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Integral Economic Development
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1. Trade and debt are closely related in all countries. Explain why this is the case. In your view,
what are the pros and cons of the presence of sovereign wealth funds in developing
countries? If a country is a small raw commodities producer developing country, would the
expectation of a decrease in the openness of the US economy combined with a fall in
absorption capacity in China be a reason for concern?
The answer should be extract from specific article attached.
Journal of Economic Perspectives—Volume 27, Number 2—Spring 2013—Pages 219–238
The Investment Strategies of Sovereign
Wealth Funds†
Shai Bernstein, Josh Lerner, and Antoinette Schoar
S
overeign wealth funds have emerged as major investors in corporate and
real resources worldwide. Estimates of their size are difficult, because disclosure regulations and practices differ widely from country to country. But in
2012, the Sovereign Wealth Fund Institute estimated that total assets of these funds
were more than $5 trillion: that is, more than double the $2.1 trillion managed by
hedge funds (as estimated by Hedge Funds Research Inc., accessed July 21, 2012),
although it is only 2.3 percent of the $212 trillion in total global financial assets
(as estimated by McKinsey Global Institute 2011).
At first blush, sovereign wealth funds might seem an excellent opportunity
for nations with high variance in public revenues to ensure steady cash flow levels
and provide resources for long-term investments: for example, countries relying on
commodity trade that occasionally encounter windfalls of natural resources. Such
countries, without a fund to direct investments, could otherwise fall prey to the
“Dutch disease” and squander short-lived windfalls from natural resources in a way
that weakens the economy’s long-run potential. But sovereign wealth funds also
have limitations, since they may create economic distortions. For example, there
are concerns about lack of transparency and political capture: funds with political
leaders on their boards may be tempted to shore-up domestic firms as they succumb
to political pressure, passing up on high net present value investments in other
Shai Bernstein is Assistant Professor of Finance, Graduate School of Business, Stanford
University, Stanford, California. Josh Lerner is the Jacob H. Schiff Professor of Investment
Banking, Harvard Business School, Harvard University, Boston, Massachusetts. Antoinette
Schoar is Michael Koerner ‘49 Professor of Entrepreneurial Finance, Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts. Lerner and Schoar
are affiliates of the National Bureau of Economic Research, Cambridge, Massachusetts. Their
email addresses are shaib@gsb.stanford.edu, josh@hbs.edu, and aschoar@mit.edu.
■
†
To access the Appendix, visit
http://dx.doi.org/10.1257/jep.27.2.219.
doi=10.1257/jep.27.2.219
220
Journal of Economic Perspectives
firms and creating product market distortions by favoring connected or poorly
performing firms. Similarly, as the interaction between sovereign wealth funds and
political agenda grows, opportunities for nepotism increase, potentially reducing
the overall skill of sovereign wealth fund managers relative to professionals and
diluting the returns.
Thus, sovereign wealth funds are particularly interesting because of the potential interactions between mission and ownership structure. Their investment charters
usually state that the fund seeks to maximize financial returns for the benefit of
long-term public policies, such as retiree benefits or economic development needs.
But the quasi-public nature of these funds means that they are exposed to political
influences, often with more short-term goals.
This article will review several of the central issues that face sovereign wealth
funds. After an overview of their magnitude, we will then consider the institutional
arrangements under which many of the sovereign wealth funds operate and how
such arrangements might influence the effectiveness of their investment policies. We
focus on a specific set of agency problems that is of first-order importance for these
funds: that is, the direct involvement of political leaders in the management process.
We show that sovereign wealth funds with greater involvement of political leaders in
fund management are associated with investment strategies that seem to favor shortterm economic policy goals in their respective countries at the expense of longer-term
maximization of returns. In particular, sovereign wealth funds where political involvement is more prevalent tend to support domestic firms by investing in segments and
markets where valuation levels are inflated (as measured by price/earnings ratios),
and subsequently see a reversal in these price/earnings ratios. The opposite patterns
hold for funds that rely on external managers. While we are not able to disentangle
causality with our existing data, the associations are striking.
Sovereign wealth funds face several other issues, like how best to cope with
demands for transparency, which can allow others to copy their investment strategies, and how to address the problems that arise with sheer size, like the difficulties
of scaling up investment strategies that only work with a smaller value of assets
under investment. In the conclusion, we discuss how various approaches cultivated
by effective institutional investors worldwide—from investing in the best people
to pioneering new asset classes to compartmentalizing investment activities—may
provide clues as to how sovereign wealth funds might address these issues.
An Overview of Sovereign Wealth Funds
Depending on how one counts, there are between 40 and 70 different sovereign
funds, run by political entities as disparate as New Mexico and Kazakhstan. Table 1
lists the 20 largest sovereign wealth funds and estimates of their holdings: the funds
on this list comprise about 90 percent of the total assets of sovereign wealth funds.
The wealth within these funds has differing origins. In many of the most visible
cases, such as Abu Dhabi, petroleum has been the source of abundant wealth. Other
Shai Bernstein, Josh Lerner, and Antoinette Schoar
221
Table 1
Leading Sovereign Wealth Funds
Country
UAE – Abu Dhabi
Norway
China
Saudi Arabia
China
Kuwait
China – Hong Kong
Singapore
Singapore
Russia
China
Qatar
Australia
UAE – Dubai
UAE – Abu Dhabi
Libya
Kazakhstan
Algeria
UAE – Abu Dhabi
South Korea
Fund Name
Abu Dhabi Investment Authority
Government Pension Fund – Global
SAFE Investment Company
SAMA Foreign Holdings
China Investment Corporation
Kuwait Investment Authority
Hong Kong Monetary Authority
Investment
Government of Singapore
Investment Corporation
Temasek Holdings
National Welfare Fund
National Social Security Fund
Qatar Investment Authority
Australian Future Fund
Investment Corporation of Dubai
International Petroleum Investment
Company
Libyan Investment Authority
Kazakhstan National Fund
Revenue Regulation Fund
Mubadala Development Company
Korea Investment Corporation
Assets
(billions
of dollars)
Inception
Origin of wealth
627
593
568
533
440
296
293
1976
1990
1997
N/A
2007
1953
1993
Oil
Oil
Non-commodity
Oil
Non-commodity
Oil
Non-commodity
248
1981
Non-commodity
158
150
135
100
80
70
65
1974
2008
2000
2005
2006
2006
1984
Non-commodity
Oil
Non-commodity
Oil
Non-commodity
Oil
Oil
65
58
57
48
43
2006
2000
2000
2002
2005
Oil
Oil
Oil
Oil
Non-commodity
Note: This information about the 20 largest sovereign wealth funds is compiled from the Sovereign
Wealth Fund Institute, http://www.swfinstitute.org/fund-rankings/ (accessed July 21, 2012).
commodities, from diamonds to copper or phosphates, have been the foundation
of other funds, like the Chilean sovereign fund (though none of these funds made
it onto the list of the top 20 funds). Still others have been primarily funded from the
proceeds from the sale of state-owned properties or businesses. Other funds, such as
those of China and Singapore, have their origin in trade surpluses.
Sovereign wealth funds are growing quickly. They increased ten-fold in the last
two decades: from $500 billion in 1990 to more than $5 trillion today. Over the
past three years, they have achieved a 24 percent annual growth rate. Much of this
growth has been driven (not surprisingly) by the rising price of petroleum, and has
been concentrated in producer nations such as Norway, the United Arab Emirates,
and Kuwait. But other important players include nations such as China that pile up
foreign currency because they run persistent, large trade surpluses. These countries
less and less often put these reserves “under a mattress”—that is, holding safe but
low-return US Treasury bonds — and are instead seeking broader portfolios.
Sovereign funds frequently have multiple goals, which different organizations
emphasize to varying extents. There are three distinct roles sovereign wealth funds
222
Journal of Economic Perspectives
can play. First, they can serve as a source of capital for future generations, especially
in countries where future generations may no longer be able to rely on commodities for a steady stream of revenue. For example, the nation of Kiribati is a collection
of islands in the Pacific Ocean (formerly known as the Gilbert Islands) with a population of under 100,000 residents. For many decades, the dominant export from
the country was guano, bird droppings used for fertilizer. The island’s leaders set
up the Kiribati Revenue Equalization Reserve Fund in 1956, and imposed a tax on
production by foreign firms. The last guano was extracted in 1979, but the fund
remains a key economic contributor. At $600 million, it is ten times the size of
the nation’s gross domestic product, and the interest generated by the fund represents 30 percent of the nation’s revenue. Such a use is similar to that of a university
that receives a major bequest: typically, these funds are not spent immediately, but
instead added to its endowment so it can benefit many cohorts of students. Second,
sovereign wealth funds can play a stabilizing role by reducing the volatility of government revenues. Countries that depend on commodities for the bulk of their exports
can be whipsawed by shifts in prices, as, for instance, many oil exporters were in the
mid-1980s and late 1990s. Finally, these funds can serve as holding companies, in
which the government places its strategic investments. Public leaders may see fit to
invest in domestic or foreign firms for strategic purposes, and the sovereign funds
provide a way to hold and manage these stakes.
The Mixed Legacy
Many nations have failed to save the wealth created by developing natural
resources. Consider, for instance, the experience of Norway in the 1970s and 1980s
(for more details, see Pope 1995; Gjedrem 2005). In the oil surge of those years,
the government received a tremendous windfall of funds from its numerous rigs
in the North Sea. While efforts were made to enact legislation that set aside money
for the future, most of the money was spent immediately. Some of the spending
benefited physical and social infrastructure: Norway rebuilt its excellent system
of roads and bridges and provided free health care and higher education to all
residents. But other expenditures were less beneficial for long-term growth. For
example, minimum wages were set extremely high, which rendered a number of
economic sectors uncompetitive in global markets, and industries were subsidized.
Much of the funding for industry was earmarked for dying sectors, such as shipbuilding. This support allowed facilities to remain open for a few years more, but
could not reverse the inexorable decline of such industries. Much of the funding
for new ventures went to friends or relatives of parliamentarians or of the bureaucrats responsible for allocating the funds. Moreover, Norway’s policy of aggressively
spending the government’s petroleum revenues brought chaos to public and private
finances when oil prices plunged in the mid-1980s. The government’s oil revenue
dropped from about $11.2 billion in 1985—or about 20 percent of Norway’s gross
domestic product—to $2.4 billion in 1988. The resulting retrenchment of public
The Investment Strategies of Sovereign Wealth Funds
223
spending and tightening of credit led numerous banks to fail, as well as bringing
an unprecedented wave of bankruptcies by private citizens.
Nor was Norway the first nation to struggle with the influx of wealth. Back in
the 1970s, The Economist magazine coined the term “Dutch Disease” to describe
the economic malaise that gripped the Netherlands when it experienced an influx
of natural gas royalties during the 1960s. An example much further back in time,
documented by historian David Landes (1998), would be the corrosive effects
that the tremendous wealth generated by Spain’s overseas conquests had on that
nation’s economy.
Sovereign wealth funds can address these downsides of a sudden accumulation of natural wealth in two ways. First, by not spending the gains from natural
resources (or other sources) immediately, but rather preserving them for future
generations, the distorting impact of the windfall is reduced. Had the Norwegian
government kept public spending in check during the 1970s and 1980s, it is
unlikely that the disruptions in subsequent years would have been as severe.
Second, earmarking a percentage of windfall revenues into an investment fund
may reduce the risk that government officials will spend these revenues in an
unwise or corrupt manner—assuming, of course, the sovereign fund is run in a
professional manner. In an ideal world, a soundly managed sovereign fund can
address some of the macroeconomic problems that an influx of funding may
cause, such as inflation and exchange rate overvaluation (see the discussion in
Ang 2010 for an exploration of these issues).
But the structure of sovereign wealth funds can face two serious agency problems. First, the political process can introduce short-run pressures on sovereign
wealth funds to financially support local firms or subsidize industrial policies within
the country. There are two opposing views of the consequences of these investment
pressures. Advocates for government-directed investments often argue that financial markets in these countries can be underdeveloped or myopic or both, and thus
leave profitable investment opportunities on the table (Atkinson and Stiglitz 1980;
Stiglitz 1993). The opposing, less-sanguine view of politically directed investments
suggests that political involvement can either lead to misguided policy attempts to
prop up inefficient firms or industries or engage in investment activities in industries, sectors, or geographies that are “hot” (Shleifer and Vishny 1994; Banerjee
1997; Hart, Shleifer, and Vishny 1997).
This conceptual framework suggests some testable implications. If the
benevolent view of sovereign wealth funds is accurate, we would expect to find that
government investments in local firms are directed at industries that face financial
constraints and subsequently perform very well. If the latter view is true, we would
predict the opposite: investments would be disproportionately directed to local
firms, follow a pro-cyclical trend, and subsequently perform poorly. In addition,
if sovereign wealth funds are run by politically connected but financially inexperienced managers, we might expect that not only would they make poor choices in
their home and foreign investments, but would also display poorer stock-picking
ability even looking solely at the international portfolio of the fund.
224
Journal of Economic Perspectives
Political Involvement and Investment Distortions
There has been relatively little empirical analysis of agency problems at sovereign funds, largely due to data restrictions.1 Recent papers by Gompers and Metrick
(2001), Lerner, Schoar, and Wongsunwai (2007), and Hochberg and Rauh (2011)
have highlighted the heterogeneity in investment strategies, and ultimately returns,
across different types of institutional investors.2 Because we are interested in understanding the extent to which the investment behavior of sovereign wealth funds
is shaped by short-term political considerations, we focus on the funds’ long-term
investments—acquisitions, purchases of private equity, and structured equity positions in public firms — on the grounds that these distortions should be most evident
in these areas.
Descriptive Statistics
To analyze the investment strategies of sovereign wealth funds, we combine
data from a number of publicly available sources. Here, we offer an overview of the
sources for this data: for details, please see the online Appendix available with this
article at http://e-jep.org.
First, we look at information on the funds themselves, starting with profiles of
the funds published by J.P. Morgan (Fernandez and Eschweiler 2008) and Preqin
(Friedman 2008). The key variables collected at the fund level are assets under
management, the presence of politicians in the managing bodies of the funds, reliance on external managers, and whether the stated investment goals are “strategic.”
By “strategic,” we mean that the investments are related to the country’s long-term
industry development strategy rather than simply aiming to maximize the financial
returns of the portfolio. We categorize a fund as “strategic” if its stated investment
goals are the management of the government’s physical assets, the acquisition of
strategic assets, or domestic development. We categorize a fund as “nonstrategic” if
its stated goals are investment of oil/commodity revenues, currency reserve management, or pension funding. These measures of the characteristics of the funds are
admittedly crude characterizations of organizational structures: these are recorded
1
Several papers conduct event-study analyses of how the stock market reacts when sovereign wealth
funds make investment announcements. The reactions are usually positive, at least in the short term
(Kotter and Lel 2008; Dewenter, Han, and Malatesta 2010; Bortolotti, Fotak, Megginson, and Miracky
2010; Knill, Lee, and Mauck 2010). Chhaochharia and Laeven (2009) show that sovereign wealth funds
largely invest in countries that share the same ethnicity, language, and religion. Fernandes (2011) and
Dyck and Morse (2011), rather than exploring transactions, focus on holdings of sovereign wealth funds
(that is, the stock rather than the flow of investments). The latter paper, which is most complementary
to the analysis below, finds that many holdings by these funds can be explained by financial return
maximization or state planning motives, demonstrating the tension between the two objectives.
2
While the Santiago principles of the International Working Group of Sovereign Wealth Funds state that
“relevant financial information regarding the SWF should be publicly disclosed” (http://www.iwg-swf
.org/pubs/gapplist.htm; accessed December 22, 2012), consistent return data for most sovereign funds
is hard to come by. For instance, the Abu Dhabi Investment Authority in recent annual reports has
reported its aggregate returns over 20- and 30-year time horizons; aggregate returns over shorter horizons have not been disclosed, much less those of individual asset classes.
Shai Bernstein, Josh Lerner, and Antoinette Schoar
225
as binary variables, rather than as continuous variables that we might be able to
analyze more carefully. M …
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