Sovereign Wealth Funds Draw Attention

Stephen DeAngelis

March 7, 2008

With oil prices remaining sky high (oil topped $105/barrel yesterday) and petro-dollars flowing into oil rich nations, it should come as no surprise that the leaders of those nations are looking to put that money to work by investing it. The vehicle that many of them have selected to do that is the sovereign wealth fund. Sovereign wealth funds are generally created by countries that have large budget surpluses and little to no international debt. It makes little sense to simply hold the money in accounts that pay little or no interest or to flood the country with money (creating hyper-inflation). Investing the money for the future is a much more logical thing to do; especially for countries that depend on the export of raw materials. The commodities market is known for its volatility; therefore, planning for the future during flush times is simply good fiscal management. The size of some sovereign wealth funds and their recently aggressive investment patterns as well as their states of origin have been raising questions in some capitals. The New York Times ran an article about the world’s largest sovereign wealth fund [“Cash-Rich, Publicity-Shy, Abu Dhabi Fund Draws Scrutiny,” by Landon Thomas, Jr., 28 February 2008].

“Abu Dhabi has about 9 percent of the world’s oil and 0.02 percent of its population. The result is a surfeit of petrodollars, much of which is funneled into a secretive, government-controlled investment fund that is helping to shift the balance of power in the financial world. After decades in the shadows, the fund, the Abu Dhabi Investment Authority, is turning heads on Wall Street and in Washington by making high-profile investments in the United States and elsewhere. Known as ADIA (pronounced ah-DEE-ah), the fund recently formed a small team that is now buying big stakes in Western companies. This unit masterminded ADIA’s $7.5 billion investment in Citigroup, the nation’s largest bank, in November. It has also taken a large position in Toll Brothers, one of the country’s biggest home builders. … ADIA is the largest of the world’s sovereign wealth funds, giant pools of money controlled by cash-rich governments, particularly in Asia and Middle East. But Abu Dhabi, the wealthiest of the seven Arab emirates, says little about its fund. Few outsiders know for sure where ADIA invests — or even how much money it controls. And secrecy breeds hyperbole; some estimates of the fund’s size surpass $1 trillion. Before long, ADIA will certainly reach that mark. But for now bankers, former employees and analysts familiar with the fund peg it at $650 billion to $700 billion — an amount that is still over 15 times the size of the Fidelity Magellan Fund.”

Emirates of the UAE, of course, are not the only states that control large sovereign wealth funds.

“In all, sovereign wealth funds in countries like the United Arab Emirates, Kuwait, Singapore, China and Russia control more than $2 trillion, a figure that could approach $12 trillion by 2015, analysts say. Such riches, coupled with the more aggressive stance being taken by ADIA and other sovereign funds, has raised concern that these investors will wield their wealth for political as well as financial reasons.”

Although it is easy to understand people’s concerns, especially with America’s lingering suspicion of everything Muslim, they should ask themselves whether it is a good thing that people with money (and good business sense) are opting to invest in the U.S. economy. Such investment is one of the few returns we are getting from the money we are spending on foreign oil and foreign manufactured goods. Senator Bayh’s concerns are associated as much with the U.S. trade imbalance as with the investment strategy of sovereign wealth funds.

“‘In the short run, that they are investing here is good,’ Senator Bayh said. ‘But in the long run it is unsustainable. Our power and authority is eroding because of the amounts we are sending abroad for energy and consumer goods.'”

That is especially true if the U.S. economy continues to survive on credit and a “no savings” culture. Another thing that raises fears about sovereign wealth funds is that they are mostly managed in secrecy. Nothing raises the “X-File factor” faster than a lack of transparency.

“ADIA’s secrecy is also drawing scrutiny. … Senator Evan Bayh, Democrat of Indiana, the chairman of the Senate subcommittee on security and international trade and finance, who has raised concerns about sovereign fund transparency, traveled to Abu Dhabi [in mid-February] to meet with senior ADIA executives. … Also … a delegation led by Clay Lowery, a top Treasury official, met with ADIA executives as part of a move to formalize investment guidelines for sovereign funds. … One view is that ADIA’s penchant for secrecy stems from its experience during the scandal at the Bank of Credit and Commerce International in the early 1990s, during which ADIA is said to have lost hundreds of millions of dollars. The al-Nahyan family became embroiled in regulatory investigations, although no charges were ever brought against them. But people who worked at ADIA from its earliest days in the late 1970s and 1980s say that the fund’s reticence dates to its formation. Some see this as a reflection of Abu Dhabi’s small size, insular culture and geographical vulnerability, a sense that the less that is known about the specifics of ADIA’s hoard, the better.”

BusinessWeek reported that the U.S. delegation visited both Abu Dhabi and Singapore to seek their voluntary adherence to standards covering the structure of their sovereign wealth funds, their governance, and how they make decisions [“Sovereign Struggle,” 10 March 2008 print edition]. The U.S. would also like to see more disclosure of their holdings.

It might surprise some people to learn that the second largest sovereign wealth fund is not held by a Middle Eastern or Asian country, but by Norway, which established its fund as a pension fund. Like all sovereign wealth funds, the purpose of Norway’s pension fund is to invest its large budget surplus (which for Norway like Middle Eastern countries is generated by the petroleum sector) in order to increase its value and prepare for a leaner future. Establishing the fund was considered farsighted by most analysts since Norway is not rich in other natural resources. It is predicted that revenue from Norway’s petroleum sector is now at its peak and will steadily decline over the next several decades. Norway’s fund is dwarfed by the Abu Dhabi fund, which Thomas reports is twice as large. ADIA has recently established a small investment group, Thomas reports, that takes a more aggressive approach than the fund has taken in the past.

“ADIA’s new strategic investment group represents the clearest sign that the fund is taking steps to leverage its size and influence. The division was set up in the summer of 2006 and is overseen by Saeed Mubarek Rashid al-Hajiri, a young Western-educated portfolio manager who also heads the fund’s considerable investments in emerging market economies. In addition to Citigroup and Toll Brothers, in which ADIA took a 4.5 percent position last summer, other companies in the group’s portfolio include EFG Hermes, one of the leading investment banks in the Arab world, and Banque de Tunisie et des Emirats, a Tunisian bank. Instead of passively tracking indexes, this unit actively picks investments in hopes of generating market-beating returns. It is a method of stock picking practiced by most hedge funds and asset management companies, and the Citigroup investment, with its size and attendant risk, is a good example of this approach. Compared with the overall fund, the assets within this group are small at about $30 billion, according to people who have been briefed on ADIA’s strategy. As with all its investments, ADIA adopts a long-term, passive approach and does not seek board seats. These people say that outsiders still manage 80 percent of ADIA’s assets, proof that the fund’s commitment to making direct investments is only in its early stages.”

Whether you love ’em or hate ’em, sovereign wealth funds are here to stay. Undoubtedly the push to make them more transparent and to establish international investment guidelines will continue. Nations managing sovereign wealth funds would be better off buying into international standards than finding themselves facing nationalist interests that establish all sorts of barriers to investment and a myriad of different regulatory requirements that become onerous. Transparency and adherence to guidelines will go a long ways towards dispersing conspiracy theories and impugning political motives behind financial investments.