I have to give a speech in Malaysia in a few weeks on SWFs’ in-house operations. As part of my preparation, I’ve been thinking about how to explain what I mean when I say that SWFs have a ‘strategic advantage’ over other institutional investors — because, as you may have noticed, I actually do say that quite a bit (for example). So, I sat down and formally wrote it all out. I’ve come up with a “top three” list of the advantages to being a SWF. And, to keep things balanced, I’ve also come up with a “top three” list of disadvantages.
Think of what follows as a sort of intro course on these funds; SWF 101 if you will. As such, if you’ve already graduated onto the more advanced 200 or 300 level SWF courses, please move along, there’s nothing to learn here. Anyway, here we go:
1) Strategic Advantages: The following characteristics should (in theory) help SWFs outperform other types of investors:
A) No Liabilities: Upon seeing this sub-heading, many of you immediately reacted by saying, “Of course SWFs have liabilities! There’s ‘spending rules’ or looming pension obligations or just the integration of the SWF into the plans of the government. SWFs don’t exist in a vacuum!” Fair enough! However, SWFs do not have non-governmental creditors or shareholders. If the SWF owes money to anybody, it owes it back to the government who sponsors it. (Admittedly, this definition is increasingly tenuous, as some SWFs are raising money in the private sector. But let’s leave that to the side for now). In my view, the fact that SWFs have no private sector liabilities means that they are less constrained because the sponsor has a permanent time horizon, which is what affords them their next strategic advantage…
B) Time Horizon: Indeed, SWFs next advantage stems from their long-term perspective. I’ve said it before, but I think (in theory) SWFs have the longest time horizon among all institutional investors in the world. Who’s got a longer time horizon than the Alaska Permanent Fund? After all, it’s permanent. And this time horizon means that these funds can focus on segments of the market that are much less competitive. To help explain what I mean, I turn to David Denison, who is the CEO of the CPPIB (which, while it does not consider itself a SWF, is a government sponsored fund with no pressing liabilities and a 75 year time-horizon):
“In our view, the vast majority of the considerable intellectual capital devoted to money management is focused on a 0-24 month time frame. In contrast, the nature of the CPP Fund allows us to effectively have a 75 year investment horizon for our decisions and results. Now in practical terms of course we aren’t making all investment decisions using a 75 year analysis, but we are able to focus on return streams well beyond the typical investor…This extended investment horizon makes categories such as real estate and infrastructure particularly attractive to us since these are by nature long duration assets.”
And so, a long-term time horizon allows these funds to avoid the asset classes with disproportionate levels of competition and, instead, focus efforts on building world-beating skills in the asset classes that favor long-term investors.
C) Scale: We can all agree that SWFs stand out relative to other investors due to their sheer size. This, too, creates an advantage, thanks to a variety of economies of scale. In short, these funds can typically afford to pay the best managers and centralize various administrative functions as well as forge partnerships with a variety of different service providers and investors. All of these opportunities, which are available only to the largest investors in the world, generate value for the fund. As Ang et al (2009) noted with respect to the NBIM, “The Fund’s large size allows it to benefit from economies of scale in the organizational costs of fund management…This potential is moderated by social norms that impose constraints on compensation, but hypothetically a fund of this size should be able to attract the very best internal staffers.”
2) Strategic Disadvantages: While SWFs have clear advantages; they also have some serious challenges to overcome:
A) Agency Problems: Overcoming principal-agent problems can be a big challenge for SWFs. Due to asymmetric information and incomplete monitoring of managers (agents), SWFs (principals) often receive lower returns (again, see the Ang et al paper on this). Put simply: there is a sense among certain SWFs that some asset managers aren’t providing services that match the high fees being charged. In order to overcome this, SWFs have been looking for ways to implement rigorous accountability procedures. But that can be challenging for external mandates, which is why many funds are bringing assets in-house. Still, bringing assets in-house is not a panacea. In fact, this strategy creates a new set of problems for institutional investors (and underscores the importance of overcoming the following two strategic disadvantages).
B) Human Capital: SWFs present a unique human resource challenge. As public organizations tasked with investing in private markets, they must find a way to fill public sector jobs with individuals that can compete in private markets. This is especially true for those funds that are moving assets in-house (and, again, lots are). However, governments are loathe to pay employees private sector rates of pay; this is particularly true in finance, where private employees can earn multiples (upon multiples) of their public counterparts. In a way, then, SWFs cannot ‘pay for performance’ like their counterparts in the private sector. As such, they must look for creative and innovative solutions that can bridge this public-private divide. For example, they have to play into individual’s ‘public service mentality’.
C) Politics: One of the obvious factors that any SWF has to be cognizant of is the role of politics in the investment decision-making process. To suggest that these funds can become entirely apolitical is, in my view, delusional; after all, every SWF is the result of a political decision. So, funds will need to consider how this influence will affect their operations, as there is plenty of research (some if it specifically about the impact of politics on SWF returns) that shows that politicians’ influence has a negative impact on financial returns. And in most jurisdictions, the lower returns that accompany politically motivated investments are deemed unacceptable. Indeed, the 2010 annual report for the CPPIB comments on the main challenges the fund’s creators faced: “They had to feel confident that the governance system was strong enough to insulate decision-making from political or government influence”.
And so, class, I hope you’ve learned today that SWFs have some very real strategic advantages. And, while they also have some rather serious strategic disadvantages, these are, in my view, surmountable with good governance and institutional design.
Class dismissed. Class? Bueller?