Cerull Global Edge, August 2013
Sovereign wealth fund report
ARTICLE ONE: Allocations
It is always foolhardy to generalize about sovereign wealth funds, such is the variety in their location, risk appetite, mandate and approach. But a few asset allocation patterns are clear across the sovereign wealth spectrum.
The most obvious is a shift to emerging markets. This is clear both in the public data of the funds that disclose information about allocations, and anecdotally about more secretive funds, based on interviews with managers who conduct third party mandates for them.
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Singapore’s Government Investment Corporation (GIC) is a prime example of a long-standing, sophisticated, mature fund making an effort to boost allocations to the emerging world. When it disclosed its portfolio split in March 2008, 10% of the fund went into emerging equities compared to 34% in developed equities. Four years later, in March 2012, emerging equities accounted for 15% and developed equities 30%. Over the same timeframe, allocations to Asia (and bear in mind GIC cannot invest in its home base of Singapore) have climbed from 23 to 29% while Europe has dropped from 35 to 26%. This is a clear, articulated strategy, and is unlikely to be reversed.
GIC’s fellow Singaporean, Temasek, represents the most extreme example of a policy to embrace emerging markets. Several years ago, a decision was taken that the emerging world was what Temasek understood best: it understood the growth dynamics, the demographics, the industries, the banking and resource stories. Moreover, it had been burned by its experience with developed world assets, buying in to western banks as they declined during the global financial crisis, and then selling out of those holdings close to what turned out to be the bottom of the market. The impact of that experience can be clearly seen in the change in Temasek’s allocations between March 2005 and March 2012. In 2005 Singapore was 49% of the portfolio, OECD economies ex-Korea 30%, and the rest of Asia 19%. By 2012, the developed world had fallen to 25% and Singapore 30% while the allocation to the rest of Asia had more than doubled to 42%, with Latin America, Africa, Central Asia and the Middle East accounting for 3%. Temasek’s stated target is 40/30/20/10 for Asia, Singapore, OECD and other emerging markets; a target for the developed world to account for only one fifth of the whole portfolio is a clear statement about where Temasek believes growth lies.
It is not just in Singapore that one finds this focus. ADIA is the only Middle Eastern sovereign fund to disclose anything of note, and it explains the bands within which its asset allocations can fluctuate. Emerging market equities can be as much as 20% of the portfolio, far higher than any market cap-based index would infer, and across the whole portfolio emerging markets can account for 25% – not counting an up to 20% allocation in developed Asia. Elsewhere, though they don’t disclose it, the Kuwait Investment Authority is known to have made a shift towards Asia in recent years; there are documented examples of the Qatar Investment Authority doing so (launching a Harrods store in Malaysia, for example); and the China Investment Corporation has moved from its early forays into western institutions such as Morgan Stanley, towards more of a focus on emerging market commodity businesses.
Cerulli recently held a presentation on sovereign wealth with a number of leading fund managers who specialize in covering this segment, and conducted a short survey of their opinions. When asked which asset class was likely to attract the most mandates from sovereign wealth funds over the next 12 months, 21% said emerging market equity and 14% emerging market debt, while none at all chose those equivalents in the developed world. However, the bulk – 64% – chose alternatives, which brings us to our next point.
GIC is also a useful place to start on this theme, because it has been considered a forerunner in boosting allocations to alternative asset classes. In March 2012, 11% of the fund was invested in private equity and infrastructure, 10% in real estate, 3% in absolute return funds and 3% in natural resources – more than a quarter of the fund in asset classes most consider alternative. GIC is also interesting as a case study of how funds gain this exposure: in a model increasingly followed elsewhere, it has often sought to be a co-investor, or to seed a new fund or strategy, rather than simply to provide funds for third party management.
Newer funds have also tended to head towards alternatives. The Korea Investment Corporation, for example, had nothing in alternatives in 2007, 1.7% of the portfolio in 2009, and 6.1% in 2012, plus a further 3.2% in a group called special investments. The former CIO, Scott Kalb, used to say that 20% would be a logical amount to commit to alternatives, given their lack of correlation with other asset classes and their long-term return potential. Kalb has now gone, but it is notable that his replacement, Dong-ik Lee, was formerly head of investments at a private equity/venture capital firm. Indeed, many of the most striking hires by sovereign funds in recent years have been in this area: John McCarthy as global head of infrastructure and Colm Lanigan as head of principal investments in private equity at ADIA; and Scott Lanphere (briefly), former Morgan Grenfell Private Equity executive, and John Breen, another former private equity specialist, at the Saudi Arabian sovereign fund Sanabil.
Elsewhere, China’s CIC’s allocation to alternatives has gone from 6% in 2009 to 12% by 2011, while ADIA – another early mover, like GIC – may have up to 10% of the fund in alternatives (by which it means hedge funds and managed funds), 10% in real estate, 8% in private equity and 5% in infrastructure. And for an example of a fund that has started out with alternatives as a priority, look at Australia. The Future Fund made many of its first internal hires in areas like infrastructure and forestry, and this is reflected in its allocations today (March 31 2013): 15.3% in alternatives (mainly hedge funds) plus 6.5% in infrastructure and timberland, 6.8% in private equity and 6.4% in property.
Still, our research shows that simply saying alternatives are popular is too simplistic. It has to be the right kind of alternative.
While 87% of respondents said they thought allocations to alternatives would increase, when we then asked which alternative asset class was likely to receive the most mandates, the entire vote was split between infrastructure (60%) and private equity (40%), with nobody at all selecting hedge funds, commodities or other alternatives.
There is a clear sense that hedge funds have fallen out of favour with sovereign funds through the financial crisis. Too many have simply not done what they are meant to: provide returns in volatile markets, thus counterbalancing falling equity holdings.
Infrastructure, on the other hand, is enormously in demand. Its profile – long-term, predictable, stable returns – fits a sovereign fund very well, and it is easy to see why a fund like the Future Fund in Australia, with a very clear mandate to meet the unfunded pension obligations of Commonwealth employees, is so attracted to it. Indeed, even Australian superannuation funds (pension funds) have often sought to invest in infrastructure, for the same reason.
The challenge here is: how to access it? There are very few dedicated infrastructure-specialist fund managers – Australia’s Hastings is a rare example – and to get exposure, sovereign funds are more likely to enter into a co-investment model, or to try to buy something outright. Thames Water is a classic example of this: in January 2012 the China Investment Corporation bought an 8.68% stake in the holding company that owns the British utility, a month after ADIA bought 9.9% of it from a consortium led by Macquarie. Years previously, the QIA had bid for it.
One other interesting allocation trend is to take the bulk of market exposure passively, and take more active positions around the edges. When ADIA began publishing an annual report, one of the most striking figures in it was that 60% of assets were in index-replicating strategies, although in the most recent document, it had fallen to 55%. Given that ADIA is believed to manage over $500 billion, these sums are clearly highly significant, and while ADIA is believed to have an unusually high proportion of funds managed passively, passive managers do report mandates all over Asia and the Middle East. For the future, 40% of our respondents expected passive allocations to increase in the year ahead, and only 20% to decrease.
Another trend, somewhat to the annoyance of third party managers, is the habit of making direct investments, long illustrated by Temasek but more recently embodied by the QIA’s brazen approach. For a long term investor, there is nothing wrong with this strategy, but it doesn’t leave much opportunity for third party managers, instead rewarding M&A bankers and brokers.
One final emerging trend is a sense of Middle Eastern funds going local in a way they never used to. Invesco recently published a survey on Middle East asset management and concluded that assets allocated to sovereign wealth funds that invest locally rose by 10% in 2011-12. Particularly post-Arab Spring, there is a sense that it is important for sovereign funds to be seen to be contributing to the development of their local economies today, with social infrastructure.
In some cases there is nothing new about this: Kuwait’s KIA has long been a supporter of its own local stock market (though it prefers not to express it like that, instead calling it prudent investment), and has seeded most of the fund management businesses in the country. But there are interesting patterns arising elsewhere, too.
For example, the Saudi fund Sanabil has been largely invisible in the six years since its formal establishment, but has finally started to announce some investments. They are not what people were expecting to see: instead of commitments to foreign stock or bond markets, or Qatar-style overseas investments in real estate or commodities, the two investments we know about from Sanabil to date are in ACWA Power and a health fund – both Saudi Arabian assets. It remains to be seen if Sanabil is just starting local before expanding overseas, or if local investments, rather than diversification, will be the future.
ARTICLE TWO: Outsourcing trends
There are two competing forces at work in the outsourcing of funds by sovereign wealth funds. On the negative side, as funds mature, they tend to outsource less and to take more asset management in-house. On the positive side, this is counterbalanced by the relentless growth in sovereign wealth, both through the growth of existing funds and the appearance of many new ones.
Evidence shows us that many funds outsource less as they become more established. Korea is a modern example. At launch, te Korean Investment Corporation was invested predominantly in fixed income, and mainly through external managers, as the fund built up internal capability. In subsequent years it diversified increasingly into equities and alternatives, and at the same time, took some of those assets back in-house as soon as it became competent to do so. At the end of 2008, 40% was managed internally, 60% externally; by the end of 2012, 67% was handled internally and 33% externally, and that is probably where it will stay.
At some funds, external managers remain the majority so far; at the China Investment Corporation, internal management has grown modestly from 41% to 43% from 2009 to 2011, but no further. But at the most developed funds, external managers are becoming all but obsolete.
This is particularly true in Singapore. GIC is notoriously one of the hardest sovereign funds to impress. If a fund manager has what appears to be a new idea and a good track record, there is a strong chance that when it pitches the idea to GIC it will find that the sovereign fund has already been running a team on it internally for years. GIC’s most recent annual report says that external managers handle “at times up to 20% of the portfolio.” But even this represents rich pickings compared to Temasek, whose direct ownership model requires brokers and bankers rather than external fund managers. If there was a role for external management, that appears to have been usurped by Temasek’s own home-grown fund management business, Fullerton.
This trend is reflected in this finding from Cerulli’s recent sovereign wealth funds panel, attended by many of the institutions with the deepest connections to sovereign funds. When asked whether outsourced asset management would increase or decrease in future, 60% expected a decrease, and only 22% an increase.
Still, there are well-known exceptions. One of them is among the biggest in the world: the Abu Dhabi Investment Authority, which outsources 75% of its funds (down from 80% a year ago but still several hundred billion dollars), although a large proportion of that figure is believed to be passive. And there is a positive view to be taken as well: that these funds are getting so big that even a reduction in the proportion that is outsourced can still be ample to sustain a good business. The Government Pension Fund – Global, which is Norway’s sovereign wealth fund, today outsources only 3.9% of its funds to external management. But that’s still Nkr146 billion (US$23.75 billion).
If big and established funds tend to reduce their external allocations over time, one natural conclusion is that it is well worth fund managers approaching new funds early in their development. Both Korea and China, as discussed, started with significant external allocations, but it would be useful to look further out along the frontier spectrum.
Here, every fund is different, and general conclusions are hard, but a few examples are worth considering. One is the Petroleum Fund of Timor-L’este (East Timor). This fund handles the revenues coming from the oil and gas in the Timor Sea and, while it will never be an ADIA or a KIA, it is likely to get about $20 billion from the fields it knows of today, a highly significant amount for a small and impoverished country. Timor stood out for its acknowledgement that it was no expert on investment, and that it should start with good governance: it hired names like Mercer and JP Morgan for investment and custody advice, and it put all of its money into US Treasuries until it gained sufficient expertise to do anything else with the money. (Since it did so just before the financial crisis, one consequence was that it was arguably the best performing sovereign fund in the world in the crisis that followed.)
What’s interesting from an external manager’s point of view is what happened next. Gradually, as confidence grew, outsourcing began. It started with a revised management agreement between the Ministry of Finance and the Central Bank in June 2009, under which the Bank for International Settlements was appointed as the fund’s first external manager, taking on 20% of the fund with a mandate to invest in sovereign and supranational bonds in dollars, sterling, yen, euros and Australian dollars. In October 2010, Schroder Investment Management became the fund’s first equity manager, with a mandate of 4% of the fund to invest in global stocks in the world’s largest 23 markets. Equity exposure has steadily risen since, reaching 25% in July 2012, by which time an amendment to the management agreement had been signed. Equity exposure will now rise gradually to 40% by June 2014 – and it will likely all be outsourced.
The pattern is quite familiar in this part of the world. In Papua New Guinea, for example, a framework has been established for a sovereign wealth fund to invest the assets generated by the new PNG LNG pipeline. In Mongolia, a similar model exists because of the wealth that will be created by the major oil and copper mining projects under development. In all these cases, there has been an emphasis on governance from the outset, to try to avoid the so-called oil curse that has hit newly-enriched markets in Africa and elsewhere, plunging them in to civil war; and there has been a recognition that external management will be vital in order to invest these funds successfully and sustainably.
Presented with a list of frontier markets, respondents in our study said they considered Kazakhstan the most likely as a source of new mandates, followed by Libya, and then a tie for Timor L’Este, Mongolia or Ghana. There are many other opportunities besides: in Central Asia, Azerbaijan has an active sovereign fund; Angola formally announced one earlier this year; and Nigeria is attempting to develop one, though it is becalmed in court disputes between federal, state and local governments about ownership and distribution.
Our respondents’ selection of Libya as a strong candidate for external mandates is interesting, because Libya is a special case. The Libyan Investment Authority has been in existence since 2006, and has involved some top-level advice: Mercer provided it with an asset allocation template, Ernst & Young with a governance format, and at various times KPMG and Deloitte have also been involved. Many of the world’s leading fund managers have enjoyed mandates from the LIA. But after the revolution in Libya, all funds were frozen by the UN, and have yet to be unfrozen until the world community is convinced that the assets would be in the hands of people with the country’s best interests at heart.
That appears to be some distance away; Mohsen Derregia, who was CEO and chairman of the LIA, was ousted by the prime minister and the central bank earlier this year, so that the LIA is now back under the central bank’s remit. But eventually stability will return to Libya, and at that point, $60 billion of money will be ready for reinvestment, hopefully along the lines that Mercer recommended rather than the old days when Saif al-Gaddafi would intervene in order to put the fund’s assets into playthings like Juventus football club. When that happens, it’s possible that neighbouring Algeria, without about $50 billion under management itself, mainly in treasury-like securities, might seek to do something similar, creating a North African bloc of sovereign capital of over $100 billion ready for outsourcing. That’s the positive view.
The pool of available wealth is also growing because in many markets were a sovereign fund exists, similar entities are appearing alongside them. This has long been the case in Abu Dhabi, where The Council exists alongside ADIA doing broadly similar things (other state vehicles in Abu Dhabi include IPIC and Mubadala).
Recently, a similar model appears to be taking shape in Qatar, too. The QIA and its subsidiaries, Qatar Holdings and Qatari Diar, have long been seen as the main game in town for asset managers, although they tend to outsource very little. But recently, the Qatar Foundation – which has existed longer than the QIA, for social development purposes – has been given its own dedicated endowment fund. This was formally set up in 2010 but came into public consciousness in May 2013 when it bought 5% of Indian telco Bharti Airtel. The idea of a Yale or Harvard-like endowment fund has intrigued many who serve Qatar, not that it will necessarily take a different investment approach to the direct-investing QIA.
Similarly Saudi Arabia now has a cluster of sovereign institutions: not just the central bank, SAMA, and the social insurance enterprise GOSI, but the small sovereign fund Sanabil, which after many years of silence has finally started investing (albeit only locally so far); and the KAUST endowment, a fund to support the King Abdullah University of Science and Technology near Jeddah.
But how to secure mandates from sovereign funds? Our respondents say that RFPs are still widespread, with the majority of respondents having filled in five to 15 of them in 2012, but just 20% of respondents expect that number to grow in future. Instead, the norm is increasingly becoming to pitch an idea directly to a sovereign fund, and in particular, to come to them with an idea of co-investment. Notably, the most public successes of foreign asset managers in Qatar have been with Credit Suisse and Barclays, both of which are banks in which Qatar has a significant stake. In both cases, either a whole new business has been launched in Qatar, or an existing one has been moved to Qatar, so that the state can say that assets are being accumulated in Qatar itself as the foundation of a broader asset management industry. Perhaps this is increasingly what fund managers will be expected to provide: not just third party advice on voluminous sums of money, but true partnership and commitment.