the recent World Economic Forum at Davos. Lawrence Summers, former U.S. treasury secretary, on the one hand praised SWFs noting “The world is a better place” because of their recent financial sector investments, but also called on these funds to agree to a code of conduct regarding the types of investments they would or would not make. Unlike the Canada Pension Plan Fund, the U.S. Social Security Trust Fund has decided to invest only in government bonds and not enter the equity market, which caused Summers to ponder the motives of other countries. Summers expressed concerned that if an SWF makes a large investment in a poorly-run firm it might entrench management. He was concerned that there may be motives beyond value maximization, for example, ensuring that a supplier is sourced in the host’s home country. He was also concerned about general politicization, for example if a fund were active in trading in foreign currencies and made a huge bet like George Soros’s fund did in 1992, shorting $10 billion worth of the British pound.

Should we be worried about SWFs?
What we are witnessing is the continual evolution of equity markets and a concentration of control. As long as wealth maximization remains the motive for investments, we shouldn’t be concerned about the size and potential influence of our own country’s public pension funds such as The Ontario Teachers’ Pension Plan, or our national savings fund, the Canada Pension Plan Investment Board, and nor should the foreign countries in which they invest. Conversely, there is no reason to have a double standard: we should encourage free-market investments in Canada’s firms, as should other countries such as the U.S. Much of the recent hype over SWFs smacks of protectionism in the guise of national security concerns and we should either put out the welcome mat for SWFs or let sectors such as the financial services industry in the U.S. find their own way out of made-at-home problems.

Stephen Foerster is a professor at the Richard Ivey School of Business, The University of Western Ontario