I got to thinking over the weekend about the remarkable performance of the CIC’s domestic, state-oriented investments in 2008. As I noted last week, this domestic portfolio outperformed the CIC’s commercial-oriented foreign portfolio. However, most of us believe that politicized investments will generally under-perform commercial investments. The IMF reinforced this point in its paper on DIY SWFs:
“Regardless of the governance framework, the operational management of an SWF should be conducted on an independent basis to minimize potential political influence or interference that could hinder the SWF in achieving its objectives…there should be a clear separation between the unit that executes and those involved in oversight.
Reading between the lines, investing for political (instead of commercial) benefits will lead to substandard returns and a failure to meet objectives.
However, I don’t raise the CIC case to try to cast doubt on these conventional governance theories. Rather, the CIC case simply reminded me of the benefits of “informed trading,” which is to say investments within local, familiar jurisdictions (a different animal than “insider trading”). Perhaps the CIC case may be an example of how good governance can allow SWFs to reap the benefits of informed trading? Here is what I mean:
Over the past few years, we (economic geographers and financial economists) have come to understand that ‘local’ investments have the potential to outperform investments in the broader market. According to Huberman (2001), “familiarity, apparently a non-financial attribute, affects investors’ choices” (page 675), and choices made about local investments are typically better informed, according to Coval and Moskowitz, which leads to higher returns. As I noted in a paper this year (page 872),
“While investing in those things familiar may represent a suboptimal investment strategy based on traditional portfolio theory, being knowledgeable or familiar with a certain investment undoubtedly carries advantages. Indeed, for those willing to look beyond the efficient market hypothesis, familiarity, which creates specific situated knowledge, is the source of investment opportunities unobserved by the market.”
Local investments represent clear opportunities for investment gain, so long as the SWFs do not over-invest in their back yard (i.e. allocate assets for domestic investments beyond the country’s share of global GDP) or fall victim to governance breakdowns. Indeed, extracting the benefit of familiarity necessitates strict and robust governance procedures that can thwart the influence of politics that would derail commercial objectives. A SWF investing in a local firm that it thinks is set for a global expansion is different than having a politician compel a SWF to invest in a failing firm. The former is representative of informed trading while the latter is representative of, in my opinion, a governance failure (though that does depend on the SWF’s mandate).
I’m not sure if the Central Huijin was a case of informed trading or something else entirely (luck?). But it does remind us that there are returns to be had in familiar (local) environments. Moreover, it suggests that we shouldn’t rush to “sound the alarm” just yet on domestic investing. Maybe it’s just another reason to focus on good governance.
