swf asset allocation after the financial crisis...swf asset allocation after the financial crisis...

The Sovereign Wealth Fund Initiative

SWF Asset Allocation after the Financial Crisis

Increased Diversification Requires Enhanced Political Risk Management

Dr. Eliot KalterPresident, E M Strategies

Senior Fellow, The Fletcher [email protected]

March 2012


mailto:[email protected]


Presentation Topics

I. Emerging Market Strength Continues After the Financial Crisis

II. EM Financial Markets Still Have Significant Room to Grow

III.Why do SWFs matter? Factors Driving Their Growth

IV.Asset Allocation Diversifies Beyond Traditional Geography and Asset Classes for SWFs and Other Long‐Term investors

V. Global Implications of SWF Growing Resources

VI. Socio‐Political Risks Faced by SWF and Other Long‐Term Investors


I. EM Countries Weathered the Financial Crisis Better than Advanced Economies

Overview Presentation


Drivers of Global GrowthAs a result, EM countries will drive most of global growth through 2016


KenyaVietnam

Portugal

Colombia

Malaysia

BrazilPeru

Russia

Hungary

South Korea

India

China

United StatesSwitzerland

Japan

Argentina

Spain

0

10000

20000

30000

40000

50000

60000

0 100 200 300 400 500 600 700

Per Ca

pita In

come

Financial Depth(% of GDP)

Financial depth measured by Debt and Equity outstanding/GDP; Per Capital GDP at PPP $ per person log scale; Source: BIS, S&P, McKinsey Global Banking

2010, end of period

II.EM Financial Markets: Sizable Room to GrowThere is a clear relationship between rising income and the depth of financial markets


Emerging markets account for small (18%) but rapidly growing share of global financial markets

Source: BIS, Dealogic, S&P, McKinsey Global Banking

Global Share and Growth of Capital Markets


III. Why Do SWFs Matter? Factors Driving SWF Growth

International reserves reached levels beyond those needed to buffer external vulnerabilities in many EM countries

Reserve accumulation must be sterilized to be non‐inflationary; domestic cost of sterilization greater than return on central bank investments

SWFs do not face same investment restrictions as central banks

Growth of SWFs also driven by need to insulate economy from volatile commodity prices, share wealth across generations and fund priority projects

SWFs long‐term investment horizon helps global financial stability


Global ImbalancesGlobal imbalances are driving the growth of SWFs; they are projected to continue


IV. Asset Allocation Diversifies beyond Traditional Geography and Asset Classes

Many SWFs noted during discussions with Sovereign Wealth Fund Initiative that they are increasing their asset allocation in emerging and frontier markets, as well as in new investment vehicles

Factors driving diversified asset allocation:

Mandate of SWFs gives them advantage with ability for long‐term investment

Impact of global crisis with less faith in advanced economy financial systems

Low returns from advanced economy fixed income

Benefits of asset diversification


SWFs have diversified across all asset classes with increasing allocation to alternatives


SWF Investments are Geographically DiverseSWF’s investments shifted out of N. America and to Europe following the 2008 financial crisis

Need for broader understanding of risk management as asset allocation diversifies


Throughout the period, pension fund asset allocation:declined for equities and increased for alternative assetsa fall earlier in the decade in the allocation to bonds reversed in recent yearsin recent years, risk management included increased exposure to alternative assets mainly coming out of equity investments

Pension Funds have also diversified across all asset classes with increasing allocation to alternatives 1995-2011


0

5

10

15

20

25

30

35

40

2010 2011 2011 2011 2010 2011 2011 2011 2010 2011 2011 2011

Percen

t

Emerging Market Debt

Percentage of European Pension Plans with Emerging Market Exposure

Emerging Market Equity Infrastructure/Property

Manager has Discretion to Invest

Specific Allocation

Included in Global Benchmark


V. Global Implications of Growing Resources of SWFs

Increasing resources of SWFs (with transfer from Central Banks) could affect relative price of equities to fixed income securities

SWFs will increasingly play a stabilizing role in global markets with their long‐term investment horizon

Facilitate broadening of markets in EM Countries and upward pressure on EM prices (1% shift in long‐term investor allocation to EM countries would result in $600 billion inflow, equivalent to 2 ½ % of EM market capitalization—much of which is still not liquid)



VI. Social‐Political Risks Faced by SWFs with Diversification Beyond Traditional Geography and Asset Classes

SWF investments require organizational and leadership capabilities to effectively manage risk in potentially difficult socio-political environments, while at the same time ensuring that their basic objectives are met

Effective risk mitigation aimed at optimizing a successful long-term investment outcome requires:

Traditional risk management for liquidity and solvency riskSocio‐political risk assessment in target country and country of origin

Incorporating social and political risk scenarios into the strategic planGathering a deeper understanding of perspectives of recipient country and companyDeveloping strategies that align with stakeholder interests and prioritiesEnhancing internal governance and implementing prudent operating practicesCreating architecture for managing multiple external relations Incorporating risk mitigation considerations into actual operations


Political Risk Management Must Keep Up with the Rapid Diversification of Asset Allocation

Political risk is commonly defined in terms of unexpected political climateinvestors must take into account underlying causes for adverse political change

that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives.

Political risk can also stem from investors not well understanding the eventual impact of existing political climateIn a macro sense, investors did not fully incorporate the financial implications of the

political/social system in the EU which lead to unsustainable budgets in the face of structurally low growth. Similarly, investors did not take into account the impact of the anti‐regulatory bias that existed

in the main financial center countries with competition for business leading to sub‐optimal regulatory frameworks. In the micro sense, political risk exists, inter alia, if there is not a clear understanding of the

existing relationship between governments and their labor unions, or the judiciary system that may be biased or underdeveloped with consequences for business operations and growth.


Global Importance of Getting Risk Analysis Right

Political risk analysis is particularly important for long-term investors:

•SWFs have the capacity to become increasingly important as a source of long‐term financing and global stability.•However, we have seen that SWFs will quickly withdraw from sectors (reduced allocations to the financial sector following losses after the 2008 crisis) and geographic regions (the current reduced allocation to EU countries) • Emphasis must placed on a number of fronts to better equip SWFs and other LTIs to account for political risk consistent with the speed of their asset diversification.need for a clear‐eyed assessment of a country’s political ability to confront growing public

sector indebtednessSWFs and other LTIs must deepen their understanding of recipient countries socio‐political

risks and develop strategies that take into account countries’ financial, political and social interests and priorities


Emerging Markets after the Financial Crisis Perspective of Sovereign Wealth Funds and other

Institutional Investors



March 2012




I. EM Countries Weathered the Financial Crisis Better than Advanced Economies


EM Economic Growth is Driven by Both Consumption and Investment


Strong Fiscal Policy and Declining Public Debt Underlie EM Strength


Global Growth versus Pre‐Crisis AverageGlobal growth exceeds pre-crisis levels in EM Countries with particular strength in Latin America


Real GDP in 2011 in Percent of Pre‐Crisis Trends(pre‐crisis trend based on 1996‐2006 real GDP growth)

Advanced Economies are uniformly below pre-crisis growth trends, projected to remain so though 2016; in contrast, most EM countries are above pre-crisis trend and projected to increase growth through 2016


Drivers of Global GrowthAs a result, EM countries will drive most of global growth through 2016


KenyaVietnam

Portugal

Colombia

Malaysia

BrazilPeru

Russia

Hungary

South Korea

India

China

United StatesSwitzerland

Japan

Argentina

Spain

0

10000

20000

30000

40000

50000

60000

0 100 200 300 400 500 600 700

Per Ca

pita In

come

Financial Depth(% of GDP)

Financial depth measured by Debt and Equity outstanding/GDP; Per Capital GDP at PPP $ per person log scale; Source: BIS, S&P, McKinsey Global Banking

2010, end of period

II.EM Financial Markets: Sizable Room to GrowThere is a clear relationship between rising income and the depth of financial markets


Emerging markets account for small (18%) but rapidly growing share of global financial markets

Source: BIS, Dealogic, S&P, McKinsey Global Banking

Global Share and Growth of Capital Markets


III. Why Do SWFs Matter? Factors Driving SWF Growth

International reserves reached levels beyond those needed to buffer external vulnerabilities in many EM countries

Reserve accumulation must be sterilized to be non‐inflationary; domestic cost of sterilization greater than return on central bank investments

SWFs do not face same investment restrictions as central banks

Growth of SWFs also driven by need to insulate economy from volatile commodity prices, share wealth across generations and fund priority projects

SWFs long‐term investment horizon helps global financial stability


Relevance of Sovereign Wealth Funds : Factors Driving Growth SWFs are a small compared with other institutional investors but have grown rapidly


Stabilization Funds Insulate Budget/Economy (e.g. Chile, Kazakhstan, Azerbaijan, Algeria, and Venezuela)

Inter‐generational transfer (e.g. Kuwait, Qatar, U.S., Alaska)Savings Funds

Reserve Investment Corporations

Development Funds

Contingent Pension Reserve Funds

SWFs – Not a Homogenous Group

Part of Reserves; Increasing Returns (e.g. Korea)

Socio‐Economic Objectives

Finance unspecified; contingent pension liabilities of governments (Australia, New Zealand)


Portfolios Reflect Investment Horizons and Mandate


Global ImbalancesGlobal imbalances are driving the growth of SWFs; they are projected to continue


IV. Asset Allocation Diversifies beyond Traditional Geography and Asset Classes

Many SWFs noted during discussions with Sovereign Wealth Fund Initiative that they are increasing their asset allocation in emerging and frontier markets, as well as in new investment vehicles

Factors driving diversified asset allocation:

Mandate of SWFs gives them advantage with ability for long‐term investment

Impact of global crisis with less faith in advanced economy financial systems

Low returns from advanced economy fixed income

Benefits of asset diversification


Impact of Global Financial Crisis on Asset Allocationto Emerging Markets

Reinforcing the secular shift of financial and economic power away from the traditional centers of the U.S. and Western Europe and towards emerging markets with varying structure, transparency and accountability

Ridding investors of the perception that developed markets in the West are less risky and more secure than emerging markets

Gradual shift of asset allocation to alternative assets and emerging market debt and equity to meet public policy objectives

Asset allocation to Latin America is expected to increase from low levels; Asia should see significant increases as well


SWFs have diversified across all asset classes with increasing allocation to alternatives


SWF Asset Allocation, 2007 vs. 2009The type of SWF investments, extent of diversification vary greatly depending on mandate;

however, SWFs increased diversification of investments across mandates


SWF Asset Allocation (% of total at 2010)

Cash Equities Bonds Alternatives

RE PE Infra HF Credit

Norway -- 53% 42% 5%

UAE/ADIA -- 45-75% 10-20% 5-10% 5-10% 2-8% -- 1-2%

UAE/ADIC -- -- -- active strategy

China CIC 25-30% 5-10% 50-65%

Kuwait KIA 3-7% 55-65% 8-12% 8-12% 3-7%

Singapore GIC 8% 38% 25% 12% 15% 5% -- --

Singapore Temasek 70% 30% -- --

Australia 37% 33% 20% 1% 3% 2% 4% --

UAE/Mubadala -- -- -- 100%

Korea/KIC 3% 20% 70% 7%

Bahrain -- -- -- 100%

UAE Istithmar -- -- -- 60% 40% -- -- --

Chile 30% 70% -- -- -- -- --

Alaska 3% 54% 22% 10% 6% 4% -- --

Canada/Alberta 3% 46% 25% 14% 8% -- 6% --


SWFs have diversified across all geographic region

Number of SWF Investments by Target Location, 2000-09


SWF Investments are Geographically DiverseSWF’s investments shifted out of N. America and to Europe following the 2008 financial crisis



SWF Investment Moved Toward EM Countries in 2010 as Global Risks Subsided


Top Five SWF Investments in 2010 by SizeOne example of geographic diversity


Geographic Distribution

Own-Region/Global Europe North America Developed Asia Emerging Markets

Norway 55% 35% 10%

UAE/ADIA 25-35% 35-50% 10-20% 15-25%

UAE/ADIC 90/10%

China CIC 50/50%

Kuwait KIA 35-40% 35-40% 13-17% 4-6%

Singapore GIC 25% 40% 25% 10%

Singapore Temasek 30/70% 25% 65% 11%

UAE/Mubadala 74/26%

Korea/KIC 0/100%

Bahrain 100/0%

UAE Istithmar 30% 20% 40% 10%

Chile 40% 50% 10%


Throughout the period, pension fund asset allocation:declined for equities and increased for alternative assetsa fall earlier in the decade in the allocation to bonds reversed in recent yearsin recent years, risk management included increased exposure to alternative assets mainly coming out of equity investments

Pension Funds have also diversified across all asset classes with increasing allocation to alternatives 1995-2011


Shift in Pension Fund Asset Allocation 2001‐2011


0

5

10

15

20

25

30

35

40

2010 2011 2011 2011 2010 2011 2011 2011 2010 2011 2011 2011

Percen

t

Emerging Market Debt

Percentage of European Pension Plans with Emerging Market Exposure

Emerging Market Equity Infrastructure/Property

Manager has Discretion to Invest

Specific Allocation

Included in Global Benchmark


V. Global Implications of Growing Resources of SWFs

Increasing resources of SWFs (with transfer from Central Banks) could affect relative price of equities to fixed income securities

SWFs will increasingly play a stabilizing role in global markets with their long‐term investment horizon

Facilitate broadening of markets in EM Countries and upward pressure on EM prices (1% shift in long‐term investor allocation to EM countries would result in $600 billion inflow, equivalent to 2 ½ % of EM market capitalization—much of which is still not liquid)



VI. Social‐Political Risks Faced by SWFs with Diversification Beyond Traditional Geography and Asset Classes

SWF investments require organizational and leadership capabilities to effectively manage risk in potentially difficult socio-political environments, while at the same time ensuring that their basic objectives are met

Effective risk mitigation aimed at optimizing a successful long-term investment outcome requires:

Traditional risk management for liquidity and solvency riskSocio‐political risk assessment in target country and country of origin

Incorporating social and political risk scenarios into the strategic planGathering a deeper understanding of perspectives of recipient country and companyDeveloping strategies that align with stakeholder interests and prioritiesEnhancing internal governance and implementing prudent operating practicesCreating architecture for managing multiple external relations Incorporating risk mitigation considerations into actual operations


Traditional Risk Management for Liquidity and Solvency Risk

Sovereign and company risk assessment traditionally take into account solvency risk (the underlying ability to meet obligations) and liquidity risk (sufficient cash flow to meet current obligations)

The IMF analyzes macroeconomic, financial and structural factors that result in a country’s projected economic growth, debt and debt service and, thus, a country’s ability to meet current and future (domestic and external) obligations.

Portfolio risk assessment is well covered by financial advisory firms. A good example of this approach is the State Street Global Markets use of five tenets of portfolio construction that take into account, inter alia:

non‐normal return distributions such as “fat tails”, correlations between fund holdings and the returns from the source of funding, and “risk factor analysis” to identifying underlying investment risk factors that describe

the return variation in a particular portfolio or asset.


Political Risk Management Must Keep Up with the Rapid Diversification of Asset Allocation

Political risk is commonly defined in terms of unexpected political climateinvestors must take into account underlying causes for adverse political change

that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives.

Political risk can also stem from investors not well understanding the eventual impact of existing political climateIn a macro sense, investors did not fully incorporate the financial implications of the

political/social system in the EU which lead to unsustainable budgets in the face of structurally low growth. Similarly, investors did not take into account the impact of the anti‐regulatory bias that existed

in the main financial center countries with competition for business leading to sub‐optimal regulatory frameworks. In the micro sense, political risk exists, inter alia, if there is not a clear understanding of the

existing relationship between governments and their labor unions, or the judiciary system that may be biased or underdeveloped with consequences for business operations and growth.


SWFs must not only face political risk in the country targeted by their investments but also political risk in the country of SWF origin

Based on the EIU Democracy Index, over half of SWF assets have authoritarian regimes as their origin.

This increases the risk of political upheaval or sudden asset allocation shifts with pressure for SWF assets to be used for shorter‐term investments or public savings, financial

sanctions freezing SWF assets, and investments made for political rather than commercial purposes

Political Risk Management Must also Take Into AccountRisks in Country of SWF Origin


Global Importance of Getting Risk Analysis Right

Political risk analysis is particularly important for long-term investors:

•SWFs have the capacity to become increasingly important as a source of long‐term financing and global stability.•However, we have seen that SWFs will quickly withdraw from sectors (reduced allocations to the financial sector following losses after the 2008 crisis) and geographic regions (the current reduced allocation to EU countries) • Emphasis must placed on a number of fronts to better equip SWFs and other LTIs to account for political risk consistent with the speed of their asset diversification.need for a clear‐eyed assessment of a country’s political ability to confront growing public

sector indebtednessSWFs and other LTIs must deepen their understanding of recipient countries socio‐political

risks and develop strategies that take into account countries’ financial, political and social interests and priorities


Emerging Markets after the Financial Crisis Perspective of Sovereign Wealth Funds and other

Institutional Investors



March 2012



swf asset allocation after the financial crisis...swf asset allocation after the financial crisis...

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