Posted : 2011-05-22 16:10
Updated : 2011-05-22 16:10

New force in global market

Korea Investment Corp. CEO Chin Young-wook talks to Business Focus during an interview held at his office in downtown Seoul.
/ Korea Times photo by Shim Hyun-chul

Sovereign wealth funds sit on $4 trillion war chest

By Kim Jae-kyoung and Chung Min-uck

With the aftermath of the global financial crisis waning, sovereign wealth funds (SWF) have emerged as a new force on the global money market, changing the landscape of the financial industry.

In terms of assets under management, SWFs around the world were sitting on a combined $4.2 trillion war chest in December, up 11 percent from $3.59 trillion year-on-year, according to The CityUK. The figure stood at only $1.1 trillion in 2000.

What has caught the attention of investors and policymakers is that they have increased investments in emerging markets to boost returns. In addition, they are increasingly pursuing alternative investment strategies, including private equity and hedge funds, according to data provider Preqin.

“Escaping from the global crisis, many sovereign funds that had delayed plans to diversify their holdings have now again pursued differing strategies by investing in various alternative asset classes,” Korea Investment Corp. CEO Chin Young-wook told Business Focus.

Leading the trend are state-owned funds from The United Arab Emirates (UAE) and China. The UAE has aggressively allocated oil money to their sovereign funds, while China has decided to pull more money from its foreign reserves and put them into its SWF, China Investment Corp. (CIC).

In other words, the main driver behind SWFs’ rising influence comes from two sides: growing trade surpluses from export-oriented Asian countries and high oil prices causing more dollars to flow into the oil-rich countries in the Middle East.

The chief of the Korea’s state-owned fund stressed that for SWFs, the seed money or paid-in-capital matters but what is more important is management capability.

“GIC (Government of Singapore Investment Corporation) is known to have around $30 billion. And they have been operating for 30 years. Do you think it received all of its assets from the Singaporean government? No. The amount climbed to $30 billion as a result of effective asset management. GIC has now more foreign exchange reserves than its central bank,” Chin said.

In addition to SWF’s growth in terms of size, its investment strategies have also shown a major change.

Alternative investment

Since the sovereign funds don’t have to meet liabilities like other institutional investors such as pension funds or insurance companies, more than half of SWFs invest long-term in alternative assets.

After experiencing a big loss by keeping their money in investment banks during the financial crisis, SWFs were pushed to diversify within alternative assets.

For example, GIC known for its high proportion of liquid assets in its portfolio showed a 10 percent increase in alternative assets in 2009, investing in real estate and private equity. In turn, GIC’s investment in stock shares fell 6 percent over same period.

There was a rebalancing of portfolios towards emerging markets too.

Singapore’s Temasek Holdings’ investment in North Asia including China, Taiwan and Korea surpassed that of the OECD countries after the financial crisis according to data from KIC.

CEO Chin hints that the KIC will also follow suit. “We (KIC) are looking at emerging markets too. Though there are some guidelines set by the government and the Bank of Korea (BOK), we are seeking to under-weight the developed market and over-weight the emerging market,” said Chin.

However talking about the investment returns for SWFs, most funds are having a hard time recovering previous levels. Exact figures are hard to find as most of the funds do not disclose their investment results.

KIC excelled in this category, with its annual investment yields averaging 3.22 percent during 2007-2009. According to Canada’s global consulting firm CEM, the annualized return for the top 25 percent SWFs averaged 0.32 percent during the same period.

The return for GIC recorded minus 20 percent from April 2008 to March 2009. Its average rate of returns from 1981 to 2010 was 7.1 percent.

Growing influence

Keeping in mind SWFs’ growing assets under management and long-term investment preferences, there is no doubt that the funds’ role would grow bigger in financial markets, especially in alternative sectors.

The current trend of economic recovery could bring more foreign currencies to SWFs in trade surpluses and oil-rich countries, and with their new appetite to seek both diversity and higher returns in long-term investments, the rise of SWFs would provide global financial market with unprecedented stability.

“The good thing about sovereign funds is that they are long-term investors and not interested in company management. As a restrained and rational investor, the funds should contribute to the stability and efficiency of the international financial market,” said Chin.

The recent movement of some sovereign funds to issue bonds to increase their investment capacity indicates that the government-oriented entities are slowly transferring themselves into more active investors.

Yet, Woo Hee-sung from the Korea Center for International Finance warns not to overestimate their role.

“Compared to pension funds or mutual funds, sovereign wealth funds are still relatively small. So I guess they are not going to have a huge impact right now,” said Woo.

But the expert agrees that in the long-run SWFs, especially the fund in China will play a significant role in the financial market.

“I’ve heard that the Chinese government is planning to set-up additional sovereign funds as it is suffering from its holdings in low-yielding U.S. treasury bonds,” added Woo.

Market investors should be aware of some structural risks such as the government’s misuse of SWFs for market manipulation and their low transparency, he said.

Woo states that up to this date all SWFs especially the ones in the Middle East have no obligation to declare management information.

Machlup’s wardrobe theory

The former CEO of Hanwha Securities emphasized that for the strategy and evaluation of performance, there should be a clear distinction between foreign reserves management and sovereign funds’ investment activities.

“The two have totally different investment purposes. Foreign reserves are for the safe management of foreign currencies to cope with external shocks, while KIC is designed to create ‘plus alpha’ in investment returns,” he said.

Citing the Bank of America (BoA) case, Chin said that it should be seen as a learning process.

“Although the KIC has contineud to suffer huge losses since the investment, we should take a lesson from it. What is more important is to do better in the future. Investment is a risk-taking business. If risk-averseness is prevalent in our organization, there is no reason why KIC should exist,” he said.

“The biggest lesson from the BoA case was the importance of diversification. The core of investment is diversification because it is the best way to minimize risk and that’s what we missed when we invested in Merrill Lynch.”

KIC has been under fire for poor risk management, with its investment in Merrill Lynch incurring huge losses in the wake of the global crisis. Hit by the crisis, Merrill was sold to the Bank of America (BoA) in September 2008.

To explain the optimal level of foreign exchange reserves, the Machlup’s wardrobe hypothesis was cited. Machlup, an Austrian economist who died in 1983, likened the apparently insatiable appetite of central banks for building up reserves to his wife’s accumulation of clothes: she always wanted more, it seemed to Machlup, even though her bulging wardrobe provided for all her needs.

“The optimal level could vary depending on whose preference you seek to satisfy. There are different theories but regardless of them, Korea’s $300 billion in reserves is deemed more than what it needs,” he said.
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