The ADIA Review 2009 is a small step into the right direction. But when benchmarked against the Santiago Principles, it reveals a number of substantial shortcomings. The Santiago Principles request SWFs to publicly disclose relevant financial information to contribute to stability in international financial markets and enhance trust in recipient countries. Many other SWFs meet this request by providing precise information about the value of assets under management, strategic asset allocation, benchmarks, and information about equity holdings. ADIA restricts itself to providing some rudimentary information about its strategic asset allocation and its long term performance in the form of 20 and 30-years annualized rates of return.

The Review also provides only very sparse information about ADIA’s funding and withdrawal policies. It states that the Government of Abu Dhabi provides ADIA with funds that are surplus to its budgetary requirements. Withdrawals that ADIA is required to make available to the government have occurred infrequently, depending on commodity price developments. This information is well short of the industry benchmark that the Santiago Principles set. Information about precise funding and withdrawal arrangements, as well as the actual cash flows in and out of the fund within a given period of time is the norm.

The report does provide some revealing information about ADIA’s governance arrangements. The Review’s claim ADIA to carry out its investment programme independently and without reference to the government of Abu Dhabi most likely needs to be interpreted as an intended reconfirmation that ADIA is operating purely on the basis of financial and economic considerations. But it also reveals a missing link in ADIA’s accountability arrangements. If not to the government of Abu Dhabi, who else is the leadership of ADIA, its Board of Directors and its Managing Director, accountable too? The Santiago Principles took great care in putting some distance between the owner of a SWF, a government, and its operational management to shield it from political interference. But the Principles are rather firm on the fact that the leadership of a SWF should be accountable to its owner, the government. As the Santiago Principles state: “The owner should set the objectives of the SWF, appoint the members of its governing body(ies) … and exercise oversight over the SWF’s operations.” The relationship between ADIA’s leadership and Abu Dhabi’s government, or rather its non-relationship, as reported in the Review, calls the robustness of ADIA’s governance and accountability arrangements into question. To be sure, members of the ruling family occupy most of the relevant leadership positions at ADIA, very much reflecting the overall governance arrangements of its political institutions.

The Review is also fairly tight-lipped about ADIA’s political exposure, given highly the volatile, fluctuating and rather overwhelming dimension of broader Middle Eastern politics – whether there is or there is not a relationship between the government of Abu Dhabi and ADIA leadership. It would come as a surprise if ADIA is not confronted with a multitude of politically motivated demands to provide its financial weight to serve the broader domestic or foreign policy objectives of Abu Dhabi. Just a couple of months ago, the Norwegian Government Pension Fund – Global, one of ADIA’s peers, based on ethical considerations excluded the Israeli military giant Elbit from its investment portfolio for supplying a surveillance system that is part of the separation barrier being built by the Israeli government in the West Bank. It can be assumed that a move like this challenges ADIA’s leadership to take positions either way. In the spirit of the Santiago Principles, it would be important to know how it deals with it.

What does the release of ADIA’s first “annual review” tell us about the impact that the Santiago Principles are having? Robin Wigglesworth of the FT has some thoughts on the issue.

“The IMF guidelines, known as the Santiago Principles , are voluntary but many funds are tentatively responding to calls for more openness – as evidenced by Adia’s report.”

First off, I need to correct Wigglesworth’s article; the Santiago Principles are not IMF guidelines. In 2008, the IMF “facilitated and coordinated” the creation of the International Working Group on Sovereign Wealth Funds, which was responsible for the Santiago Principles (also known as the Generally Accepted Principles and Practices or GAPP). The IWG was made up of 20 or so SWFs with observers from a variety of investment receiving countries and international organizations, such as the IMF, the OECD, the European Commission, and the World Bank. Anyway, it’s a common mistake. One that I myself made during a conversation with an observer to the IWG back in 2008. In that case, she stopped me mid-sentence to say that this was not an IMF-led process. Still, I’m surprised to see the FT (which is in my view a paper of record) get this confused.

Anyway, back to Wigglesworth’s point about the Santiago Principles. It’s true; over the past year we have seen ‘annual reports’ from some of the biggest and formerly most secretive SWFs in the world (e.g. ADIA, CIC, GIC, Temasek, etc.). It is undeniable that the Santiago Principles are having a noticeable impact on the transparency of these funds. This is all the more remarkable given that these principles were considered too watered down to have any real effect. In fact, one very smart SWF analyst once told me during an interview:

‘The Santiago Principles are the weakest possible guidelines that the IWG could have come up with and still claim to have done anything at all.’

In my view, the Santiago Principles are weak and toothless. However, weak principles are more easily adopted, which is why we have seen so many SWFs attempt to become GAPP-compliant. In that sense, perhaps this was the right “starting point” for SWFs’ process of opening up; baby steps.

It will now be up to the International Forum to determine if further principles and practices are necessary for these funds to sustain their international legitimacy.

The “on again, off again” debate over whether India should set up a SWF is apparently back “on”. The country’s oil ministry has put in a formal request to the finance ministry to set up a SWF using a portion of the country’s $254 billion in foreign exchange reserves. According to reports, the SWF is being conceptualized by its proponents as a tool to better compete with China in the ongoing drive to secure resources:

“Chinese companies spent a record $32 billion last year buying oil, coal and metals assets abroad, while a $2.1 billion investment by ONGC was India’s sole energy acquisition.”

India has been considering a SWF since 2008. In February that year, the government established an advisory group to evaluate how a SWF might be set up. But the new fund never materialized for two reasons:

• The generic position against was based on the fact that India’s foreign reserves come from capital inflows (not commodity wealth), which makes the country susceptible to capital flight. Alas, many felt that the country had no “excess” reserves. Indeed, because the Reserve Bank of India is  extremely cautious about shocks to the country’s current account, it was too conservative to get behind the idea of a SWF.
• There was also a widespread fear that the SWF would become corrupt and the assets would be misappropriated.

I think these positions are justifiable.  But I’m still not entirely convinced.

• On the first issue, the same argument could be made about China. As Bernhard Reinsberg has said , “a non-commodity SWF would be equally beneficial to India as it already is to China, given the preceding strategic policy choices to intervene in the FX market in both cases.”
• On the second issue, governance is the crucial determinant of the success of the fund. You can’t tell me that India has a more difficult political environment than São Tomé and Príncipe (which had a coup attempt as recently as 2003). And yet, STP’s National Oil Account was recently flagged as a “model” SWF for developing countries. The governance structures that prevent corruption in STP could be adopted in India.

In my view, with the appropriate structure, India could benefit from a SWF. Indeed, most of its peers are already benefiting from SWFs (e.g. the rest of the BRICs). In addition, holding excess reserves has high costs, which can be minimized through more aggressive investing.

However, the Reserve Bank of India is extremely conservative, which means it is anybody’s guess as to whether India will actually be setting up a SWF any time soon. File this under TBD…

Reuters had quite the eye catching headline yesterday: “China state fund open to shorting stocks”. Even before reading the article, I immediately imagined a trading floor in CIC headquarters with some risk seeking traders looking to profit from the demise of foreign companies. Then, I pictured the diplomatic fallout from an official Chinese government agency shorting failing US and European firms (see Norway’s experience with Iceland). My mind was already racing with implications and analysis…and then I actually read the article.

As it turns out, the story isn’t as intriguing as I had hoped:

“China’s $300 billion sovereign wealth fund is looking at directly investing in funds that could benefit from falling equity prices.”

In other words, the CIC is looking to allocate some money to long-short hedge funds, which, in my view, is something any large, well-diversified portfolio investor should consider. We’re not talking about people within the CIC shorting stocks; we’re talking about private sector fund managers (who, in all likelihood, are based in the US or Europe). So my hastily constructed prediction of diplomatic fallout evaporated; China would not be shorting US manufacturing firms. But could you imagine that? It would have been a heck of a story.

Anyway, while the Reuters article wasn’t what I had hoped, it still managed to shock me in another way. Can someone explain to me what Fidelity (Pyramis) is doing talking to Reuters about what the CIC is “looking at” or “talking” about with them? In my experience with these funds, SWFs (and especially the CIC) are extremely sensitive about information control, which is why these types of discussions and negotiations are kept under wraps. By saying to the press that Fidelity is “in talks” with the CIC for a specific mandate, I expect that Fidelity has immediately removed itself from consideration for the mandate.

As if to confirm this, Reuters subsequently issued the following correction to the article:

“Corrects to delete first bullet point, which said that Pyramis and China were in talks. Fidelity says Chin misspoke in suggesting that Pyramis and China were talking directly about a long/short strategy.”

In other words, someone at the CIC shut this down. If you can’t be discreet during the negotiation phase, how can the CIC trust you to be discreet once you have their cash?

This reminds me of something my grandfather would say; he spent four years in the Canadian navy in WWII’s Pacific theater of operations: “Loose lips might sink ships.” Apparently, they can also sink SWF mandates…

The rumors are true; the Abu Dhabi Investment Authority – one of the most secretive SWFs in the world – has released its first “annual review” for 2009. Given that Abu Dhabi was a co-chair of the International Working Group of SWFs (i.e. those responsible for the Santiago Principles), I’ve been expecting a report along these lines to appear at some point.

In my view, this report is specifically designed to demystify what is one of the world’s largest SWFs. This is all part of the process of securing legitimacy for ADIA in western markets. For example, the report has a section showing how asset managers are selected. It has a section on ADIA’s relationship to the government. It has a section on governance. You get the picture.

However, there really isn’t much in the way of hard data. In fact, there is nothing on the size and scope of its assets under management. That said, there are some more details on the fund’s asset allocations. For example, we learn that ADIA, like  its cousin up in Norway, seems to have completely bypassed investing in Sub-Saharan Africa.

Anyway, for a more detailed summary of the annual review, go read Rachel Ziemba’s article. Once again, she beat me to the punch on this.

]]> http://oxfordswfproject.com/2010/03/15/demystifying-adia/feed/ 1 Ashby Monk ADIA image http://oxfordswfproject.com/2010/03/12/weekend-reading-joshua-aizenman/ http://oxfordswfproject.com/2010/03/12/weekend-reading-joshua-aizenman/#comments Fri, 12 Mar 2010 17:58:42 +0000 Ashby Monk http://oxfordswfproject.com/?p=4148 ]]>

Ashby Monk

I’ll be honest, I’m jealous of Joshua Aizenman. Not only does he write some very sensible things on foreign reserves and SWFs, but he gets to live in Santa Cruz, CA while doing it. Can you think of a better life? I can’t. Anyway, Aizenman has just released two new papers that are definitely worth a read:

1) “Macro prudential supervision in the open economy, and the role of central banks in Emerging Markets.” This paper uses the recent liquidity crisis to evaluate the prudential supervision role of central banks. I learned a lot reading this paper, but one specific insight is worth repeating here:

“Diversification by means of Sovereign Wealth Funds exposes the economy to the risk that value of the fund may collapse precisely at the time when hard currency is needed to fund deleveraging as has been the case during the 2008-9 global liquidity-crisis.

It’s a good point, which is why SWFs should only be comprised of “excess reserves” (i.e. those not needed for precautionary purposes).

2) “International reserves and swap lines: substitutes or complements?” with Yothin Jinjarak and Donghyun Park. This paper examines whether “swap lines” between central banks of larger economies and their counterparts in smaller economies can reduce the need for reserve accumulation. Again, I learned quite a bit from this paper; here is an excerpt:

“One way to reduce such costs is to use reserves more productively via sovereign funds and more generally, by active reserve management. Although the global financial crisis has inflicted heavy losses on Asian sovereign funds and temporarily dampened their risk appetite, they provide an important channel for more productive use of reserves in the medium- and long-term. There are already signs that the funds are returning to the financial markets, and there are indications that China may inject up to US$250 billion of fresh capital into CIC. However, investing surplus reserves more efficiently after they have already been accumulated is a second-best solution. The first-best solution is to avoid building up such large reserves in the first place. Furthermore, if we view reserves as insurance against unexpected shortage of international liquidity and financial crisis, pooling risks is more efficient than individual risk bearing. That is, collective insurance is always less costly than self insurance. The seemingly irrational behavior of reserve hoarding can partly be explained by the region’s loss of confidence in the IMF during the Asian crisis. In principle, the IMF pools the risks of all countries and thus offers the most efficient collective insurance. In practice, a region wide perception that the IMF has mishandled the Asian crisis, compounded by a broader region wide perception that the IMF does not serve the interests of Asian countries, has eroded the region’s confidence in IMF. Regardless of the validity of the perceptions, the perceptions themselves have contributed to a marked preference of self-insurance over collective insurance.”

I totally agree. As such, this paper explores innovative mechanisms that would reduce countries’ demand for precautionary reserves in the first place, such as swap agreements. It’s worth reading in its entirety.

(Photo by Jim Whitehead)

]]> http://oxfordswfproject.com/2010/03/12/weekend-reading-joshua-aizenman/feed/ 0 Ashby Monk View from Aizenman's office...maybe http://oxfordswfproject.com/2010/03/12/alabama-eyes-change-to-constitution-to-tap-swf/ http://oxfordswfproject.com/2010/03/12/alabama-eyes-change-to-constitution-to-tap-swf/#comments Fri, 12 Mar 2010 16:37:44 +0000 Ashby Monk http://oxfordswfproject.com/?p=4128 ]]> Ashby Monk

The Alabama Senate (led by the state’s Democrats) yesterday passed a constitutional amendment that will allow the government to tap the state’s SWF for an “Alabama stimulus program.” The idea is to take $1 billion from the Alabama Trust Fund for road and bridge building over the next ten years–$100 million will be drawn from the fund each year and invested in construction works so as to create local jobs.

Because the bill calls for drawing down on the SWF’s principal (and requires a constitutional amendment), it has not been well received by everybody.

“People are treating the Alabama Trust fund like free money,” according to Sen. Scott Beason, R-Gardendale.

Indeed, the states’ Republicans see this bill as a breach of the SWF’s original intention and rationale.

The Alabama Trust Fund was launched in 1985 as an “an irrevocable, permanent trust fund”. The plan was to sequester a portion of revenues from offshore drilling rights and royalties in an intergenerational savings fund. Indeed, the trust receives 99% of all oil and gas payments paid to the State (the remaining one-percent goes to the Department of Conservation-Lands Division). In turn, the government only gets a portion of the interest from the Fund’s investments (which is used to fund prisons, health programs, elderly care, among other things).

In short, the Alabama Trust Fund was never meant to be a stabilization fund. As such, using it to pay for a stimulus package to create jobs–while politically expedient–is quite a departure from the fund’s original purpose.

In times of crisis, politicians around the world must be tempted to put SWF assets to work in their communities; even if the fund has a mandate that explicitly prohibits that type of behavior. So, how do you set up an intergenerational savings fund with appropriate checks and balances to ensure the assets aren’t misused?

• In Canada, the CPPIB’s mandate is harder to change than the Canadian constitution. The idea being that, while past governments can’t tie the hands of future governments completely, they can make it very difficult to change the fund’s mandate (so as to access to these assets).
• When Ireland tapped its National Pension Reserve Fund to bolster the country’s banks, new legislation was required that changed the fund’s mandate.

And so, Alabama is currently following a similar path through the state’s checks and balances. Indeed, this bill requires both the approval of the House and voters (since it’s an amendment to the constitution). If all agree that this is in the best interest of the state, then who’s to say they are wrong?

In the current lackluster M&A market, SWFs are starting to stand out. In fact, according to an article in Emirates Business, Middle Eastern SWFs are emerging as the world’s most active strategic investors.

“The region’s largest SWFs, particularly in Qatar and Abu Dhabi, are emerging as major investors, interested in sectors ranging from financial, commodities to real estate.”

Apparently it isn’t that these funds are doing more; it’s that other types of investors are simply doing less. Still, SWFs seem to have been able to do as they please in global financial markets. This is remarkable given the widespread “national security” concerns of 2007/08, which led to the IWG and the Santiago Principles.

This got me thinking, to what extent have recipient countries’ fears affected SWFs’ investments and deals. We all remember the Dubai Ports debacle. Is anything like that still going on?

Fortuitously, Paul Rose of Ohio State University just posted a paper to SSRN entitled, “Sovereign Wealth Fund Investment in the Shadow of Regulation and Politics.” The paper considers how recipient country public sentiment and regulatory burdens affect SWF deal-making. Drawing on a series of detailed case studies, he concludes:

“There is no evidence to suggest that SWF investment suffers from significantly higher transaction costs than other foreign investment. Indeed, the fact that other domestic and foreign investors are investing on the same terms as SWF investors in the Merrill Lynch and Citigroup transactions provides compelling evidence that transactions costs are not higher.”

In short, the article suggests that SWFs are not being constrained more than their private sector cousins (i.e. are not incurring higher transaction costs). In other words, national security concerns aren’t having an appreciable impact on SWF deal-making. This conclusion jives with the Emirates Business’ article.

That said, Rose goes on to acknowledge that his case material could be temporally biased. After all, he draws his conclusions from transactions that took place during the financial crisis:

“…the extraordinary pressures on the banks at the time of the investments may also suggest that the banks were willing to absorb higher transactions costs (perhaps by agreeing to terms that would not have accepted from only private investors) in order to secure investment from what were essentially lenders of last resort.”

So, while SWFs have had free reign during the financial crisis, Rose raises the possibility that this will end once target firms regain their footing.

I came across a rather surprising statistic this morning. Apparently, one out of every two SWFs is today investing in private equity, real estate or infrastructure:

“55 percent of the funds are known to invest in private equity, 51 percent in real estate and 47 percent in infrastructure,” according to Preqin.

I’m a little bit shocked by this. This implies that a significant portion of SWFs have no exposure to these assets.

Remember, these are the longest-term investors in the world. With no liabilities, they are perfectly suited to these types of illiquid investments. In fact, in our survey of SWFs’ own asset managers, we asked, relative to the 55% equities, 35% debt, and 10% alternatives standard, which asset class should be overweighted. Most of our respondents chose to overweight alternatives; i.e. SWFs (in the eyes of professional asset managers) should have more than 10% of their assets in alternatives.

And yet, some SWFs have 0% of their assets in alternatives? Why? It’s tough to pin it to any one thing. Perhaps the government employees running the SWF are just too conservative? Perhaps they don’t have the necessary internal competencies to make these types of investments? Perhaps their original mandate forbade these types of transactions? Perhaps the funds avoid these illiquid assets so as to be able to act quickly if the government has need for the money?

Whatever the reason, it’s a missed opportunity for SWFs.

I can’t read Norwegian. But I can read maps. And the map that Norway’s Aftenposten has put together to illustrate the geographic dispersion of GPF-G’s investment portfolio is definitely worth a gander. The map, for which the data is drawn from the 2009 annual report, includes all of the fund’s 10,288 investments aggregated and sub-divided into countries. (Thanks to these guys for a description of this in English.)

In large part, the map confirms what we already know about the GPF-G; that it is a traditional portfolio investor. Accordingly, concentrations of investments are in jurisdictions with large financial markets. Still, one aspect of this map was particularly interesting; it appears that the African continent has been almost entirely passed over. As best I can tell, the GPF-G has only invested in South Africa and (to a much smaller extent) North Africa.

Are there no profits to be had in Sub-Saharan Africa? Isn’t this a region with some benefit for a highly diversified institutional investor? After all, we are all used to hearing about SSA’s uncorrelated returns. For example, during the global sell-offs due to the sub-prime crisis, several of the SSA stock markets, such as Ghana’s, were up. Shouldn’t the biggest investors in the world be interested in this type of exposure? And yet, the GPF-G, one of the biggest investors in the world (full stop), has decided to take a pass on the region; either they don’t have the capacity or they lack interest.

There are good reasons for avoiding Africa, namely high levels of risk and uncertainty. It’s a very difficult environment to try to invest in for profit (remember, investors aren’t philanthropists). It’s for this reason that I initially felt that only emerging market SWFs would take the plunge into Africa. The south-south link gives them considerable experience operating in difficult legal and regulatory environments that are characteristic of this region.

In my view, this just reinforces the importance of some of the initiatives to bring SWF assets into Africa. Specifically, I think the World Bank’s Sovereign Funds Initiative is attractive. (It seeks to direct 1% of SWF capital into Africa via the International Finance Corporation). By acting as a skilled intermediary, the IFC can help overcome some of the constraints above and bring SWF cash into this under-served market. This would be to the benefit of both Africa and the world’s largest institutional investors.