Sovereign wealth funds: Getting the basics right

Often sovereign funds call on investment management consultants, such as Watson Wyatt and Mercer, as well as other advisory outfits, to help them. "There’s a huge need for helping sovereign funds build the infrastructure, the risk models and the asset allocation," says Afsaneh Beschloss, a former treasurer and chief investment officer at the World Bank, who is now chief executive and president of the Rock Creek Group, a firm that provides advisory services to sovereign funds as well as managing money on their behalf. "These are the areas that need the greatest consideration. The investing part is almost easier."

Getting the basics right is the secret to success, adds Beschloss, who during her time at the World Bank started a project to advise and manage money for a number of sovereign wealth funds and central banks. "Investment management is all about asset allocation and allocation of risk capital. But how does a fund do that and how does it measure performance? The basics are something that the established funds understand but the newer ones less so," she says.

The first issue that needs to be resolved, she adds, is ownership. "Who has the authority to do what? Who is setting the benchmarks? Is it the heads of the central bank, is it the finance ministry, is it heads of government?"

The problem, says Deborah Hazell, a managing director and head of international business at Fischer, Francis, Trees & Watts in New York, is that the newer funds are still determining the identity of the owner, whether it is the central bank or the ministry of finance.

Typically, she adds, if the central bank rather than the finance ministry is the owner then the asset allocation tends to start less aggressively. That’s because central banks think more along the lines of reserve management, investing in treasuries and other safe assets to manage their liquidity needs, as opposed to managing an endowment.

Ownership, therefore, can be a vital clue as to where the fund is likely to invest initially. Another more important one, according to John Nugee, head of the official institutions group at State Street Global Advisors, is the source of the capital. Those funds that finance themselves from foreign exchange reserves typically have a bond-type balance sheet, while those that are dependent on income generated from commodity exports will have more of an equities-type balance sheet.

Once the bias of the fund has been determined, the next challenge is gradually to diversify the portfolio. The extent to which new asset classes are considered depends on the fund’s asset-liability structure, its risk appetite and its performance benchmarks.

Then there are other practical issues to consider such as establishing overseas offices, creating strategic partnerships and, most critically, finding and keeping hold of talented people. For public-sector organizations this is no easy task. "These funds can get high-calibre people but it’s difficult to get experienced people," says Hazell. One big problem that sovereign funds face is keeping staff after a few years’ service in the face of competition from the private sector.

The very best sovereign funds understand all of these issues. Norway’s Global Pension Fund, for example, has a clear ownership structure. It is owned by the government, which sets out its investment guidelines following agreement from parliament, although the management of the fund is undertaken by Norges Bank Investment Management, which is part of the central bank.

It has an extremely transparent benchmark portfolio, with an asset allocation of 40% in equities and 60% in fixed income, although that is in the process of being turned around. Investments are split between Europe, Americas/Africa and Asia/Oceania, with a specified expected relative tracking error of 1.5%, according to a report by Merrill Lynch, The overflowing bathtub, the running tap and SWFs. The maximum ownership stake of a company is 5% (recently raised from 3%). Although 78% of the fund is managed internally, internal managers are responsible for only 39% of overall risk and 38% of total management costs. Front-office employees receive performance-related pay.

As for performance, the fund has achieved an average annual nominal return of 6.5% – real return 4.6% – with management costs of just 0.09% a year, adds the report.