Asian sovereign wealth funds: where they’re going and what it means for the rest of the world

Just a few years ago, any article on Asia Pacific sovereign wealth funds would have struggled to get far out of Singapore. The city state’s two sovereign entities – Temasek and the Government of Singapore Investment Corporation (GIC) – have long been seen as elder statesmen of the sovereign wealth community, sophisticated and largely successful. But where else would you go after that? You could argue that the investment portfolio of the Hong Kong Monetary Authority’s Exchange Fund has sovereign wealth characteristics; beyond that, there was little to discuss.

Today, things are very different, for two reasons: firstly, the appearance of several new fund vehicles; and secondly, the fact that they have, to varying degrees, committed to at least some transparency, certainly far more than is commonplace in the Middle East. As newer funds in China, Korea, Australia and even Timor L’Este have moved past three year track records and started to reflect their likely long-term asset allocation, it is now possible to have an entirely different discussion about Asian sovereign wealth.

So what trends can we see? Let’s start with the obvious one: dramatically rising asset volumes.  Cerulli Associates calculates that volumes in Asian sovereign wealth funds have risen from $432 billion in 2006 to $1.268 trillion today. Definitions of sovereign wealth funds are fraught with difficulty, so let’s dissect that figure right away: we’re including the investment portfolio assets of the HKMA’s Exchange Fund (but not the chunk that is kept in backing to Hong Kong’s monetary base); we’re including Malaysia’s Khazanah; we haven’t added smaller or newer funds such as Brunei or Timor-L’Este, nor more distant Australia’s Future Fund; and we’ve made an educated guess at GIC’s total assets, which are not disclosed beyond being “over $100 billion” (we think they’re at least three times that).

Secondly, the diversity of sources of funds is growing. Whereas Singapore accounted for at least two thirds of regional sovereign wealth assets in 2006, they fell below half of the regional total by 2010 and will continue to drop. It would be no surprise to see the China Investment Corporation become the biggest fund in the region in coming years as the State Council entrusts more assets to it. Korea’s fund assets, from a low base, are becoming significant, and Australia’s too.

Moreover, sovereign funds are beginning to appear in progressively more obscure and frontier-spirited locations. It is a surprise to many to learn that one of the most transparent and conservative sovereign wealth funds in the world is located in the fledgling nation of Timor L’Este or East Timor, investing the wealth that comes from natural gas fields in the Timor Sea. It has become a role model for newly commodity-rich states: Papua New Guinea and Mongolia are also developing sovereign funds.

Sovereign funds do vary dramatically in their approach to asset allocation, either by asset or geography, but there are some general conclusions one can draw. One is that, gradually, sovereign funds are becoming more inward looking into Asia, at the expense of the developed world.

The gold standard in this respect is Temasek, which in 2002 launched a revamped 40-30-20-10 benchmark, with the 40 being Asia ex-Singapore, 30 Singapore, 20 OECD and 10 ‘other’, which in practice so far chiefly means Latin America. If Temasek’s conviction towards this was ever in doubt, any concerns were surely erased by the losses it made in its holdings in western banks during the financial crisis. Temasek knows it knows emerging markets best, and almost everything about its investment policy today relates to emerging market themes: transforming economies; growing middle income populations; deepening comparative advantages; and emerging champions.

Others simply express Asian convictions with overweights; CIC, for example, has a much bigger holding in Asia than any MSCI weighting would come up with, but it’s still less than its assets in North America. Singapore’s GIC has long talked about shifting towards emerging markets assets, and in the year to March 31 2011, finally appeared to do so: emerging market equities climbed from 10 to 15% of the portfolio during the year, while developed market equities dropped from 41 to 34%. Asia across the board now accounts for 27% of the portfolio, up from 24% last year – and remember GIC can’t invest in Singapore.

Another widespread trend is a move into alternative assets.  Singapore’s GIC is seen as a leader in this respect: it made its moves into alternatives early and by 2009 they accounted for 30% of the fund, if real estate is included (GIC being one of the world’s biggest real estate investors in its own right). The figure has actually dropped slightly to 26% in 2011, but still GIC is considered a regional expert in private equity, venture capital, infrastructure and hedge funds; it has worked with pretty much every major private equity player worldwide.

CIC’s 2010 report was particularly interesting, because it was the first time that the Chinese institution had invested enough of its assets to provide a meaningful representation of what its long-term allocations are likely to look like. 21% of the fund was in alternatives. In particular much of 2010 was spent investing in REITs, private equity and infrastructure, while new alternative strategies adopted during the year included a metals and energy indices swap, a gold equity fund, an active commodity index strategy, and futures or options around indices, bonds, commodities and FX forwards. Another important step came in May, when CIC reorganized its investment departments. There are now four, and three of them have alternative attributes: alongside the Department of Public Equity, which combines external fund managers and proprietary trading, there is the Department of Fixed Income and Absolute Return, which apart from bonds handles credit derivatives, hedge funds, multi-asset portfolios and commodities; the Department of Private Equity, which handles real estate, industry and technology, financial services, consumer goods and services, healthcare and biopharma investments; and the Department of Special Investments, which is more focused on energy, mining, precious metals, agriculture and infrastructure.

At KIC, an alternative investments program was launched in 2009. When last disclosed alternatives accounted for just 5.8% of the fund, not counting a special situations division, but CIO Scott Kalb has spoken of 20% being a logical figure to reach.

Globally, this is a pattern: a recent report by Preqin concluded that 36% of sovereign wealth funds globally were investing in hedge funds, 61% in infrastructure and 59% in private equity. Perhaps related to this, there is growing interest in megatrends like sustainability, scarcity and security, all of which are of course highly relevant in the Middle East too. In Asia, these themes tend to be expressed in deals with big energy and resources companies, often as pre-IPO investments. Some also consider currency an interesting asset class in its own right, and in Asia the discussion is particularly keen around the RMB as it becomes an increasingly international, offshore-traded currency. GIC, for example, holds a QFII licence, allowing it to invest up to a quota amount in mainland Chinese assets.

In other respects, though, sovereign wealth funds in Asia are exceptionally diverse. This is nowhere more true than in mandates. Temasek and CIC have no defined liabilities: they are tasked with building up assets for some nebulous future good. GIC and KIC are entrusted with foreign exchange reserves, but even then there’s a difference, as KIC has an odd combination of central bank and finance ministry funds, each with a different risk tolerance. Some are hydrocarbon resource funds in the manner of the Middle East, like Timor L’Este’s Petroleum Fund, the Brunei Investment Agency fund, and the developing entities in Mongolia and PNG. Then there’s Khazanah, which exists to manage and improve state-held companies.

One other trend, not so good for fund managers, concerns outsourcing. Here, too, Singapore is illustrative. Temasek rarely outsources anything anymore; it doesn’t invest through portfolios but mainly through direct holdings in companies themselves, and doesn’t need external managers for that, apart from which it already has its own fund management arm, Fullerton. GIC is renowned for its internal smarts – it is believed to have a larger headcount than ADIA – and can do almost anything you can think of internally; generally the best way in to GIC now is probably to be a hedge fund and to encourage co-investment.

The pattern tends to be that funds start out outsourcing, master a particular asset class, then bring it in house again. This is true of the KIC, for example, where the proportion of outsourced assets has declined from 60% in 2008 to 35% in 2009 and 29.3% in 2010. In younger funds, the proportion outsourced is higher. CIC outsources 59% of its portfolios assets today, but is also expected to bring more assets in-house over time.

In this respect, it’s important to get in early. You might not think East Timor is the most lucrative place in the world but its fund is already approaching $9 billion, and there’s 20 years of gas there. So far it has outsourced only conservative and largely passive fixed income portfolios to the Bank of International Settlements and Schroders, but its finance minister, Emilia Pires, is trying to get parliament to approve a shift to a more traditional asset allocation with about 50% of the fund in equities. Similarly the PNG LNG project in Papua New Guinea will generate $30 billion of wealth to be managed, and there is every intention to outsource once the money starts flowing. Mongolia’s Stabilization Fund will at some point start to be invested as a sovereign fund; one only has to look at the economics around the Oyu Tolgoi and Tavan Tolgoi mines being developed in the country’s south, very much the tip of the iceberg in Mongolian resources, to see what the potential is.

It’s often said that sovereign funds will use passive approaches for the bulk of their money and take active bets around the edges, where the opportunities arise for foreign managers. Actually, it’s not always true that all passive work is done in-house; we believe ADIA, for example, outsources passive mandates. It’s probably closer to the truth to say that outsourcing opportunities are keen either for highly active or completely passive managers, but not for would-be-active benchmark-huggers. Several sovereign wealth funds won’t even countenance a meeting with an external manager without a clear illustration of where alpha will be added.

So the picture for external managers is mixed. On one hand there’s a bounty of assets coming into sovereign funds, from a greater range of institutions than ever before. On the other hand, they want more from their external managers. Those who thrive will be the ones who can be demonstrably successful and different from the herd.

Emerging Markets, September 2011

China’s sovereign wealth fund will not invest in new eurozone bonds, but expects to find other investment opportunities amid the chaos in Europe.

Gao Xiqing, Vice-Chairman and President of the China Investment Corporation, said the fund would not follow the lead of the Chinese sovereign in investing in securities issued to support troubled Eurozone states, such as the European Financial Stability Facility (EFSF). “You heard from our Premier, we like to support Europe,” he said. “But as a corporation our mandate from the government is to maintain a certain amount of profitability given the risk adjustment rules. We can’t just go there and try to save someone. We have to save ourselves.”

He told Emerging Markets: “We have our own requirements, our own mandate and asset allocations, so we have to act on that principle alone.”

But asked if he thought investment opportunities would arise for CIC as a consequence of European turmoil, he said: “That’s true. There will always be opportunities wherever there are problems, that I know. But at a macro level you have to be very careful.” CIC, which had US$374.3 billion under management at the end of 2010, was previously burned by $10 billion of ill-timed investments in Morgan Stanley and Blackstone ahead of the 2008 financial crisis.

In comments to a packed session on the eurozone in the IMF’s headquarters, Gao had some sharp comments about the problems that have led to the crisis. “Culturally you need to change your way of living, your way of spending,” he said. “Lots of people blame the Chinese for saving too much money and not spending; that made it possible for European and American friends to borrow. You should probably reinvent the system.”

He also said that Europe’s diversity was part of the problem. “A lot of people still doubt whether Europeans can get together and have fiscal union. All the people down in the south are trying to work five hours a day and three days a week, in the north eight hours a [day]. The Chinese work 100 hours a week.”

And he blamed ease of credit for exacerbating problems in the western system. “In this country and Europe, people are able to borrow money beyond their means,” he said. “You cannot live off tomorrow’s money, or someone else’s money – but today you are, because of all the geniuses employed by investment bankers. Now the pendulum is swinging. You need to get onto these things: they are innate in your system and you have to rethink.”

He was also bearish on Europe’s ability to fix its problems. Responding to another panelist’s comment that disintegration of the eurozone was unlikely, he said: “The fact that it’s going to be really bad, like the end of the world, doesn’t mean it isn’t going to happen. There is so much procrastination and inaction.” He said that there was ample liquidity available to meet Europe’s investment needs. “There are multi trillion dollars out there. I hope it works, but this whole system needs to be reformed.”

Note: this was a sponsored report and not editorially independent, but is included here as a resource

SECTION 1 – interview with Alisher Ali, Chairman, Eurasia Capital

EM: Set the scene: what is the opportunity in Mongolia today?

AA: Mongolia has so many things going for it. It is physically located next to China, which has become the de facto engine of growth in the global economy. It has been blessed with natural resources. And you have the government and political system: the country is a true democracy, so as a result there is a good chance of the country being able to manage effectively not only its mineral wealth but the economic growth that will come with the development of those mineral resources.

So we have been early believers in Mongolia. We opened our office in 2008 in the same week as the Lehman disaster, and even though the timing may not have been perfect, we are still proud of the fact that we saw the opportunity for Mongolia’s growth potential and investment opportunities much earlier than many others. We built the infrastructure, we focused on building relationships with government entities, and with the corporate sector and international investors. Now we have the largest investment bank in the country, well positioned to capitalize on opportunities. The mission for Eurasia Capital is to provide a bridge between Mongolia and the international markets: to give international investors access to Mongolia growth, and to facilitate the entrance of Mongolian companies and banks to raise capital internationally.

EM: What shifts have you seen in the business climate since 2008?

I’ve appeared at least 20 times in studios for interviews with Bloomberg, CNBC, Al Jazeera and others to talk about Mongolia. And I always get the question: why haven’t we heard about Mongolia before, with its massive resources? The reason was that for years, the Mongolian government, parliament and public in general have had intense debates about how to develop those resources. It took a long time and was frustrating for foreign investors trying to bring big mining projects into production. The big example was Ivanhoe Mines, which discovered the Oyu Tolgoi deposit a decade ago yet only signed the landmark agreement allowing it to develop it in October 2009. But when we set up here there was no doubt in our mind that the government would decide to develop its strategic projects and large mines. The question was when.

The 2008 crisis hit Mongolia very hard: by the first quarter of 2009 the government was running out of money, foreign exchange reserves were depleted and investors were fleeing. It led to a bailout with support from the IMF and a number of bilateral agreements. But that crisis, in my view, had a silver lining, because it helped the government and public to focus on the key need to develop mineral resources. It became clear they had no luxury to wait and debate further. So we were all relieved when, on October 6 2009, they finally came to agreement with Ivanhoe and Rio Tinto. That was a turning point. It was a big sign: this country is ready for business. It was a crucial milestone and the catalyst for a change in investment sentiment towards Mongolia. The country has never looked back since then.

EM: Where are the opportunities in investment? Everyone knows about the mining, but how about the knock-on effects in the economy?

One of the main reasons for us spotting the opportunity in Mongolia early on was our early experience in Central Asia, especially Kazakhstan. Our time in frontier markets and Eurasian countries allowed me to see the parallels: that once you have momentum, and the development of world class resources, you are going to see knock-on effects. Yes, mining is going to be the largest and most important sector for Mongolia, but there will be other sectors and the opportunity is not going to be confined only to mining.

In January 2010 we produced a report called Mongolia Outlook 2010 – a historical document in the development of our firm. It was positive and optimistic about Mongolia at a time when the turnaround wasn’t obvious, but we said that Mongolia was going to go through a multi-year bull market: that there would be growth in GDP and in FDI. Beyond that macro vision, we made two important calls which were – this is important – executable investment recommendations for international investors. The first was that the Mongolian tugrik was going to appreciate and influence FDI. There is no derivative or spot market, so investors had to initiate bank deposits with Mongolian banks, which at that time were offering 16% in tugrik local currency deposits. Those investors who followed our advice made over 25% return after subtracting all costs, a combination of high deposit rates and the appreciation of the currency.

The second important call was that we recommended investors start investing in local equities. In January 2010, this was considered an optimistic call: the local market collapsed in 2008 and was also negative in 2009 in dollar terms. But we were confident the worst was behind us and estimated the market would gain 70% that year. In fact, it went up almost double that amount. In 2010 the tugrik was the second best performing currency globally, and the stock market was the best in the world.

From the beginning I have trained our research team to think in a way so as to come up with actionable recommendations. We look at opportunities in the currency markets, in fixed income, in public equities – domestic and international – in private equity, infrastructure and property, then tailor recommendations around them. We have built indices allowing investors to track performance of Mongolia-related companies listed in countries around the world.

EM: What funds and businesses have you built to do this?

Eurasia Capital Management is a Central Asian investment and fund management business. Silk Road Management, which started in 2008 as a wealth management advisory firm, is now being transformed into a Mongolia-focused investment management firm. We aim to build the largest such institution in the country. Our first product was the first ever venture capital and private equity fund focused on Mongolia, the Mongolia Human Capital Fund, which raised US$30 million from investors. The idea of this fund is to focus on non-resource sectors where human capital is going to be crucial in the success of the business: areas such as media, healthcare, education, professional services industries and information technology. These are industries in their infancy stage that are going to benefit from strong economic growth.

We have plans to launch funds across different asset classes. We intend to launch a publicly-listed Mongolia-dedicated fund. And we have teamed up with a Korean group, Goran Capital Partners, to launch a Mongolia-Korea resources fund and to tap the interest of Korean institutional investors looking for investments in Mongolia. We tailor investment products around the interests of investors.

Eurasia Capital itself has been recognized by several international publications; this year it was named the best investment bank in Mongolia by Euromoney magazine.

SECTION 2 – interview with Ganhuyang Chuluun Hutagt, Vice Minister of Finance, Mongolia

Euromoney: At a time when the rest of the world is struggling, economic projections for Mongolia are extremely positive. Is the outlook realistic?

Minister: The outlook will be as good as the demand for what we are producing. In recent years what we possess in terms of minerals has attracted a lot of investor interest, based on global demand for these commodities: copper, uranium, gold, coal, iron. There will be demand for our products despite what happens with Chinese inflation, the American budget and debt ceiling, and European defaults.

EM: What is a realistic expectation for GDP growth?

Minister: It will depend on what’s going to happen in the US and how it will affect production in China, and what appetite China will have for Mongolian commodities. I don’t think the Mongolian government can become too arrogant: I advocate we watch out for negative trends, and manage risks. Consecutive crises have shown that they do have an impact on the Mongolian economy.

Despite that, the outlook that is being projected by the international community, our development partners and ourselves is pretty positive. We will have tremendous growth in our economy based on mining and the building of physical infrastructure to make our products more available to international markets: border ports, railways, roads, airports. We are going to need to build new cities in the new mining areas, currently mostly in the Gobi. Most of the business will happen around the mines and in the value chain. We need new power plants, new houses, and even here [Ulaanbaatar] with growing incomes we have a minimum of 200,000 people who will need houses and apartments. You don’t need too much imagination to think of the investments behind these numbers in terms of water, sewage, energy, roads, schools and hospitals. It entails huge business opportunities, but mining can support it only through steady and growing cashflows.

What will be the role of the state in all this investment?

The role of the state is going to not diminish in the near future. At this stage of development the government needs to take a leading role, creating not only the environment and good opportunities for foreign investors, but also intervening in managing the economy, supporting our traditional industries such as agriculture, as we did today [in an issue of bonds to support agricultural producers and SMEs]. We need to help our industries in this tough environment with foreign competitors coming in and cheap imports, aggravated by the impact of the strong tugrik. We will need to continue direct involvement such as the development bank, to build public services. This year we budgeted MNT627 billion for capital investments, and the number will go above 1 trillion this year. Altogether in the past 20 years put together, the capital expenditures were only MNT1.6 trillion; in two years we are doing what was done in 20.

What will be the role of the private sector in this?

The private sector has plenty on its plate already. Almost all of the banking sector is in private hands: out of 70,000 registered companies, only 100 are state-owned, although they include the champions.

How do you rate ease of doing business in Mongolia?

We have fared pretty well. Mongolia is one of the friendlier environments in which to do business. Because we are latecomers we can implement some systems immediately: for example we rank one of the top countries in terms of extractive industries transparency. If you compare us with some Eastern European countries, we are pretty similar; if you compare us to former Soviet Republics, we are way better.

And what still needs to be done?

Last year the government announced the year of Business Environmental Enabling Reform, or BEER. The results of it are yet to be fully reflected, but the government made an important decision to continue with reform here in 2011.

Can you explain the mandate of the new Development Bank? For example will it fund small business as well as long-term infrastructure?

It’s not for small business, it is to support large national projects and to help the government invest in energy, infrastructure and to help us utilize our mines more efficiently. It is specifically stated in the law what sort of projects will be funded, and they will include housing. The bank is operational – it has not yet funded projects, but we have given them the guarantee to issue MNT800 billion of bonds. They are working hard to issue those bonds, get the funding and start financing projects.

Are you considering a sovereign wealth fund?

We have set up a stabilization fund, which by the end of the year will have MNT180 billion. When it hits 5% of GDP we will start investing it actively; in the meantime it’s in cash. I will do my utmost to make sure the government makes the right decisions and does not have incentives to spend it all right now. It is a big responsibility for our future.

What are its sources of funding?

Any income that is in excess of certain fixed prices for coal and copper. We also have the Human Development Fund; we put revenues from the mines in that fund and will start investing this money outside of the country to protect our economy and insulate it from foreign currencies, as well as preserving wealth to share with future generations.

You said Mongolia is dependent on demand for commodities. What is being done to diversify the economy away from such reliance on mining?

Traditionally Mongolia has been an agrarian economy: livestock and anything related to it like meat, pelt, felt, wool and cashmere. They are all industries of high potential. Food security is a big concern for us; Mongolia has become self-sufficient in terms of wheat, which is a success. We could focus on and develop other industries: our increasingly educated workforce will be able to drive industries such as tourism and financial services to become major contributors to the economy.

The financial services industry had a rough time in 2009. How is its health today?

Over 95% of the financial industry is commercial banks. The system is doing well: it is growing, NPLs are decreasing on the back of the economic boom, and the stock market has consistently outperformed most others. But we start from a low base and there is a need for reforms. We need to approve the draft law on securities – hopefully this year – and reform in the pensions system will need to happen. We need to overhaul our insurance sector. And with this we will create local institutional investors who will help us create robust, dynamically growing local stock markets.

The world is watching the forthcoming Erdenes Tavan Tolgoi IPO. How transformative will it be for Mongolian markets?

The current capitalization of the local stock exchange is $2 billion; we are talking about $10 billion in an IPO of one company. That’s the magnitude, and if we decide to float some percentage locally it will have a huge impact. Right now 10% is owned by the Mongolian people and another 10% will be sold to Mongolia-based companies. This will provide a strong incentive for international investors to come in early and take part in the trading of those securities.

What is the idea behind giving shares in it to every Mongolian citizen?

It gives people a feeling that they are benefiting from the big national treasure directly. It’s a good lesson to all Mongolian citizens in terms of managing capital, really understanding what a stock market is and how it works, and what being a shareholder entails. It brings accountability to the person, whereas if the state was to manage the wealth for our own citizens, it is more indirect. Tavan Tolgoi will be a better governed organization because it is owned by individuals, not just the faceless state.

With the US and Europe in turmoil, what is your resilience to external shocks?

I don’t think we have been particularly resilient at any time in history. We depend on our buyers; we have one rail line. Economically we are dependent on two neighbours: we import all of our gas from Russia, we export most of our coal to China.

What message do you want to give to foreign investors about Mongolia?

It makes sense to get exposed to Mongolia. It is the top opportunity globally in terms of our mineral resources. We possess almost all the elements in the periodic table. We are tripling coal exports this year. The ambition with our partnership with the London Stock Exchange is that one day Asian investors can trade on the Mongolian exchange with their stocks listed in London, on the same platform, the same systems.

Cashflows are exploding, the budget is in surplus and we have record high cash levels in our treasury. We will one day make a decision on sovereign bonds: we are issuing local currency and giving a very good return to our investors. Debt to GDP is just 17%, so we can borrow, and I think we want to borrow to make investments and increase the capacity of the economy.

SECTION 3: ECONOMY

Economy

Mongolia has experienced rapid economic growth since the global financial crisis. Eurasia Capital, an Ulaanbaatar-headquartered investment bank, estimates that Mongolia became the world’s second fastest growing economy in 2010 in terms of US$ GDP growth rate at current prices, with a 44% year-on-year increase, driven by the 12.9% appreciation of the Mongolian tugrik (MNT), the national currency, against the dollar over that period. This means that Mongolia outperformed the BRIC emerging economies as well as all other leading frontier and high-growth economies globally. Fueled by investment in the mining sector and a significant increase in exports, real GDP growth reached 6.1% last year, according to official data, versus 2.7% in developed and 7.1% in emerging and developing economies. And it is getting better still: in the first half 2011 it was up 14.3%, or in nominal terms 29.1%. The second quarter, with 17.3% year on year growth, was the fastest expansion since 2005.

Significant investments and demand from China, the major market for Mongolian products, have allowed Mongolia to double coal output to more than 25Mt in 2010, up from 13Mt a year earlier. Coal exports increased 2.9 times in 2010, overtaking copper for the first time, and in 1H2011 Mongolia overtook flood-hit Australia as the largest coal exporter to China. Crude oil production rose 17% to 2.2MMbbl, and iron ore output more than doubled to over 3.2Mt. Major manufacturing industries, such as food and beverages, grew 24% in 2010.

Mongolian foreign trade surpassed its historical high in 2010. Trade turnover surged 53.5% year-on-year to US$6.2bn. 2010 was a record year for exports, reaching US$2.9 billion, with a 53.8% annual expansion driven primarily by Chinese demand (it bought 85% of Mongolia’s exports), commodity price increases and volume expansion. Record level exports have been the primary driver of Mongolia’s impressive economic growth. And they are getting better still: Mineral exports jumped 72% year-on-year in the first half of 2011, with coal up 135% and iron ore exports 122%.

Increases in international prices for Mongolia’s major export commodities boosted already substantial export earnings. The price of coal, the largest 2010 export earner for Mongolia, rose more than 14% over 2010, with copper, gold, iron ore and crude oil gaining 28%, 26%, 52% and 8%, respectively.

Eurasia Capital expects Mongolian foreign trade to grow at an even faster rate in 2011. A positive outlook on commodity prices, increased output from existing operations, the launching of new mines, and strong growth prospects in major trading partner markets – particularly resource-hungry China – should fuel increased exports from Mongolia. Eurasia now believes that Mongolian economic growth should beat its original projection of 10% GDP growth for 2011.

Foreign direct investment (FDI), which was considered frozen until as recently as 2008, hit a record high of US$1.6bn in 2010, according to official data, further underpinning the economy. The mining sector was the major destination for FDI.

China was for many years the only major FDI player into Mongolia, accounting for US$2.5 billion between 1990 and 2010. That is changing. Canadian FDI, the second biggest in Mongolia, increased more than 140 times in 2010 to US$147.8 million. Investment from Hong Kong is also climbing.

By sector, geology and mining have attracted US$3.15bn in FDI – 65.3% of the total – since 1990. The majority of this investment has come since 2008, when the mining industry began to entice resources giants around the world. Hong Kong and Canada’s FDI focus is mainly on mining and related activities, while South Korean and Japanese investments have targeted trade and service, engineering construction, and financial sectors. The biggest investor, China, has followed varied targets covering almost every sector. Infrastructure is likely to attract more FDI in coming years, with 1100km of Mongolian railways planned, for example.

Remarkably, Mongolia is thriving with limited inflation. Prices rose around 13% last year, and there were concerns from the World Bank that an expenditure plan – including major increases in salaries – could push inflation over the 25% mark. Yet according to N Zoljargal, deputy governor of Bank of Mongolia, the central bank, inflation has instead declined to around 6.5% year on year in June. In any case, he says, Mongolia is an exceptional case when it comes to considering inflation. “Mongolia has for so long been under-invested,” he says. “So when you see a flow of new cash wealth, how much of it do you sterilize and how much do you let trickle into the economy? That is the challenge we faced in 2010, we are facing it now and we will probably live like this for the next few decades.” Last year the bank sterilized around 30% of net inflows in foreign exchange, feeling that it was short-term and speculative; this year, it has sterilized far less.  “Yes inflation is a worry, with banks over-extending credit in the good days; people argue the economy is getting too hot,” he says. “I say we are nowhere near to that: we are just warming up. Everybody has their own temperature.”

Indeed, some argue inflation should actually be higher, and monetary policy looser. “Economists say that if there is inflation, just take out money from the economy,” says Sambuu Demberel, Chairman and CEO of the Mongolian National Chamber of Commerce & Industry, and a key economic advisor to Mongolia’s president and prime minister. “It’s nonsense. We need money in circulation: the more money the better. People in real sectors want money to create business and profit, but the majority of SMEs don’t have access to lending. We need decisive action to change our monetary environment to drive the economy.”

Rich mineral resources

Mongolia hosts world-class mining deposits, including estimated coal resources of over 160Bt, ranking fourth in the world after the USA, Russia and China. Erdenes Tavan Tolgoi, one of the world’s largest untapped coking coal mines, is a vivid example of a world class resource: it is estimated to contain 6.4Bt of thermal and coking coal worth approximately US$390bn. The Government of Mongolia is in the process of finalizing the deal with international bidders.

Another world class mine is Oyu Tolgoi, which is one of the world’s largest undeveloped copper-gold deposits, rivaling Escondida and Grasberg. Oyu Tolgoi contains approximately 37Mt of copper and 1,300 tonnes of gold, with a project cost of US$5.9bn. Based on conservative calculations, the monetary value of the Oyu Tolgoi project is approximately US$252bn. It may become as much as US$424bn if measured, indicated and inferred resources are taken into account.

Balanced Political Environment

Mongolia is to hold parliamentary elections in the summer of 2012. The newly elected parliament will oversee the implementation of major mining, infrastructure and industrialization projects, which will define Mongolian politics, economy and society for years to come.

The parliamentary election in 2008 saw a brief period of turmoil, but the formation of a coalition government between the two main political parties, the Mongolia People’s Party (MPP) and the Democratic Party (DP), has resulted in a stable functioning government. Domestically, the coalition government has focused on expanding investments in Mongolia’s vast natural resource wealth, diversifying the economy, job creation and improving living standards. Internationally, the government has maintained good relations with Mongolia’s traditional partners, Russia and China, as well as expanding relations with countries beyond its traditional partners.

In June 2011, Mongolia and China agreed to upgrade bilateral ties to a strategic partnership level and to bolster economic ties. The agreement is expected to bring more Chinese investments and financial support into resource and non-resource sectors and infrastructure development. Mongolia also enjoys strategic partnership status with Russia. In terms of “third neighbor” relations, Mongolia has held high-level meetings with Japan, the USA, Korea and India, among others: it expects to sign an Economic Partnership Agreement, roughly equal to a free trade agreement, with Japan in 2012. During the visit of Mongolian President Tsakhia Elbegdorj to the USA in June 2011, the Obama Administration stated that it was committed to developing a broader, deeper and more strategic relationship with Mongolia, including expanded commercial, political and cultural ties. India is actively pursuing cooperation with Mongolia in nuclear energy and mining.

With upcoming elections, the coalition government is eager to start the Tavan Tolgoi coking coal project in partnership with major international mining players. Large mining deals, infrastructure development and poverty reduction will remain recurring themes of parliamentary elections in 2012. There is a wide political consensus among major political parties about the development needs of Mongolia. Therefore, regardless of the election results, the country should be expected to stay on its current course of resource-driven growth.

SECTION 4: CAPITAL MARKETS

Public equities: Best Performing Market Globally

Despite its relative tiny size in global market terms, the Mongolian Stock Exchange (MSE) is increasingly gaining importance for local and international investors intending to gain exposure to the Mongolian market. Naturally, most of the market is resource-related.

Mongolia has so far this year maintained its title as the world’s best performing equity market. Having gained 138.4% (173.7% in US$ terms) last year, the MSE Top-20 Index has continued its global outperformance in 2011 at +43.8% at the time of writing. By comparison, the MSCI Frontier index gained 16.6% in 2010 and is down 11.6% so far in 2011; the MSCI EM Asia index gained 12.9% in 2010 and is down 0.7% year to date; and the Shanghai Composite Index fell 14.3% and 5% respectively.

After the Mongolian Stock Exchange benchmark surged 123.3% within the first two months of the year, hitting 32,954.97 on February 25, it went through a significant correction, losing 43.8% by the end of May. This volatility is a function of speculation, low liquidity, a small free float in listed companies, and unrealistic and uninformed investor expectations. Improved investor sentiment driven by the expected launch of Tavan Tolgoi coal mining operations and proposed IPO, the strategic partnership agreement between the MSE and the London Stock Exchange (see box), and a strong outlook for commodities, contributed to the surge and underpin further growth.

The MSE market capitalization grew 2.5 times in 2010, passing the landmark US$1bn in November 2010  and reaching US$1.7 billion by July 2011. The top five stocks (Coal groups Baganuur, Tavan Tolgoi, Shivee Ovoo and Sharyn Gol, and beverage group APU) contributed 82.1% of this growth. The combination of expected double-digit economic growth, and the experience of other commodity-linked emerging markets, suggests that the momentum has just begun: Kazakhstan Stock Exchange’s market capitalization grew 100-fold to US$100 billion between 2000 and 2008, while the Qatar Stock Exchange grew 31 times from 1997 to 2007 to US$95 billion. Stock market penetration – total market cap representing just 20% of GDP – is relatively low compared to other emerging and even frontier markets, underlining the growth potential.

The MSE, with its huge gains, is still challenged by companies with small free floats and low trading volume. Average daily trading volumes were US$234,000 from January to February 25, and US$33,000 from then to May 30. It is likely that the lack of liquidity will remain a concern in the short term.

The Mongolian government has approved a list of state-owned enterprises that are slated for privatization starting from 2011. These SOEs are in mining, mineral processing, construction materials, power distribution and generation, telecommunications and airline industries. Many will pursue a listing locally on the MSE to serve as a vehicle for privatization and then seek additional listings in regional or international markets to raise capital for expansion and modernization.

The leader among these expected privatizations is the highly anticipated IPO of Erdenes Tavan Tolgoi, expected early next year, and potentially worth over US$10 billion. This government-owned company holds the licence for Tavan Tolgoi, the world’s largest undeveloped coking coal mine. The government has distributed 10% of the company’s shares to Mongolian citizens, with a lock-up period that has not yet been decided, and plans to sell another 10% to Mongolian companies and offer 30% on a combination of domestic and international markets. It should substantially boost MSE market capitalization and liquidity while also enfranchising citizens in the capital markets. “The entire population of Mongolia will become shareholders,” says Munkhtushig Dul, Deputy Director and head of finance and logistics at the MSE. “When that happens, new brokerages will have to develop, as will the capital markets themselves.”

“There are several separate pipelines of new listings,” he adds. “First there are the big strategic mineral deposits, which by law should have no less than 10% listed on the MSE. Then there are many companies with huge assets in Mongolia who are not listed here: we are hoping to repatriate them to create more involvement in the Mongolian markets. And then there are local privately held companies: cell phone companies, food companies, very strong businesses that will need more money.”

There have been no new IPOs on the MSE in the last two years, but it is expected this will change dramatically in the coming years as a number of leading domestic private companies are expected to launch IPOs first internationally and later on MSE. Mongolian private business groups that are expected to launch IPOs at a group or subsidiary level include MCS Holding, Petrovis Corp, Bodi Group, Newcom Group and Monnis Group. New IPOs, whether from state or private sources, should ease liquidity concerns and therefore volatility.

Many Mongolian companies – now over 20 – have listed overseas, often instead of domestically, in locations including Toronto, London, Hong Kong and Australia. But Mongolian authorities do not see this as capital fleeing the country. “I don’t see it as a bad sign,” says Bayarsaikhan D, chairman of the Financial Regulatory Commission of Mongolia. “Companies are using the opportunity to raise funding in large amounts.” The hope is that companies that have listed overseas will come to list more of their stock domestically as the Mongolian market gains in scale and sophistication.

Eurasia Capital believes the outlook for Mongolian equities in the short to long term is very positive. This year, it expects the MSE to retain its title among the top three equity markets, if not the best.

BOX: The LSE partnership

Mongolia took a historically important step to develop its capital markets when MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement to manage the MSE on April 7 2011.

Through this agreement the MSE will be modernized with the LSE’s support over the next three years. LSE will introduce an integrated securities trading system, create an effective legal and regulatory environment, and will bring infrastructure, technology and human resources capability in line with international standards. LSE has appointed a management team at the MSE to oversee its development and privatization, and has brought in Millennium IT, the leading global exchange technology provider, to assist with trading, surveillance and post-trading infrastructure.

The partnership should bring modern market rules, procedures and operations, as well as broadening tradable asset classes to derivatives and ETFs. The ultimate aim is for MSE to become a regional resources hub for international investors. In future it may even attract resources listings from neighbouring countries.

“The main purpose of the agreement is to bring the stock exchange to international standards,” says Bayarsaikhan. “A lot of work has been done so far on the legal framework, on IT, and in corporate governance and transparency. The future is bright and all the professional players in the market are working hard.”

In Eurasia Capital’s view, this partnership should accelerate the process of MSE becoming a viable source of capital for Mongolian companies and an efficient channel for wealth distribution from mineral resources among the Mongolian population.

Private equity

Flurry of M&A Activity

In recent years Mongolia has seen a flurry of M&A activity, particularly in the resources sector. M&A volumes doubled from 2009 to 2010 to a record level of over US$1bn, most of it in mining, and chiefly coal; international interest has grown dramatically since the investment agreement on the Oyu Tolgoi (OT) mine was signed in late 2009. The origins of acquiring companies were diverse but Hong Kong and Australia led the charge: Hong Kong was involved in US$473mn worth of M&A deals through injections of resource assets into existing publicly listed companies.  Australian companies have not only bought assets but held IPOs.

This year M&A activity is more vibrant still. Total deal value for the first half of 2011 increased 45% year on year to US$636mn, and had reached US$690mn by July 27; Eurasia Capital expects another record year. Close to 50% of the announced deals were reached in participation with Australian companies, suggesting Mongolia will continue to be on the radar of cash-rich mining companies that have strengthened their cash positions through improved operational efficiencies and high commodity prices. The Erdenes Tavan Tolgoi deal will impact this year’s numbers: some bankers estimate the overall worth of the asset at US$15-20bn.

Fixed income: Bond Market Kicking off

Until very recently, not many people knew of the existence of the bond market in Mongolia. But it is becoming more active. The market has been waiting for the right time and conditions while building knowledge, experience, and infrastructure. News about bond issues is not on-and-off anymore; the market is underway.

The Mongolian Government is being cautious in approving new issues, knowing the damage any default would cause to the reputation and credit rating of the market. Government issues have focused on national benefit: for example, in September 2010 it issued a MNT60bn bond, half of which was offered to the public, to fund the “4000 Apartments for Public Servants” project. So far, offers worth MNT69.6bn out of a planned MNT72bn have been launched for project funding.

Backed by confidence in Mongolia’s expected growth, the government is planning another offering to support the cashmere and wool sectors, and small-to-medium enterprises.

Through the Development Bank, established in 2010, big industrial, infrastructure and mining projects will be funded and the government will issue MNT800bn bonds for necessary funding as new projects come up. The Bank also supports those projects by providing guarantees to the loans. Both domestic and international investors can participate.

Corporate bonds will become an interesting area for investors. For most of the companies who intend to tap the debt markets, it is a testing period: they need models to follow, but there have been only 12 issues since 2001. But by waiting, they risk losing out to competitors. Just Agro has made the first move this year to attract bond investors with a MNT30bn bond offering. If successful, other companies may follow.

Trade and Development Bank (TDB) is the only bank in Mongolia to tap the international bond markets so far, with a US$75mn deal in 2009 (successfully repaid), and two new bonds in 2010. Other banks, Khan Bank and XacBank, have followed suit and announced smaller debt issues. But bank deposits, offering more than 11% returns in MNT, remain favoured by many local investors.

BOX: Currency

After an impressive 12.9% appreciation in 2010, the Mongolia tugrik (MNT) has been relatively volatile this year, appreciating 1.6% year to date by August 4. Eurasia Capital believes it will remain a strong currency to hold. This confidence comes from expected capital flows to the large projects in the mining industry and infrastructure: FDI was US$1.5bn in 2010. The revenues from the two mega-projects of Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold), both under development, will consolidate the MNT for many years to come. Mongolia’s exports of mineral resources will dramatically increase when the necessary infrastructure, including the rail lines, become ready.

The currency is comparable to other resource driven currencies, such as the Australian dollar or Brazilian Real, which have experienced large appreciation. The MNT has emerged as a new resource currency and is increasingly correlated to the export commodities. It represents an excellent carry trade opportunity.

SECTION 5: PROPERTY, INFRASTRUCTURE AND FINANCIAL SERVICES

Property

As mining has brought wealth to Mongolia, the property market has experienced speculation and rapid expansion. After the highest ever price for a luxury residential apartment was registered at US$8000/sqm in the new Blue Sky Tower, an April Fool’s joke by a local broker about Donald Trump’s plans to build 120-storey “Trump Tower” for US$1bn in the center of Ulaanbaatar was picked up and distributed by some respected online sources.

Although Mr. Trump is not planning to build a tower in the capital city of Mongolia, the property market is poised to benefit from the country’s mining-led economic growth. Already, the residential, office, retail and hospitality property segments have consistently grown over the last few years, with supply struggling to meet demand. The market in Ulaanbaatar stabilized in 2010 following the turmoil of 2008-2009, and has benefited from increased inflows of foreign capital. Industry experts expect a period of accelerated growth.

Residential property prices in Ulaanbaatar have nearly quadrupled since 2002, although the global financial crisis corrected the steep market growth up to 3Q2008. The past year’s strong economic growth, national currency appreciation and speculative inflows of foreign capital for Mongolia have driven residential property prices up nearly 20% in the capital; the average residential property prices in 2010 was around US$900 per square meter, although much of that can be attributed to the 12.9% MNT appreciation.

Although foreign investors have an impact, the growing number of wealthy Mongolians is also significant, boosted by successful capital raising by mining companies. Fundamental demand for housing in Ulaanbaatar and nationwide will be a key driver of near-term growth. Since 2005, the population of Ulaanbaatar has increased 22% to 1.16 million, which represents over 40% of the total Mongolian population. More than half of Ulaanbaatar’s inhabitants live in traditional “ger” settlements, whilst the others live in old buildings that are deteriorating fast. Facing the need to accommodate its population, the Mongolian Government has initiated several measures that stipulate construction of mid-budget accommodation through government support. These initiatives include programmes such as the “100,000 Apartments Project” which aims to alleviate the strains on infrastructure services, social services and pollution.

Despite the newfound wealth, more than one third of the Mongolian population lives below the poverty line. Increasing prices might deter low income earners from buying property. However, 2010 was marked by a revival in the mortgage market as major Mongolian banks have started providing loans to the population, albeit at high rates – currently from 11% to 28.8%, with required downpayments as high as 50% (but more commonly 30% and sometimes 10% if the construction company takes on some of the risk).

Ulaanbaatar is again crowded with construction cranes, just as before the 2008 crisis. Maybe Mr Trump will really build a Trump Tower in Ulaanbaatar during the next few years.

Infrastructure

Mongolia’s mining boom may stutter if the country cannot solve its infrastructure problems. Infrastructure is regularly listed among the major inhibitors of Mongolian growth, and vast investment is needed, probably in excess of the current GDP of the country.

The Concession Law, adopted in 2010, sets the legal framework for private sector participation in the development of infrastructure projects. The Mongolian government has approved a list of 121 projects in road and railroad construction, power generation and transmission, industrial development, urban development, telecommunications, education and healthcare, inviting private sector investments. Both foreign and domestic companies can participate in the projects individually or jointly. Concessions can be gained via open tender, competitive bidding or direct contract.

The development and expansion of railroad infrastructure is one of the most pressing issues in the Mongolian economy. To support its mining sector, Mongolia is currently focusing on extending its railroads to major mining areas within the country, as well as on opening trade corridors and export routes to neighbouring countries. In the next five to ten years, the country is planning to build about 5,700km of new railroads, providing easier access to Mongolian minerals and exports to neighbouring and international markets. The railroads will be constructed in three stages. The first stage, which has already started, envisages construction of a new 1,100km main rail line from the Tavan Tolgoi coal deposit to Choibalsan, the town connected to Russia by the existing railroad. The new main line will intersect the existing Trans-Mongolian Railway in Sainshand station in Gobi region. Mongolian Railways was selected to implement the project. The project is in feasibility study stage. It is expected to be completed in the next 4-5 years.

In the near future, major infrastructure projects in Mongolia may offer numerous investment opportunities. Construction of new railroads would create opportunities for investors, construction and operating companies. A new US$10 billion development, the Sainshand Industrial Complex near the Chinese border, will be a hub to process Mongolian raw materials for export, and should spur investor interest. A number of other government-priority projects will be open for private bidding in the coming year.

Financial services

Mongolia’s banking industry endured a difficult financial crisis in which two banks failed. But there is a sense that it has returned to health on the back of the growing economy. N Zoljargal, Deputy Governor of The Bank of Mongolia, the central bank, says the banking system has “never been better than it is today. It is very healthy.” Those banks that survived the crisis are now strong. “During the crisis our banks were well managed, beefed up their liquidity, and since then have seen high growth in assets.” Non-performing loans, which at one stage topped 20%, are now around the 6% mark, he says, and “coming down dramatically” as previously troubled businesses in construction and other areas pay back their loans. As Zoljargal says: “It the economy is growing 10%, it’s hard to produce NPLs. You have to be doing something very wrong.”

Some local banks with distinct strategies look healthier still. Xac Bank’s NPLs peaked around 7% and today stand at 1.7%, according to CEO Bat-Ochir Dugersuren, because its portfolios are well diversified. Xac Bank is an interesting study: founded in 1998 under a UNDP program, it is fundamentally a microfinance institution, with a governance and shareholder structure unique in Mongolia (EBRD and IFC are stakeholders, and the board is independent). Today, SMEs are very much a focus for expansion. “We have big corporates in this country but I don’t believe they are going to expand and carry the country’s growth forward,” says Bat-Ochir. “We need a broad base of promising SMEs to allow double-digit growth to take place in our economy.” Xac Bank, like most, gets around 90% of its income from interest, and accepts that growth in other business lines will have to take place to diversify earnings.

Another example of an unusual strategy is Chinggis Khaan Bank. Chairman Sergey Gromov – a pioneer investor in Mongolia whose holdings also including the leading brewery APU and the insurer Mongol Daatgal, discussed below – says the bank focuses on areas like agriculture and building materials, but not mining. “Agriculture has huge potential,” he says, pointing to the sheer scale of land and the as yet limited use of fertilizer or other techniques.

International players such as ING and Standard Chartered have started to appear in Mongolia, though chiefly with representative offices rather than significant on-the-ground commitment so far. PricewaterhouseCoopers, KPMG and Ernst & Young are also represented.

Eurasia Capital is the nation’s leading investment bank today, and it is likely that this will be a growing part of the market in future. “There will be more of a focus on long term investment funds and institutional investors in future,” says Bayarsaikhan D, Chairman of the Financial Regulatory Commission of Mongolia. As the finance ministry interview explains, two quasi-sovereign wealth funds – the Stabilization Fund and Human Development Fund – are being developed, while a development bank focused on long-term infrastructure has been formed and will soon start lending. The development of new investment, capital markets and securities laws, in varying states of readiness, will help growth.

Another area ready for dramatic growth is the insurance industry. Mongol Daatgal, the country’s first insurer, dates from 1924, but the industry is still in its infancy; only one company provides life insurance, while a handful of others provide property and commercial cover. “It is a very virgin market,” says Batzul Tumur-Ochir, Mongol Daatgal’s CEO. “It only holds 7.4% of GDP, and total premium income in 2010 was just US$30 million for the whole industry. People have not understood insurance, or have seen it as a cost in the past; but now the economy is growing because of the mining industry, people have more money from wages and may spend some on insurance.”

On top of general economic growth, legislation will drive the industry too. Mongolia today does not have mandatory insurance for drivers, but this year a new law is likely to change that. “That will automatically give a 30 or 40% increase to the market,” Batzul says. Professional liability insurance will also become mandatory in the near future, while the growth of the mortgage market is also going to feed through to insurance – through corporates and banks, and through individuals. Batzul plans to enter life insurance too within three years, as he also sees momentum for growth there.

Two of Asia’s frontier markets have given new details of the sovereign wealth funds they hope will radically change their prosperity. Papua New Guinea plans to launch a new fund based on its reserves of liquefied natural gas, while Timor-Leste’s fledgling fund is set to make a major shift in its investment approach.

Timor-Leste’s Petroluem Fund was launched on the back of oil and gas field revenue that began accruing in 2006 and now brings in about $2 billion per year. The fund today has $7.7 billion under management, of which 90% is invested in US Treasuries or similar instruments, and the remaining 10% in equities managed by Schroder Investment Management.

Yesterday Timor-Leste’s Emilia Pires, Minister of Finance, told Emerging Markets that she has submitted a recommendation to change the allocation considerably to 50% global equities and 50% bonds. “The 50% bonds will not just be US Treasuries,” she added. “It is diversification we are after: increasing the risk, but also diversifying to counterbalance that risk.”

Andrew Oaeke from Papua New Guinea’s Department of the Treasury outlined plans to build a sovereign wealth fund to handle the revenues that will come from the country’s transformational PNG-LNG liquefied natural gas project, which he said was expected to start producing revenues from 2018 and should generate a total of around US$30 billion over the lifetime of the project.

The government and central bank have now set up a basic structure for a consolidated pool of three offshore funds: one for infrastructure, one for economic stabilization, and one future fund. The funds will be integrated with the budget and fiscal framework and will aim for international best practices of governance and transparency. Drawdown rules will be governed by legislation, which has yet to go to parliament, and an investment board will oversee allocation, including external fund managers.

Both countries are dealing with the challenges as well as the bounty that a discovery of commodity assets can bring to a small country. “It is likely that the scale of LNG as a new and major revenue resource will give rise to major macro pressures such as the appreciation of the exchange rate, potentially undermining the competitiveness of our export sector,” especially for agriculture in 80% rural PNG, said Mr Oaeke.

In Timor-Leste’s case, there has been an acute challenge to balance the need to improve the country today, and to save for future generations when the existing fields run out, expected in approximately 20 years time. “There was major civil unrest in 2006 [when] we were sitting on a growing bank account while many ordinary people were in desperate need to be lifted out of poverty,” Ms Pires said. “You do need a balance on this.” Since then the country has taken funds out to develop infrastructure, but must go to parliament for withdrawals over about 3% of the fund in any given year. The fund is considered among the most transparent in the world.

Mr Oaeke said communication would be vital. “It is important people understand how [assets] are going to be used and why they will be kept abroad and not onshore.”

The insistence on transparency is striking given that the largest sovereign funds in the world, such as those in Kuwait and Abu Dhabi, disclose very little about their holdings or performance. But SWF commentators said it was the right approach. “Transparency is a good thing for three reasons: it stops abuse; it is public money; and because it leads to better decisions,” said Professor Simon Chesterman of the National University of Singapore Law School.

Asian central banks are on the cusp of a major shift in their approach to investment, according to bankers and fund managers who work with them. There is a growing sense that their soaring levels of reserves are so far in excess of requirements that they ought to be invested more widely than they are today.

The view is amplified by comments on April 19 from Zhou Xiaochuan, governor of the People’s Bank of China, that “foreign reserves have exceeded our country’s rational demand, and too much accumulation has caused excessive liquidity in our markets.” He said China’s State Council had required a cut in excessive accumulation “and good management of the funds accumulated, including diversification of investments.”

The remark has been widely noted by bankers. “It’s not something you ever hear central bankers say,” said Michel Paulus, head of public sector coverage for Asia at Citi. But it reflects a growing sense that a surplus exists not just in China but at central banks across the region. “Generally most of them have enough now to weather any storm,” Paulus said.  “And if they have a surplus, how do they manage it? Perhaps they will have 10% they want to put into alternatives, or to invest to better understand the market, or use an external manager.”

Thirachai Phuvanatnaranubala, Secretary-General of the Thai Securities and Exchange Commission, said reserve use “will become a more hot topic. There have been suggestions for Thailand to set up a sovereign wealth fund, taking some of our reserves,” but the central bank has not supported it, he said. He argued, though, that something had to be done to make better use of reserves. “There is no way the central bank can get enough yield from its investments to cover the opportunity cost” of holding the reserves, he said.

Oliver Bolitho, head of Goldman Sachs Asset Management in Asia, said this process of surplus investment was already in evidence with the establishment of sovereign wealth funds to invest state assets in China and Korea in recent years. “But increasingly, the original mother organization [the central bank] is talking about diversifying its underlying asset base,” he said. “That is a reflection that the book of reserves has outgrown its original purpose, and also that increasingly there is a risk in being constrained to a single asset exposure in those reserves.”

Gerard Lyons, chief economist at Standard Chartered, said he expected a continuing increase in reserves, but “the question is which currency you put the money in. I call it passive diversification: reserve managers don’t actively want to sell their dollars lest it triggers the crisis they fear. But… less net new reserves will go into dollars.” Lyons called for a deepening of local currency bond markets to deploy assets, and said: “There is a desire to use reserves more proactively, maybe as a social investment. What the Chinese are going to do with their money is going to be key to this whole story.”

That said, expectations of sufficient reserves have changed, Mr Paulus said, citing the example of Korea, whose foreign reserves fell from $240 billion to $190 billion during the financial crisis and which was consequently badly hit in the markets. “Other central banks in the region watched in amazement,” he said. “How could that not be enough? One lesson they took from that was you think you have enough reserves but you can never be sure you really do.” This suggests central banks will continue to accumulate foreign exchange reserves, even if they then deploy them in a more active and diversified way than they used to.

In January, headlines began to appear about Asian sovereigns saving the eurozone. They were caused by public comments from officials in China and Japan indicating that the two sovereigns would, in different ways, support debt issues from struggling European Union nations. This convenient mirroring of a shortage of funds in one continent and a surplus in another seemed a tidy way of remedying a potentially crippling problem. As one of those headlines said, reflecting the sense of happy symmetry: “Sovereign crisis, sovereign solution?”

Asia’s involvement in EU debt raises a number of questions, starting with how much commitment of funds actually happened. There are also issues about how much tolerance these sovereigns, and others in Asia, will have for eurozone exposure, and precisely how they are likely to engage.

First, it’s useful to pin down exactly what happened in January. In that regard, it’s much easier to answer the question with respect to Japan, which came in as the lynchpin for the inaugural bond from the European Financial Stability Facility. (The EFSF is a Luxembourg-incorporated entity set up to preserve financial stability in the EU by providing temporary financial assistance to troubled member states, and its bond issues are backed by guarantees from member states of up to Eu440 billion).

The bond, placed on January 25, raised Eu5 billion as part of the EU/IMF financial support package for Ireland. Japan had pledged to be a big part of the deal, and the EFSF has confirmed that it purchased more than 20% of the issue. EFSF also said that “very strong demand came from Asia,” though it has not been more specific on how and where that was represented; one bookrunner said 38% of the deal went to Asian accounts.

Pinning down what China did is trickier to do. When Klaus Regling, who heads EFSF, was asked if China had come in to his bond, he appeared to confirm it indirectly by saying: “None of the major players were missing.” Certainly, media and analyst coverage has spoken widely of China’s pledges to support the eurozone’s debt markets, but it is hard to be certain about any tangible investment. The certainty of China’s involvement all stems from comments made by Li Keqiang, who is China’s Vice-Premier (China actually has several of these, but he is understood to rank highest) and deputy party secretary of the State Council; he’s considered a likely successor to Premier Wen Jiabao, so what he says matters. In January, he wrote a guest article in El Pais, the Spanish national newspaper, that “China is a responsible, long-term investor in the European and particularly Spanish financial markets, and we have confidence in Spain’s financial market” and “It [China] has purchased Spanish Treasury bonds and will buy still more.” The figure Eu6 billion has been mentioned, but not confirmed, in relation to purchases of Spanish Treasuries.

In other remarks on visits around the region that month, he appeared to suggest China would support the debt of the eurozone’s more troubled countries, and it is understood – but again not confirmed by China – that it has bought Greek debt too. Finally, when the European Financial Stability Mechanism, a rescue fund representing the EU and a separate vehicle from EFSF, raised Eu5 billion earlier in the month, China – through the State Administration of Foreign Exchange – is believed to have bought 6% of the bond (we do know, from bankers close to the deal, that Asian investors made up one quarter of demand, and those close to the deal say that SAFE, the Bank of Korea, Bank Negara Malaysia and Hong Kong Monetary Authority all received full orders rather than being scaled back in the four times over-subscribed deal).

Whether or not China did come into these deals, in some sense it hardly matters; the market took enormous comfort from the sense that there was a flood of sovereign wealth waiting and potentially able to solve Europe’s problems. Partly for these reasons, Portugal’s closely-watched bond sale in January – actually earlier than the EFSF, but after China had made positive noises about support and Japanese finance minister Yoshihiko Noda had said it would be sensible for Japan to take 20% of the EFSF deal – sold very well, comfortably oversubscribed in both its five and 10 year tranches. Spain and Italy completely fairly long-term debt the same week, and Belgium, which had also been drifting into scrutiny, completed an FRN issue.

The improvement in sentiment has happened despite the fact that, in Japan’s case at least, there has actually been no new flow of euros involved. Noda said of the ESFS investment that “we’d like to do this within the realm of euro liquidity in the foreign currency reserves,” which is understood to mean that the investment comes from holdings Japan already had in euros, rather than from, say, a sale of US treasuries to convert those funds into the European currency. This news did have an impact on the euro itself – it rallied first, then fell back again when it became clear the investment would come from existing euros – but doesn’t seem to have impacted sentiment about the debt markets themselves.

But what’s in it for these Asian investors? Why does any entity – the state itself, or its designated investment vehicle – invest in troubled EU debt? These aren’t just acts of charity, of course. The spread on the EFSF deal was fixed at mid-swaps plus 6 basis points, implying a borrowing cost of 2.89% for the facility, and that proved remarkably attractive: 500 investors came into a book of Eu44.5 billion. While not a huge payer, the suite of guaranteeing nations makes this unquestionably AAA-rated paper, yielding modestly more than German bunds; the earlier EFSM deal was 12 points over mid-swaps.

But there’s more to it than that, and clearly a political dimension. When Li Keqiang went to Spain, he didn’t just bolster the country’s debt markets with his comments, but sign Eu 6 billion or more of trade agreements that, among other things, give Chinese companies greater access into Spain. It’s not unreasonable to think there might be a quid pro quo in supporting a country’s debt position. Similarly, when Japan’s Noda made his pledge on the EFSF bonds, he couched it not in investment terms but prudence and responsibility. “The euro zone is planning to issue a large amount of bonds in a cooperative manner late this month to raise funds to assist Ireland, and it is appropriate for Japan, as a major economy, to buy some of the EFSF bonds to bolster confidence.”

Economists and strategists see plenty of this latter sentiment in the behaviour of the Asian buyers. “The euro zone is of incredible importance to both China and Japan as trading partners,” says James Woods, chief Asia strategist for Citi Private Bank. “There’s a sense of a need to support these countries, both for what you might call global prudential purposes, but also to underpin some of the demand among trading partners.”

This political element might also explain why almost nobody in Asian banking wants to speak publicly about the trend: seven different economists and strategists declined to be interviewed on the subject.

Diversification is also key. China in particular is felt to be particularly heavily exposed to dollars and sees the need to do something about it. “The diversification aspect is particularly apparent with regards to China’s concentration risk in Treasuries,” Woods says. “Japan has its own challenges at the moment, and investing in the eurozone is not going to be top of its list of priorities. [Woods was speaking shortly after the earthquake in Japan.] But China will be doing much more to diversify its FX holdings, and I suspect this underpinning of support to countries like Greece is having quite a positive effect.”

Does he expect them to continue to invest? “Yes, I absolutely believe that will be the case. I can’t see any reason why not.”

Also, Asian sovereigns do already have exposure in euros, and it is not in their interests to watch the currency decline or even fail. Rachel Ziemba, analyst at Roubini Global Economics, estimates that 25-30% of China’s reserves are in euro denominated assets. If that’s true, it equates to almost US$800 billion-worth of euro-denominated securities. “Recent Chinese rhetoric has oscillated between providing pledges of support for eurozone assets, and calling on European leaders to prove that they can get the debt issues under control, lest the bloc’s woes continue to destabilize the global economy and financial markets,” says Ziemba in a recent study. “The mixture seems designed to protect China’s existing portfolio, stabilize the global economy and perhaps if necessary secure for China some seat at a restructuring table.” The first of those – the portfolio – is clearly of pressing importance if her estimates on the proportion of holdings in euros is correct; she believes that China has invested in both sovereign debt and agency issuance of European countries, and chiefly European bonds in order to ensure liquidity. “The search for yield may have made some of the debt of periphery countries attractive, but such debt may not make up a large part of the portfolio,” she adds.

On top of that, a weak euro creates competitive pressures for exporters in Asia – none bigger than China and Japan. Toyota, for example, most certainly doesn’t benefit from a weak euro as it seeks to sell Japanese cars into Europe.

There is, after all, a track record of Asian and Middle Eastern sovereign entities – and in particular sovereign wealth funds – intervening in support of the western financial system, believing that doing so creates a long-term investment opportunity while also stabilising the global economy to everyone’s benefit. They did so by buying into flagging US and European banks during the Asian financial crisis. It’s well worth remembering that this yielded heavily mixed results, and caused a lot of pain for all of them at least for a while. On the positive side: both the Government of Singapore Investment Corporation and Kuwait Investment Corporation bought stakes in Citi and, after suffering for a while, sold out (at least in part) at a profit. The Qatari state made a fortune with a swift purchase and sale of a stake in Barclays. But Abu Dhabi Investment Authority, the biggest of them all, is suing Citi for money it lost on its investment in the US house, and Temasek in Singapore lost unspecified amounts – but likely billions – by selling out of stakes in Bank of America Merrill Lynch and Barclays Capital at what turned out to be the bottom of the market. Korea Investment Corporation is still sitting on a heavily underwater position in Bank of America Merrill Lynch. They are not all going to pile in blindly again in support of a turnaround story.

Global sovereign wealth is truly vast: common estimates are around the US$4 trillion mark for sovereign wealth funds alone. And that’s not counting overall foreign exchange reserves: Japan’s foreign currency holdings were worth US$1.096 trillion at the end of 2010, second only to China, where they were last logged at $2.85 trillion.

That scale is especially helpful since the existing EU/IMF support package is already too small to bail out Ireland, Portugal and Spain in aggregate, much less Italy or anyone else. Sovereign entities are a good fit with any macro-related debt instrument that is going to require years to come good, since in the main they don’t have to justify quarterly or even annual performance.

For groups like this, a designated facility like the EFSF (or its sister agency, the European Financial Stabilisation Mechanism) make a lot of sense. Though most sovereign entities in Asia and the Middle East don’t really have to justify their decisions to anybody, it is nevertheless an easier sell politically to invest in a broad multilateral European agency than, say, directly into Greece. Additionally, EFSF creates conditionality on fund recipients that an individual sovereign would find it difficult, politically or practically, to impose itself. “I think it makes more sense to go in to support the facility, because essentially it means that the checks and balances and terms of conditions for the facility are protecting their money as well,” Woods says. “It encourages a greater amount of cooperation from the recipient country to the donors than going in with direct bilateral lending. Much better to support the conditionalities which are being imposed by the donors, rather than to circumvent those conditionalities by going directly.”

They will have plenty of further opportunity: according to the EFSF itself, it plans to raise up to Eu16.5 billion this year, and up to Eu10 billion in 2012, while the EU through the EFSM will raise up to Eu17.6 billion this year and Eu4.9 billion in 2012. That’s on top of the sovereign debt issuance from member states themselves.

Will other Asian entities seek to invest in European sovereign debt? “I think that’s largely a call on two factors,” says Woods.” Firstly, the euro itself: whether it will perform well in the coming year or so. Secondly, what the eventual resolution of the peripheral story is – whether it’s a bailout, a restructuring or just more of the same. Once there is clarity as it relates to those two drivers, we will see support as a consequence.” Additionally, he points to an anomaly in European economics at the moment. “One factor I would highlight is the likelihood of higher interest rates in the eurozone, alongside the liquidity support.” That creates an unusual situation: rising interest rates clearly impact bond yields, but liquidity support underpins support for those bonds. “It’s a conundrum Asian sovereign wealth funds will want to understand first before having comfort to start investing.”

The likely outcome is that some Asian money will come, and this will certainly help; but expecting Asia to prop up the eurozone is unrealistic and probably dangerous. And, moreover, Asia can’t fix the eurozone, just apply the band-aids that get sovereigns through to the next redemption deadline. Beyond that, it’s all up to Europe itself.

Euromoney, April 2011

Chief investment officers of sovereign wealth funds are, by definition, a rare breed. Despite the $3-4 billion of global capital they manage between them, there are only about 40 such funds in the world. Scott Kalb is rarer still: a foreign CIO.

Kalb works at one of the newest sovereign funds, the Korea Investment Corporation, which was founded in July 2005 and really only started putting money to work in November 2006. Kalb was not there at the start – he replaced Guan Ong, another non-Korean, as CIO in April 2009 – but he is nevertheless instrumental in shaping one of the sovereign funds that is most animatedly discussed by the fund managers who pitch them for business.

KIC is one of a cluster of sovereign funds that comes with a somewhat nebulous mandate. Unlike the sovereign funds of Abu Dhabi, Kuwait, Qatar or Norway, it does not have to invest the proceeds of a depleting single commodity asset like oil and gas. Unlike the Government of Singapore Investment Corporation, it does not have overall responsibility for a country’s foreign exchange assets. Unlike Australia’s Future Fund, it does not set out to meet a clearly defined need like an unfunded pension liability. Instead, like fellow newcomer the China Investment Corporation, it has no liabilities, and no obvious mandate bar protecting and generating a return on sovereign wealth for some as yet unspecified future need. “We don’t have a liability stream, so our job is to protect and grow this capital for the benefit of future generations in Korea,” Kalb says on a snowy January day in Seoul. “They haven’t yet defined how this money is going to be spent – we hope it will be spent on positive social infrastructure, or other things that will benefit the people – but in the meantime our job is to protect it and grow it.”

Trying to compare sovereign wealth funds, with their myriad mandates and attitudes, is “like a blind man trying to describe an elephant by touching it,” Kalb says, and the constituency of sovereign funds without liabilities is a small subset of the sovereign wealth world. The lack of that liability stream ought to mean a greater freedom in investment approach, and since his arrival Kalb has been trying to develop an investment policy that takes advantage of that. “When I first came here we were 100% in publicly traded fixed income and equity – 70% of it in fixed income,” he says. He and his team then moved that to 50-50, then in June of 2009 introduced an alternative investment program, which really meant investing as an LP in private equity, hedge funds and real estate. Next came commodities and inflation-linked bonds, and then strategic investment.

“The first thing you’ve got to do if you want to create a bulletproof portfolio is you’ve got to diversify,” he says. “You want uncorrelated return streams. And if you are a sovereign wealth fund without a liability stream, one of your biggest advantages is a long-term investment horizon.”

But that doesn’t fix all your problems. “Being a long term investor is no magic bullet,” he continues. “Just because you can invest for the long term doesn’t mean you are always going to make money: if you invested in the top of the market in 2007, even though you are a long term investor you may never get your money back. Being a long term investor doesn’t mean you can be a blind investor, but it is a great tool to have in the toolbox and it can help free an asset allocator to look for and collect attractive risk premiums.”

Carrying this out has meant a steadily increasing exposure to alternative assets, and this is the reason the KIC is being so excitedly talked about in asset management despite total assets (around US$37 billion at the end of 2010) that are relatively modest by sovereign wealth fund standards. When last disclosed in the 2009 annual report, alternatives occupied just under 7% of the portfolio; today, in terms of committed capital, it is a little over 10% (though the precise figure won’t be disclosed until the 2010 annual report comes out shortly). And Kalb isn’t finished there: he thinks 20% is a logical ceiling. “Attractive risk premiums arise in areas that are beaten up, where there is mispricing, or a lack of investors or liquidity, and often they are things that may take some time to work,” he says.

Similarly, KIC launched a strategic investment program in June, allowing it to take direct stakes in companies, notably Chesapeake Energy. Again, full year returns won’t be clear for another month or so, but Kalb is clearly pleased so far. “Normally when you do alternative and strategic investment there’s a J-curve effect: it takes a while to see your performance, and your costs are front-loaded. But we’re ahead in all of our alternative and strategic programs, and it’s all making money even on a short-term basis. That helps in expanding those businesses.”

It’s useful to be able to demonstrate good news, because although Kalb has the benefit of working without the hindrance of liabilities, he does face some distinct challenges.

One is the fact that the KIC is funded by two separate sponsors: The Bank of Korea, which is Korea’s central bank, and the Ministry of Strategy and Finance. Most of the initial funding came from Bank of Korea; the finance ministry has provided most of the subsequent funds in blocks of $2 or 3 billion apiece in the meantime; and this coming year, there will probably be about $8 billion more contributions, this time split between the two sponsors.

This would be fine if the two sponsors brought the same attitude to risk and investment, but they don’t. The central bank is naturally conservative, the ministry more inclined to take risk for returns. Some say the discussions over how these interests should be represented in the portfolio can get heated.

For his part, Kalb says: “As you’d expect, the money you manage for the central bank is more conservatively managed because that’s their job. We try, within their frame of reference, to be a little creative and to deliver returns for them. The ministry is a bit more flexible in their capital and a bit more risk-oriented which makes sense: it can afford to be more strategic and have a longer vision, which gives us much more flexibility.” He says, though, that positive returns so far have led the central bank to gain comfort in KIC’s approaches; “we’re an important conduit for them to invest capital in areas other than treasuries and fixed income. They can take the money they don’t need for policy purposes and are comfortable allocating and placing it with us.” In this context the likely commitment of Bank of Korea funds this year – the first new allocation since the original US$17 billion funding – is significant.

Asked if it’s possible to keep both consistently happy, he says: “Nobody’s happy all the time. In a variation of what President Lincoln said, you can keep some people happy some of the time but you can’t keep all people happy all of the time.” He says KIC reports to its sponsors on a segregated basis and “in terms of managing these disparate interest, that’s our job.” The big areas of overlap in the portfolio are managed collectively or on a pari passu basis.

Another, related, challenge is that Kalb works in one of the few big sovereign wealth funds that exists in a vibrant democracy with a lively parliament. If we accept that Singapore, which is nominally a democracy but could hardly be called a vibrant one, is a separate case, then out of the biggest funds only Norway and Kuwait (with a vigour of parliamentary debate that surprises outsiders) are really structured for direct public scrutiny of their behavior. Norway’s vast sovereign fund is a case in point: after almost flawless returns for decades, the fund had one bad year and faced a parliamentary inquiry. Similarly KIC has undergone investigations and public fury over its $2 billion investment (before Kalb’s time) in Merrill Lynch, still heavily underwater today.

“From my point of view, this is a very important part of the democratic process,” says Kalb. “People have a right to know how their money is being invested, what it’s doing and what the thought process is behind it. I believe in it, the institution believes in it and we want to support it: it’s good for transparency.” He says the only disadvantage is getting caught in “the political winds that may be blowing,” not in terms of specific investments – which nobody has the legal right to force KIC to make – but in things like new hires and salary ranges. “That’s part of my job, to help the organization to move forward to become much more like a global private asset management company, even though it is 100% government owned.” On the Merrill investment, he says it “remains a thorny issue… but it’s history. I came here to manage the portfolio on a forward-looking basis. You can’t manage money from a position of regret.”

Kalb was an interesting selection in a country which tends to be hands-on with its state vehicles, especially given this level of public scrutiny. Quite apart from being an American, Kalb’s background is steeped in hedge funds: he was principal and CEO of Black Arrow Capital Management and a senior equity portfolio manager at Tudor Investment, as well as having worked at places including Citigroup and Drexel Burnham Lambert.

In fact it’s not quite as out-there as it seems: Kalb spent much of the 80s in Korea, and three years working for the Economic Planning Board within the government, subsequently merged into the finance ministry. He speaks Korean and considers the country “a second home”. But nevertheless it was a bold appointment. “I think it’s to their credit that they are willing to bring in an outsider to this kind of key position,” he says. “There are many foreigners working in lots of the sovereign wealth funds but I don’t know any that are in this kind of position and I think that speaks volumes about Korea’s intentions to put best practices in place, to adhere to global standards, and to be willing to tolerate some potential discomfort to achieve those objectives.”

Foreign fund managers talk effusively about the KIC, far more so than the country’s National Pension Service, despite the fact that the NPS has a vastly greater pool of assets to target. “KIC are ones to watch,” says one. (Fund managers hate being quoted directly about sovereign clients so all have been kept on background in this piece.) “When they were first announced, they were the institution everybody had to work with, even though in the grand scheme of things they are still pretty small,” says another.

There is a lot of chat about the relationship between the two sponsors and the impact it has on the overall mandate; “we think Scott’s view is that they will use the BOK money as beta exposure, and offset that with high alpha using the MOF money,” says another. And there is just as much chat about the manager being particularly tight on fees. But people want to be involved with it. “Scott says he wants managers to visit him only if they have a true sustainable alpha capability,” says one manager. “He is not willing to pay for beta generation.” Another echoes the point. “When you approach them they are very clear: they will not set an appointment unless you have a clear alpha generating capability.”

And they’re right. Kalb hates paying for beta, and so the sophistication he has brought to the place comes with disadvantages for external fund managers. Between 2008 and 2009 the proportion of funds that were outsourced to external managers fell from 60% to 35%, although Kalb says it’s likely to stay around that level.

Kalb is a believer in what he calls “beta architecture”. When you manage a portfolio with a 5% real return target, he says, 3.5 to 4 points of the return are likely to come from beta, just 1 to 1.5 from alpha. “Alpha is very elusive and it’s a zero sum game; beta is what you get in the market,” he says. Initially, a lot of that passive beta exposure was outsourced, but as the KIC has built ability in different asset classes it has increasingly brought that exposure back in-house. “There is no reason to pay for enhanced or passive fund management if we we can do that ourselves, and we can,” he says. “When you give a passive mandate out, you’re throwing in the towel on any kind of alpha. You’re saying: I give up, I just want the beta, and you wind up getting the beta minus cost.”

“So the idea for externals is that we want guys that can really deliver,” he says. “I want to focus my risk budget on guys who can give me alpha, not just market returns.”

Other changes are underway at KIC: an increased benchmark emphasis on emerging markets, so as to better reflect their contribution to the world economy rather than world capital markets, is an example. “If you don’t make that adjustment you will constantly be behind the trend, trying to catch up.” Another is increased exposure to credit. But in particular Kalb is seeking to change the way allocation is thought of, to a discussion that starts with risk tolerance. “Benchmarks are very useful in terms of monitoring performance and controlling your direction,” he says. “They are very poor in terms of risk control. The assumption is that your risk free position is to be neutral to the benchmark. In real terms that’s not risk free at all, it means you have 100% benchmark risk, and we all learned in 2008 what can happen when you do that.”

“It’s risk adjusted returns, that’s the name of the game, and the object is to sit down and have that risk discussion first. Then we can design a portfolio that makes sense.”

Asked if he feels that’s where KIC is up to today, he speaks of dialogue and progress, but his emphasis is on a work in progress – for everyone in the enterprise, from sponsors to management to himself. “We’re continuously adjusting as we go along,” he says. “It’s all a growing experience.”

It’s no surprise that sovereign wealth funds capture the attention of the world’s asset managers. Estimates of the total wealth these enterprises manage typically range from $3-4 billion, and in most cases they outsource generous amounts of that wealth to external managers.

Attention typically focuses on a handful of the biggest names such as the Abu Dhabi Investment Authority, Kuwait Investment Authority, Government of Singapore Investment Corporation, Norway’s Government Pension Fund Global, or newer arrival the China Investment Corporation. But one of the most interesting trends in this area is the emergence of a newer wave of secondary sovereign entities: far smaller than the more famous behemoth famous, but representing either the emergence of a new bloc of capital, a newfound sophistication in investment technique, or both.

In this article we take a look at three institutions that illustrate the trend: the Petroleum Fund of Timor-Leste in East Timor; the Abu Dhabi Investment Council; and the endowment fund of KAUST, a new science and technology university in Saudi Arabia.

PETROLEUM FUND OF TIMOR-LESTE

To find the next generation of sovereign funds one most go to some obscure parts of the world. A prime example is East Timor, whose sovereign fund is a fascinating story reflecting the emergence of the country itself.

East Timor is one of, if not the, newest countries in the world (depending on how one views the status of Kosovo, and whether you’re reading this after South Sudan becomes a sovereign state). But when it came into being in 2002, it did so as a miserable new entrant into the world economy. Neglected by Indonesia when it was part of that country, and cruelly damaged on the road to independence, Timor had (and largely still has) an infant mortality rate of almost one in 10, a male life expectancy of 47, and 40% of the national population in poverty.

But it had a bounty: plentiful oil and natural gas reserves in the Timor Sea. Hammering out sharing agreements with Australia took several acrimonious years, but today East Timor gets 90% of the Bayu-Undan oil and gas field (being exploited by a ConocoPhillips-led conglomerate which expects the field to be good until 2023 and to provide 4 trillion cubic feet of natural gas and 500 million barrels of condensate); 50% from the Greater Sunrise field, with almost twice as much gas and 300 million barrels of condensate; and 90% from any further finds within the Joint Petroleum Development Area. One way or another East Timor is likely to get at least $20 billion from these fields, and possibly much more.

Many new countries have found themselves with the gift of hydrocarbon reserves and have then destroyed themselves as a consequence. But from the outset, Timor has stood out for the prudence of its approach to its assets. The Petroleum Fund was set up in 2005 in order to build up its assets for the future. It has certainly not been without controversy: in a country where there is not enough money to educate or heal people, it is highly contentious to put all the money from commodities away for the future, and today there is something of a compromise with some funds withdrawn for expenditure and the majority saved for the future. And since oil and gas account for 170 times more than the second-biggest national revenue provider (coffee), based on official 2008 numbers, it’s very clear that these commodities are the country’s only shot.

But, in this poor and unlikely location, the fund is among the world leaders for transparency, accountability and governance: when the Peterson Institute for International Economics tried to put together a scorecard for sovereign wealth funds based on those criteria, East Timor’s fund ranked 3^rd behind New Zealand and Norway, ahead of democratic and transparent beacons like Canada, Alaska and Australia, and an absolute mile ahead of anything in Asia or the Middle East (ADIA ranked 32^nd).

So, today, a visit to the fund’s website, hosted within the central bank, reveals precise assets under management, holdings, allocation and performance, all of it revealed on a quarterly basis. Absolutely everything is spelled out: what can be withdrawn and in what circumstances; what external mandates might be announced; how the benchmark is composed. It’s perhaps not surprising to hear that one of the Norway sovereign fund’s senior management serves on the Timor fund’s investment advisory board.

At this stage, the fund is deeply conservative: it got up and running just ahead of the financial crisis and was in no rush to diversify out of treasuries – a decision that may have made it the best performing sovereign fund in the world during the worst months of the crisis. Whether because of nervousness, lack of expertise or conscious decision, it still hasn’t. Its global benchmark today is 90.4% US government treasuries in a 0-5 year duration; a further 2% in 5-10 year treasuries; 2.6% AAA government or supranational dollar debt; 1.4% AA; and then a sprinkling of Australian, euro, UK and Japanese government bonds. Until recently BPA, the central bank, ran 80% of that portfolio (most of the short-dated Treasuries), while the Bank for International Settlements ran 20%, including the non-US holdings.

While that’s hardly the most exciting allocation, returning just 1.6% in the quarter to September 30 2010, it has served the fund well: given that modest performance but mostly because of new revenues from the oil fields, it has grown from US$3 billion in 2007 to $6.6 billion in September 2010, even after a quarterly withdrawal of $175 million for the quarter to the state budget (which doesn’t sound much but is substantial in a poverty-line country with a population of just a million).

That conservatism might suggest little reason for foreign asset managers to get excited, but there are gradual signs of that wealth being ready to be trusted to external managers. Back in 2009, the Ministry of Finance asked the BPA to consult a manager for an equity portfolio – and on September 7 2010, that finally happened, with Schroders getting a contract to put 4% of the fund into global equities. That chunk, about $260 million, was apparently deployed in October.

And this is exactly the reason international managers ought to look off the beaten track. Timor’s fund will never be ADIA, but it’s very likely to hit $20 billion within the next decade or so; that’s not so far short of, for example, the Korea Investment Corporation. And, over time, as confidence and sophistication grow, it is likely to put more and more of its capital to work in a structure in line with other sovereign wealth funds around the world. Plus, it’s highly unlikely to feel it has that expertise available in the national capital, Dili, which suggests that most of the non-Treasury allocations will be outsourced.

ABU DHABI INVESTMENT COUNCIL

ADIA obviously gets the headlines, but there are a host of other sovereign wealth entities in the United Arab Emirates. In Abu Dhabi alone, for example, there is Invest AD (formerly the Abu Dhabi Investment Company), Mubadala Development Company and the Abu Dhabi Investment Council (known as The Council, or sometimes ADIC 2).

A look at the last of these illustrates the possibilities for international managers in sovereign vehicles beyond what you might call the mother ship. The Council is one of the newer ones, and was set up only in April 2007. Like ADIA, it is an investment arm of the government of Abu Dhabi, and again like ADIA it is responsible for investing government surpluses for the future good of the people, by achieving strong returns and diversifying the economy away from oil. It also has a direct investment mandate to broaden Abu Dhabi’s economic base and help local companies to develop internationally.

In some respects The Council looks a bit like a holding company or a Temasek, in that it holds major stakes in several of Abu Dhabi’s leading businesses: National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Union National Bank, Al Hilal Bank, Abu Dhabi National Insurance Company, Abu Dhabi Aviation Company, and Invest AD (which is itself a sovereign investment vehicle).

In other ways, however, it looks like a more nimble version of ADIA. It has a dedicated special situations division, for example, which ADIA does not. And this gets to the heart of the big question about The Council: why is it there? Who needs another sovereign wealth fund in Abu Dhabi?

Many feel that ADIA simply became too big to be able to move quickly. It has never revealed its precise assets under management and estimates vary dramatically, but Cerulli believes the total to be between $400 and $500 billion. With such a large amount, one has to deploy a lot of capital into a position for there to be any point in doing so – and that can be difficult in, for example, small caps or special situations. There are political and personal reasons mooted too, but the idea of a quick-acting sovereign fund as an adjunct to ADIA has a lot to recommend it. Some even say that ADIA is beta and The Council is alpha, but in fact a large part of ADIA’s assets are actively managed.

It’s certainly a more opaque institution than ADIA, which itself used to set the benchmark for opacity. These days ADIA produces an annual report with detailed information on asset allocation ranges, governance and even long term performance; at the time of writing, The Council’s web site contained only a picture of some buildings and a brief mission statement: “To assist the Government of Abu Dhabi in achieving continual financial success and wealth protection while sustaining prosperity for the future”, and “to increasingly participate and support sustainable growth in the Abu Dhabi economy.”

We have not yet seen many more satellites come off established sovereign funds, but it’s not impossible that we could do in future. Many of the biggest institutions – Norway’s, Kuwait’s, Singapore’s, China’s – face these scale issues, and a free-reined lower-asset think tank could be a smart way for all of them to deal with it.

KAUST

On a 36 million square metre custom-built site on the Red Sea 80km north of Jeddah, a remarkable new educational institution is taking shape. The King Abdullah University of Science and Technology opened its doors in September 2009 and was by then already an exceptionally well-equipped research university, with specialisms distinct to Saudi Arabia such as water desalination. But that’s just the start, and by 2020 it aims to be among the top 10 universities of its type worldwide.

Ambition like that requires a lot of money to realise, particularly since one of the stated ambitions within the university’s mission and vision statements is to have “a diversified and sustainable revenue base that supports both its operating and capital requirements.”

For this purpose, and with the endowment funds of Yale and Harvard very much in mind, KAUST Investment Management Company was set up. In March 2009, it made a landmark hire as its chief executive and chief investment officer: Gumersindo Oliveros, who was previously the director of the pension plan and endowments at the World Bank.

Although the figure has never been confirmed, it is believed that the new fund was seeded with $10 billion of assets. The board at the time of Oliveros’s appointment makes for interesting reading and shows the scale of the ambition: alongside the Saudi royal family (Prince Khalid bin Adbullah bin Abdulaziz) and government (Ali Ibrahim Al-Naimi, who is the minister of petroleum and natural resources as well as the chairman of KAUST’s board of trustees) are local private sector leaders (Lubna Olayan, the CEO of Olayan financing group, and senior representatives of Saudi Aramco and the Abdullatif Jameel Group) and a couple of striking foreign names: John Brennan, chairman of Vanguard; and Charles Ellis, chairman of the investment committee at Yale University.

Yale is clearly a role model, and those asset managers who have had discussions with the new endowment fund say that it appears to be every bit as sophisticated – at least in what it is talking about doing – as its American cousin. Managers going in for pitch meetings talk about discussions in which typical asset allocation models are discarded in order to talk in detail about thematic investment styles, which might include themes distinct to the Gulf such as water or food scarcity.

The Gulf is not short of well-funded trophy projects, and while we tend to associate these with tall or grand buildings, a commitment to world class education is a logical and laudable way of deploying oil wealth. KAUST could be mirrored by similar institutions in the region.

For the moment, all eyes are on two other Saudi institutions that have been announced but don’t yet appear to be doing a great deal. One is Sanabil al-Saudia, formally launched in 2008 under the supervision of the Public Investment Fund, another state entity. The other is Hassana Investment Co, approved in 2009, to manage the assets of the General Organization for Social Insurance (GOSI), a key Saudi pension fund.

It’s not yet clear whether these new funds will be closer to KAUST’s thinking, or to that of the Saudi Arabian Monetary Agency, the country’s central bank which fulfils some sovereign wealth roles with its considerable assets but is by its nature conservative (and does not at all like being described as a sovereign wealth fund). Either way, these new pools of capital being created around pension funds, academic endowments and other sovereign wealth all suggest opportunity for foreign fund managers.

The news that the Government of Singapore Investment Corporation (GIC) and China Investment Corporation (CIC) will invest in Brazil’s BTG Pactual bank underlines a theme we are going to hear more and more about in years to come: intercontinental emerging market trade.

While GIC and CIC are the names that have struck the deal as part of a consortium putting in $1.8 billion, it’s another sovereign fund, Temasek, that has given the clearest signal that Asia-Latin America interest is going to grow and grow.

About two years ago Temasek shifted its target geographical allocation from one that had previously put a lot of money into developed markets, to a new 40:30:20:10 model, for Asia, Singapore, OECD countries and other markets respectively. At the time, comment focused on the relative increase of importance for Asia at the expense of developed markets, but another story was largely missed: the ‘other’ bit, which accounted for just 2% of the portfolio in March 2010 but will rise to 10 in this new model. Temasek’s portfolio, when last disclosed, was worth S$186 billion (US$141.29 billion), suggesting that $14.13 billion will go into other markets like Latin America and Africa, and that more than $11 billion of it will be new investment.

Temasek has been building a presence in Latin America for some time. In May 2008 it hired a new managing director for investment in Mexico, Barclays Capital’s Mexico president Lorenzo Gonzalez Bosco, and sent its MD for Latin America, Alan Thompson, to Sao Paolo. By then it had already bought 15.4% of the Brazilian oilfield services group San Antonio International, and this year followed it up with a JV with Mexico’s IMDI to pursue land banking opportunities there, seeding it with US$200 million. Greg Curl, the former Bank of America chief risk officer who became Temasek’s president in September, has responsibility for developing Temasek in the Americas; it’s already clear he’s likely to spend more of his time in the southern continent than the northern.

Set alongside this has been the headlong pursuit of African assets by Chinese companies, most obviously through resources companies like CNOOC and Petrochina, but also banks such as ICBC, which has bought into South Africa’s Standard Bank. China has a stomach for markets that make others queasy: Petrochina is big in Sudan (far too big for many advocates’ liking), while CNOOC has struck deals in Somalia. CIC’s purchase in BTG Pactual shows the sovereign wealth fund, which has been steadily getting into more frontier parts of the world like Mongolia and Kazakhstan for two years, following that lead into other, non-Asian emerging markets.

It’s natural that sovereign funds like GIC, Temasek and CIC should look to other emerging market blocs outside Asia. The financial crisis saw all three of them badly burned by investments into western financial institutions: Barclays and Merrill for Temasek, UBS for GIC, and Morgan Stanley and Blackstone for CIC (although several of those investments eventually turned positive after considerable pain in the meantime). And viewed from Asia, Brazil in particular has a lot to recommend it: scale and pace of growth reminiscent of BRIC counterparts China and India; and clear emerging champions like Petrobras – recent victors in the world’s biggest ever rights issue – and BTG Pactual itself.

Pactual is emblematic of what Asian sovereign wealth funds want from these markets, because it is the perfect emerging market story. A homegrown investment bank, in 2006 it did what most homegrown investment banks do and sold to a foreign global heavyweight, in this case UBS. It got $3.1 billion for it, much of that going to the bank’s partners. But, better still, when UBS ran into trouble in the financial crisis, it sold it back again, to BTG, which was the investment fund that former Pactual executive Andre Esteves had founded after his UBS windfall in the first place. UBS got $2.5 billion, an almost 20% erosion of value in three years if reported numbers are correct, and BTG Pactual is once again owned by its partners. Somewhat like CICC, it is a local powerhouse, often leading the market in capital raising and trading on both the debt and equity side, and increasingly in M&A too. And so it has that sense of the dawning power of emerging economies that Temasek, in particular, so frequently elucidates: growing from its own emerging market roots, taking on the biggest competitors in the world and, in this case, coming out the stronger for it.

BTG Pactuals don’t come along every day, but there’s enough strong companies in Latin America and Africa, and enough sovereign wealth in Asia, to ensure that these tentative engagements are just the start.

Sovereign wealth fund annual reports are always eagerly awaited, if somewhat disappointing. China Investment Corporation gives tantalising glimpses of a powerful institution but won’t disclose its target asset allocation; Temasek gives plenty of information on investment but none about the leadership conundrums of recent times. At Government of Singapore Investment Corporation, there’s welcome information on allocation, but a frustrating lack of the magic number of its overall assets.

A look at GIC’s latest report, released this week, raises some puzzling questions. GIC, the report says, has conducted a comprehensive review of investment policy. One result of this is that it will be easier for the management to move away from long-term asset allocation when it is sensible to do so, but the bigger commitment is that investments in emerging economies, especially Asia, will be increased, a process that has supposedly been underway for some time.

This makes perfect sense for a host of reasons: the hopeless state of US and European markets, with little short-term hope of relief; the outstanding dynamics in Asia, both at an economic and an investment level; the familiarity with nearby markets and cultures; the availability of pre-IPO investment, particularly in resources companies. On that piece of strategy, we’re sold.

There’s just one problem: it isn’t actually happening.

GIC, unsurprisingly, showed a dramatic shift towards public equities over the last 12 months, as it regained risk appetite and positioned itself for the market rebound after the financial crisis, and as the value of its existing equity holdings grew. So the move from 38% to 51% is not particularly surprising.

What is surprising, though, is that absolutely all of that increase came in developed market equities. The emerging market contribution – 10% – didn’t move. The Americas account for 43% of GIC’s investments, and Europe – in an increase from last year – 30%. The UK and France between them account for exactly the same proportion of the portfolio as the whole of ex-Japan Asia, at 13%.

Contrast that with Temasek which is moving towards a 40:30:20:10 split between Asia, Singapore, OECD countries and others (chiefly Latin America so far). Temasek has its critics but it puts its money where its mouth is: just one fifth of the portfolio in the developed world because it perceives the greatest opportunities are in the region which it also happens to know better than any other.

GIC’s a curious place. Fund managers describe it, along with ADIA in Abu Dhabi, as the most sophisticated of sovereign wealth funds, with outstanding expertise internally among its 1000-strong staff. Many recount turning up to pitch a flash new idea to GIC only to find that the fund has been doing it internally for years anyway. It has built a real estate division that is, in its own right, one of the largest in the world (the spin-off of its Chinese and Japanese logistics assets next month may yet be the largest ever Singapore IPO); it also houses one of the smartest and connected alternative investment businesses in the region, if not the world. Yet its long-term return, at an average of 7.1% a year over the last 20 years in US dollar terms, or 3.8% over global inflation, is not actually all that amazing and, barring last year’s crisis-hit number, has been drifting for a decade. Maybe by doing what it says it will, and looking for opportunity closer to home, it can arrest that drift.

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So Stuart Gulliver will be the next CEO of HSBC. Many who recall his time as head of treasury and capital markets in Hong Kong will have seen this coming for a decade: he always had the gravitas to be a candidate. And he will, it seems, be back, following Michael Geoghegan’s example to run the company from its spiritual home in Hong Kong.

When he gets here, what will we see? Gulliver is taking on a bank which has, for the second crisis in a row, emerged stronger by comparison with its peers. HSBC had its brush with US sub-prime in an uncharacteristic duff move. But by comparison with any global peer bar Standard Chartered, it emerged from the global financial crisis galvanised and vindicated, the stoic prudence that has long characterised the place once more being proven appropriate.

But it’s significant to see an investment banking man promoted to the top job (it’s interesting that both HSBC and Barclays put investment banking people in charge of their entire banks within a week of one another, barely 18 months after investment banks came close to wrecking the global financial system). So one wonders whether, when he gets back, he might finally correct a glaring omission in the HSBC product set and get it to take investment banking more seriously in Asia.

Not the debt side: there’s no problem there. According to Dealogic, Asia is second in Asia ex-Japan G3 debt capital markets so far this year, having also been second in 2009 and the leader in 2008. On the local currency side the top positions these days inevitably go to the mainland Chinese houses, but of the foreigners only Stanchart has beaten it in Asia so far this year.

But look at equity capital markets. Where’s HSBC? 32^nd in the region, year to date. That’s not a blip, either: it was 29^th last year, 26^th the year before. And what about M&A? For announced M&A in Asia ex-Japan, Dealogic ranks it 10^th so far this year, which is at least an improvement on the 33^rd place it occupied in 2008. No question, there’s plenty else that HSBC gets right, and in an era of emerging offshore RMB bond markets perhaps it’s right to focus resources on the debt side. But it’s an odd gap, and maybe one that Gulliver will correct when he relocates back to Queen’s Road Central at the end of the year.