The Design and Governance of Sovereign Wealth Funds
This blog has officially moved to its new home over on Institutional Investor. It’s called ‘Avenue of Giants‘, and it will be nothing short of awesome. So check it out.
Thanks again to all those who’ve made this website and project a success. It’s been a ton of fun. But it’s now time to move on…
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I’ve been of the mind that private sector investors are generally shorter term than public sector investors. And it’s simple to see why: a vehicle sponsored by an individual is going to operate according to an individual’s discount rate, while a vehicle sponsored by a government is going to operate according to a government’s discount rate. In theory, the government will consider longer-term factors than its private cousin (if only because the government will go on existing long after the individual has perished).
But the theory breaks down in practice for a variety of reasons. First, while governments may be long-term, the politicians that run governments are not. This is one of the failings of democracy; it’s challenging to deal with intractable problems outside of a given election cycle. In addition, while public pensions or sovereign funds may have inter-generational time horizons, the people that staff these organizations do not. As such, long-term investors often struggle to live up to their moniker.
In order to counter these factors, public funds are often set up with governance procedures that limit the short-term influence of politicians. And, perhaps more importantly, these funds also tend to devise compensation structures that extend the time horizon of their staff (as much as is feasible and possible). For the more sophisticated funds, this may mean establishing long-term incentive plans (LTIPs) that smooth performance compensation over time (e.g. five years). This may also include capping upside compensation to prevent employees from over-reaching. Whatever the case, there are a variety of ways to try to align an individual’s short-term interests with the long-term interests of pensions and sovereigns.
But where all of these public incentives fall short — and where the private sector may actually have a leg up — is on the issue of ownership. By granting an individual some ownership rights over a certain asset, you, in effect, provide that individual with an opportunity to hold that asset for life (and even bequeath that asset on to future generations). Without going into all of the theory here, let’s just agree that ownership is a powerful private sector ‘time-extender’ that is often deployed in non-financial industries through equity stakes, partnerships, or stock options. The idea is really simple: Give employees a stake in the long-term growth and sustainability of the organization so that the individuals will act in the best interests of the company. (There are problems with stock options due to the fact that they reward company-wide rather than individual performance, but I can go into that offline if anybody is interested.)
Anyway, I then started to wonder if there was a way to synthetically provide public sector pension and sovereign fund employees with some notion of ‘ownership’ that could extend their own time horizon for decades. One obvious way is seeding new subsidiaries and then giving staff a small ownership stake in the separate vehicle. While effective, it’s not a scalable solution for the entire organization. So I started thinking about some form of ‘notional ownership credits’ whereby the credits increase in value over time along with the total value of the fund’s assets? It could even be a specific portfolio’s assets. In other words, what if public pension and sovereign fund employees were paid with derivative-like assets that tracked the value of the fund’s portfolio and could be redeemed when the employees wanted? There would be plenty of challenges associated with such a policy (i.e. calculating the liability from outstanding credits), but at least people would be tied to the long-term growth of the fund. And that might drive them to think about the pension’s health in 10 or even 20 years from now. That’s the value of ownership.
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Abu Dhabi in January is outstanding. Seriously. Anyway, here’s some of today’s investment news of note:
This is, literally, the view from my hotel:
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I’m on planes for the better part of two days, as I’m making my way to the other side of the planet. That means I’ll have plenty of time to catch up on my reading. And, so, here are two papers I loaded on my tablet for some ‘in-flight infotainment’:
First, Brad M. Barber and Guojun Wang have a new paper entitled “Do (Some) University Endowments Earn Alpha?” It looks like the answer is ‘Yes’ but it’s almost all due to the asset allocation. Should be interesting.
Second, Eiichi Sekine has a paper out entitled “Moves by China to Improve How It Manages Its Foreign Exchange Reserves.” This looks like one of a number of papers offering details on China’s SWFs. Even if repetitive, there’s usually some interesting nuggets of info.
Anyway, away I go…
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Good morning, London. Here’s our top story this morning:
In other news:
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Michael Nobrega is an interesting personage within the pension community. He’s been the CEO of the Ontario Municipal Employees Retirement System since 2007. And, prior to that, he was the President, CEO (and one might say Founder) of OMERS wholly-owned infrastructure manager Borealis (which he launched in 1998). In short, Nobrega has been an instrumental figure at OMERS during a time period when the Toronto-based pension fund was (as it continues to be) one of the single most innovative pension funds in the world. As you can imagine, then, those of us in the pension community generally pay attention when Mr. Nobrega offers some insight into what he’s thinking and doing. And, significantly, Benefits Canada has just published an interview with, and an article on, the innovative OMERS CEO. So I thought I’d share some of Nobrega’s ‘deep thoughts’ with you here:
The rationale for OMERS shifting its assets into illiquids: “The principal reason it was done was to reduce our exposure to the volatility of the capital markets, especially public equity. The second reason was to acquire assets that would give us as predictable as possible long-term cash returns to fund the pension plan.
The practical challenges of OMERS focus on illiquids: “It’s not an easy exercise. You want assets you can live with for 25 years…To do that, you have to keep your investment criteria in place. It’s easy to go and buy assets, but it’s a question of buying them at the right price, managing them properly and adding value to them later on.”
The importance of talent within a pension fund: “A pension fund makes money in two ways: it leverages its capital, and it leverages its people. And the best leverage is to have people with ownership responsibility [to leverage the capital].”
The importance of local knowledge in making investment decisions: “I think we made a good decision to open our offices in New York and London. That has really helped us in terms of sourcing investments…To get to where we want, we need to do two things: find the right people, and deploy the capital. Those two offices have helped us attract people we couldn’t attract to Toronto, because they want to live in New York or London. And they’re also part of the networks in those locations, which gives us an advantage in getting to the assets.”
Why OMERS is moving into Venture Capital: “It’s our intention to be the parent for some of the serious innovation in the country. And we hope the [venture capital investment] ecosystem will go from $1 billion to $10 billion annually over the next five years. That’s what we need in this country. Our intention in making this step is to encourage others to join us.”
Fascinating stuff!
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And now, the news:
