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SWFs-Global Overview

SWFs-Global Overview. FLAR Legal Seminar August 29-39, 2013. Why sovereign wealth management?. Revenues from extractive industries Fiscal smoothing of expenditures Permanent wealth/inter-generational equity Funding of future pension obligations

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SWFs-Global Overview

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  1. SWFs-Global Overview FLAR Legal Seminar August 29-39, 2013

  2. Why sovereign wealth management? • Revenues from extractive industries • Fiscal smoothing of expenditures • Permanent wealth/inter-generational equity • Funding of future pension obligations • Reserves accumulation from balance of payments surpluses

  3. Non-commodity funds • Cumulativefiscal or balance of payments surpluses fund US$2.1 trillion in long term investment funds for investment income and to meet future pension liabilities Source: Sovereign Wealth Fund institute 2011 1/ Central Banking Publications US$ Billions

  4. Commodity funds (oil and gas) • Revenues from extractive industries fundUS$2.7 trillion US$ Billions Source: Sovereign Wealth Fund institute 2011 1/ Central Banking Publications

  5. Commodity Funds • Objectives • Fiscal stabilization • Protect tradeable sector from currency appreciation • Support current spending while investing long term for intergenerational equity • Two types of funds • Integrated fund that both supports current fiscal spending and invests long term for capital preservation and intergenerational equity • Earmarked funds • Stabilization fund for to smooth fiscal spending • National pension fund to cover future pension liabilities • Future funds (unpopular)

  6. Commodity Fund-Integrated • Funds structural budget deficit • Guidelines on withdrawals to preserve capital over time Norway Abu Dhabi Saudi Arabia Kazakhstan Azerbaijan Alberta Timor-Leste Botswana

  7. Stabilization fund-earmarked Chile Mongolia Russia Government establishes a threshold price level based on the expected long term average When the current prices exceeds the long term threshold price, “excess” revenues are paid into the Fund and can be drawn down during periods of below normal prices.

  8. Pension fund-earmarked • National pension funds funded by contributions (plan) or by fiscal surpluses to meet future government pension obligations and invested in overseas assets • New Zealand Superannuation Fund • Australia Future Fund • Chile Pension Reserve Fund • Russia National Welfare Fund

  9. SWF Governance • Fiduciary-beneficiary relationship • Government as “sponsor” • Enabling legislation • Investment policy • Investment process • Transparency and reporting • Oversight • Statutory regulations and standards of care

  10. SWF Institutional Arrangements Risk and performance reporting Regulation & delegation of authority

  11. Norway’s Government Pension Fund Global Authorizing legislation Government Pension Fund Act 2005 Auditor General Council of Ethics Ministry of Finance Management mandate and Ethical Guidelines Governance Committee Norges Bank Executive Board Investment mandate and selection of CEO CEO Norges Bank Investment Management Implementation of Investment Policy Global Custodian Internal Managers External Managers

  12. New Zealand Superannuation Fund New Zealand Superannuation and Retirement Income Act 2001 General Audit Ministry of Finance Appoints Board and sets strategic investment objectives Board of Guardians Sets Investment Policy, responsible investment guidelines, budget and appoints CEO CEO New Zealand Superannuation Fund Implements Investment policy Global Custodian Equity Managers Fixed income Managers Alternative Managers

  13. Asset manager can be dedicated government agency or central bank • Most governments have set up a dedicated government investment agency with its own governance, pay scale and specialized skill set • Central bank as asset manager: • Norway whereby the investment management corporation was embedded within the central bank • Emerging market countries with little international investment infrastructure (East Timor, Botswana, Trinidad &Tobago) • Stabilization funds that are invested in low risk strategies similar to investment of foreign currency reserves (Chile, Peru, Mexico)

  14. Policy alternatives to a sovereign wealth fund • Domestic investment in state owned enterprises, development banks and jobs creation (not a good record but back in vogue) • Public investment in infrastructure • Direct dividend to citizens (or reduction in taxes) to foster private savings and investment • National asset/liability management—foreign direct investment in “deficit” sectors; eg Chinese acquisition of commodity producers and agricultural land

  15. Sovereign Fund Investment Strategies • Official Reserves/ Central Bank • External assets for directly financing international payment imbalances • Highly liquid, often OECD government bonds • Stabilization Funds • Funds to insulate budget & economy from excess volatility, inflation, Dutch disease, & other macro economic threats • Low-risk, liquid assets: cash, government bonds • Sovereign Wealth Funds • Investment vehicles by foreign exchange assets • Managed separately from official reserves • Typically have a higher tolerance for risk • State Owned Enterprises • Companies in which the state has significant control • May make investments in foreign assets • Pension Funds • Investment vehicles to meet government’s future pension obligations • Funded and denominated in local currency Increasing investment horizon and investment risk Source: Monitor 2010 SWF Report

  16. SWF Strategic Asset Allocation Risk Fixed income Equities Alternatives Expected return

  17. SAA is main driver of wealth generation and investment income Balanced equity/bond vs government bond/cash portfolio (1979 – 2011) Cumulative Wealth Annual Return Typical Central Bank Portfolio: 100% US Government Bonds between 1-3yr ; Diversified Portfolio: 40% Developed Global Stocks/10% EM Stocks/5% EM Debt/5% Commodities/20% US Treasuries/20% US Corporate Bonds Source: World Bank Treasury calculations based on data from Ibbotson Associates and Bloomberg Source: World Bank Treasury calculations based on data from Ibbotson Associates and Bloomberg

  18. Diversification and modern capital markets theory But divide your investments among many places, for you do not know what risks might lie ahead. Bible, Ecclesiastes, 935 BC A portfolio of uncorrelated investments has a lower risk than any single investment Harry Markowitz, Modern Portfolio Theory, 1957

  19. Modern paradigm of the prudent person rule “Prudence is to be found principally in the process by which investment strategies are developed, adopted, implemented, and monitored in light of the purposes for which funds are held, invested, and deployed. Prudence is demonstrated by the process through which risk is managed, rather than by the definition of specific risks that are imprudent. Under a modern paradigm, no investment is imprudent per se. The products and techniques of investment are essentially neutral. It is the way in which they are used, and how decisions as to their use are made, that should be examined to determine whether the prudence standard has been met. Even the most aggressive and unconventional investment should meet that standard if arrived at through a sound process, while the most conservative and traditional one may not measure up if a sound process is lacking.” Longstreth, B. “Modern Investment Management Theory and the Prudent Person Rule”,1986

  20. Investment strategy by statute or regulation Blunt tool that may dictate • Allowable asset classes • Minimum rating for allowable investments • Maximum exposure to a sector or investment (diversification by regulation)

  21. Portfolio diversification is required to meet long term risk-adjusted return targets 1976 - 1983 1983 - 1990 1990 - 1997 1997 - 2004 2004 - 2011 Highest return Real Estate Developed Equities EM Equities Real Estate EM Equities Developed Equities Commodities Real Estate Commodities EM Debt Commodities US Govt. Bonds US High Yield Bonds EM Debt US High Yield Bonds Cash US Corporate Bonds EM Debt US Corporate Bonds Real Estate US Corporate Bonds US High Yield Bonds Developed Equities US Govt. Bonds Commodities US Govt. Bonds Cash Commodities Developed Equities US Govt. Bonds Real Estate US Corporate Bonds US High Yield Bonds US Corporate Bonds US Govt. Bonds Cash Developed Equities Lowest return World Bank Treasury estimates Cash EM Equities Cash Source: World Bank Treasury calculations based on data from Bloomberg 21

  22. How does the legal environment impact the SAA? Risk Fixed income Equities Alternatives Expected return

  23. Threat of liability and impact on portfolio management • Contemporary application of the prudent person rule (NZ, Alberta, Alaska, Australia) • Focus on investment process • Role of diversification • Standards of behavior • Statutory regulation of allowable investments • Bright line that provides more protection and less scope for interpretation • Asset allocation by parliament as “fiduciary” rather than by investment manager (Norway) • Where the government is risk adverse or unprepared, can lead to highly sub-optimal portfolios (East Timor, Russia, Azerbaijan) • Combination

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