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Stung by political resistance to their global investing ambitions, a group of leading sovereign wealth funds met three years ago with representatives of the U.S., European governments and the International Monetary Fund to agree on a code of conduct. They approved a document that called on funds to adhere to good governance standards, be more transparent about their activities and invest on economic — not political — grounds. The so-­called Santiago Principles, named after the Chilean city where the two camps met, were lauded by the participants as an achievement that would reassure skeptics and maintain free flows of capital. Few outsiders were convinced, though. The wording of the principles was vague, compliance was voluntary, and there were few signs that sovereign funds took the initiative seriously. The principles seemed like little more than a public relations exercise aimed at keeping Western markets open to these giant pools of money.

Today that modest beginning is spawning a quiet revolution. Under the auspices of the International Forum of Sovereign Wealth Funds, which was established in 2009, the Santiago Principles are gaining wider acceptance among a range of leading sovereign wealth funds. As a result, some of the largest and most opaque funds are changing the way they interact with their domestic stakeholders, governments of recipient countries, external fund managers and even each other. The principles are also influencing the design of a whole new generation of sovereign funds being created in Africa and Latin America, and that impact in turn is making transparency increasingly the norm rather than the exception. The changes are happening gradually, but momentum is discernible in every annual report, executive profile and investment strategy now published and discussed.

Nowhere is this trend more evident than at China Investment Corp., the sovereign fund of the world’s largest creditor nation. CIC was seemingly born in controversy. Its big investments in Blackstone Group and Morgan Stanley back in 2007, the year the fund was founded, raised hackles in the U.S. Congress, where some politicians expressed fears that Beijing might use the fund to pursue its geopolitical objectives. Almost as quickly, CIC took a bashing at home when the value of those holdings plunged during the 2008 financial crisis, and Chinese bloggers criticized the fund for squandering the nation’s wealth.

Beijing-based CIC has responded to the criticism with a degree of openness that’s remarkable for a Chinese institution — and stands comparison with such entities as Australia’s Future Fund and ­Norway’s Government Pension Fund Global, which are among the most transparent of sovereign funds in disclosing information about their investment practices. In its annual report for 2010, released in July, CIC provided the richest detail yet about its holdings, including a shift in its asset-­allocation strategy to reflect the growing importance of long-term investments and its decision to adopt a ten-year time horizon for its portfolio. The fund also disclosed a big move into alternative investments last year, as well as providing information about its purchases of stakes in U.S. and Canadian utilities and resource companies.

The benefits of the fund’s new openness are clear, says Jin Liqun, chairman of CIC’s board of supervisors and newly appointed chairman of the International Forum. “The positive effect of implementing the Santiago Principles has helped change the perception of CIC, and that is really important for other members to understand,” he tells Institutional Investor. “This will not do them any harm. On the contrary, implementing the Santiago Principles can help a particular sovereign wealth fund to be better understood and accepted by the countries in which it invests. But implementation of the principles is equally important for the corporate governance of the fund itself. If you are investing for your own country, these kinds of standards are critical to the sustainable growth, development and operational health of your fund, and I think this could be better appreciated by our members.”

With the number of sovereign wealth funds set to rise significantly and the assets at their disposal expected to surge, the importance of the Santiago Principles can only grow. At the time of their formulation, the Generally Accepted Principles and Practices, as the guidelines are formally called, were endorsed by 23 countries with sovereign funds. Malaysia’s Khazanah Nasional joined the International Forum last year, raising the number of countries to 24. Brazil, Ghana and Nigeria have established sovereign wealth funds in the past three years, and another 20-odd countries — including Colombia, India, Israel, Japan and Lebanon — are considering doing so, according to Ashby Monk, co-­founder of Oxford University’s Sovereign Wealth Fund Project.

“Over the next five years, we could have another 20 sovereign wealth funds in the world — maybe even as many as 30,” says Gary Smith, London-based global head of official institutions at BNP ­Paribas Investment Partners. “Prospective members of the ­International Forum are now going along to its meetings. Many more countries are going along as observers. This is a growing club, and it is extremely powerful because it represents the new world, not the old.”

With most of these countries continuing to accumulate large currency reserves because of high commodities prices and trade surpluses, the power of sovereign wealth funds looks set to grow dramatically. Steffen Kern, a director of research at Deutsche Bank in Frankfurt, projects that sovereign funds will increase their collective assets to some $10 trillion by 2020 from an estimated $4.5 trillion currently.

“If you look at the wealth accumulation in emerging markets, and if you look at economic development and the change in market structure on a global basis, then it is not difficult to predict that more sovereign wealth funds will be appearing,” says Jin. “Existing sovereign wealth funds will probably increase in size, too, so I expect the pool of sovereign wealth funds to further swell.”

Persuading sovereign funds to embrace transparency hasn’t been easy. David Murray, chairman of the board of guardians of Australia’s Future Fund and honorary chair of the International Forum, campaigned intensively during his two-year tenure as the group’s inaugural chairman, which ended in May, to urge sovereign funds to comply with the principles, contending that it would demonstrate to other countries that they were professional, long-term investors. At the Forum’s annual meeting in Sydney in May 2010, the group announced it would undertake an internal survey of members’ experiences in applying the Santiago Principles and publish relevant sections. Two months ago the Forum made good on its promise and surprised the global investment community by releasing the results of the survey in full.

The report makes for compelling reading. Twenty-one members from 20 countries responded to the survey, and virtually all of them claimed to have developed a heightened level of trust and domestic legitimacy because of their greater openness. Transparency has been a “key element in building trust, both internationally and domestically,” the State Oil Fund of the Republic of Azerbaijan said, according to the report. Botswana’s Pula Fund observed that transparency mitigated the potential use of the fund by politicians for ­development projects “against the spirit of saving for future generations” and has helped create “the checks and balances needed for preservation of capital.” Sovereign wealth funds also indicated that transparency has translated into a stronger appreciation of their professionalism among their peers and other financial market ­participants.

The trend of greater openness has some notable gaps, though. Among some of the largest, most powerful sovereign wealth funds in the Middle East, compliance with the Santiago Principles has been minimal at best. Although Abu Dhabi co-­chaired the group that drafted the principles, the Abu Dhabi Investment Authority, which ranks as the largest sovereign wealth fund in II’s annual survey, with assets estimated at $600 billion, has done little to fulfill the code. Market sources believe the notoriously secretive fund suffered significant losses during the financial crisis. In addition, Abu Dhabi extended a $10 billion bailout to its debt-­plagued fellow emirate, Dubai, in late 2009, significantly reducing the amount of oil revenue available to ADIA. In March 2010 the sovereign fund released its first annual report, which detailed its organization and management structure but gave little insight into its investment portfolio. Less than two weeks later, its managing director, Sheikh Ahmed bin Zayed Al Nehayan, was killed in a glider crash in Morocco. Since then, ADIA has said little about its activities under the leadership of the new MD, Sheikh Hamed bin Zayed Al Nehayan, Ahmed’s brother.

The Kuwait Investment Authority, whose managing director, Bader Al Sa’ad, is deputy chairman of the International Forum, has arguably done even less than ADIA. The fund, No. 3 on II’s list, with $292 billion at the end of March, has tightly managed its disclosures to the outside world, claiming that the reports it provides to Kuwait’s National Assembly are sufficient. In his rare public statements, Al Sa’ad has rejected demands for more information about KIA’s investments, saying it would serve no purpose except to whet the curiosity of outsiders.

Another small group of funds has been even more resistant, openly defying the International Forum’s efforts. The sovereign funds of Iran, Libya and Equatorial Guinea refused to participate in the group’s internal survey. The Forum now must decide what, if anything, to do about the holdouts. In its July report the organization indicated that it intends to review its membership and discuss adherence to the Santiago Principles before the next annual meeting, in Mexico in May 2012.

Some analysts believe the Forum is likely to impose some sanctions for noncompliance. Funds that refuse to play along may find themselves relegated to a separate category, says Edwin Truman, a senior fellow with the Peterson Institute for International ­Economics in Washington. But even he admits that the International Forum’s leaders, who are keen to attract new sovereign wealth funds to their club, are unlikely to kick anyone out. Future Fund chairman ­Murray’s goal has long been inclusion, not exclusion. “Even back when we were formulating the Santiago Principles, we understood that — while the majority of funds would be very actively involved — some of the funds were going to be observers by their nature,” he tells II. “That being said, however, as we continue forward, we are going to expect that our members will implement the principles properly. It is an evolutionary process but a necessary one. There are going to be substantial benefits to being in this group, and those who have signed up to it understand that.”

Some of the biggest benefits of transparency have come at home, which is ironic considering that the principles were drafted in large part to address the worries of ­Western countries. The financial crisis provided some salutary lessons. Desperate for cash to stabilize their economies, governments in Ireland, Kuwait and Russia raided their sovereign wealth funds for money to bail out banks and companies. Such political pressures proved impossible to resist, regardless of the funds’ governance structures. “At the end of the day, the funds belong to the state — and the state can pretty much do what it wants,” says Guy ­Henriques, Hong Kong–based global head of official institutions for London’s Schroders.

Greater transparency about long-term investment goals can help sovereign wealth fund managers gain much-­needed time when their portfolios are recovering from market losses and can deter politicians from meddling with portfolio strategy, analysts say. “High levels of compliance may, to some degree, help inoculate the managers of sovereign wealth funds from their stakeholders,” says Truman. “These funds are transparent for a reason, and I think their increasing compliance with the Santiago Principles is correlated with domestic criticism — it has behooved the managements of these funds to become more transparent.”

Consider the case of Norges Bank ­Investment Management, the central bank arm that oversees Norway’s giant ­Government Pension Fund Global, which is No. 2 in II’s ranking and had 3.11 trillion kroner ($575 billion) in assets as of June 30. In 2008, as global markets plunged, the fund suffered the worst loss in its 15-year history — 23.3 percent. NBIM’s hefty equity ­allocation did draw fresh scrutiny from the Finance Ministry in the wake of those losses, but the fact that the fund managers had kept officials fully informed about the rationale behind their strategy ultimately protected them from political interference. The managers bought equities aggressively in the first quarter of 2009 to restore the fund’s equity allocation of 60 percent, up from a crisis low of 50 percent, and then profited handsomely when global stock markets rebounded. The fund delivered a return of 25.6 percent in 2009, 4.1 percentage points higher than its customized benchmark, and rose by a further 9.6 percent in 2010, outperforming its benchmark by 1.06 percentage points.

With the sovereign-debt crisis in Europe deepening and global equity markets plummeting this summer, sovereign wealth funds are thinking hard once again about managing downside risk. Some of the newest funds, like Australia’s Future Fund, which ranks ninth on the II list, are determined to take a long-term perspective with their portfolios. The fund, which managed A$75.2 billion ($78.4 billion) as of June 30, was established in 2006 with a mandate of achieving an average annual return of at least 4.5 percentage points above the Australian consumer price index. The fund’s board of guardians made plain to the government that although management would report and discuss quarterly performance, the fund would measure its performance over rolling ten-year periods. Significantly, the board decided to ignore the concept of peer risk, or the possibility of underperforming other institutional investors over the short term, and instead focus on meeting its benchmark by balancing expected returns across various asset classes against tail risk, or the probability that the worst 5 percent of potential outcomes might occur over three consecutive years.

The Future Fund’s unusual approach to risk also informs its decision to adopt six broadly defined asset classes: listed equities (all kinds, anywhere in the world); private equity (including venture capital); debt (primarily corporate and mortgage-­backed); tangible assets; alternatives (including anything not covered in the other categories); and cash. This approach enables the fund to monitor broad return and risk characteristics across the portfolio while giving the investment team freedom to move nimbly within the asset classes to take advantage of opportunities or mitigate risks. So far, so good: Its most recent results, for the year ended June 30, 2010, showed that the fund delivered a return of 10.6 percent, beating Australia’s CPI by 7.5 percentage points and outperforming the MSCI all-country world index, which rose by 4.8 percent in Australian dollar terms.

As the sovereign fund of a parliamentary democracy, the Future Fund is naturally open in discussing its investment principles and risk-­management practices with its political overseers and the public. The same cannot be said of CIC, which makes its fulsome compliance with the Santiago Principles all the more significant. The fund managed $135.1 billion in its global portfolio at the end of 2010; it also oversees another $239 billion in Central Huijin Investments, a vehicle that holds controlling stakes in the major state-­owned Chinese banks.

In its latest report, CIC provides greater detail about its portfolio strategy and actual holdings than previously. The fund disclosed that its board of directors had extended the investment horizon to ten years from five, echoing the Future Fund’s approach. The change will enable CIC’s investment team to accept a higher risk-­return profile and could help insulate the fund from political pressure as markets pitch and heave in the short term. In addition, the report shows that CIC has split its alternative investment allocation into two categories — absolute return and long-term investments — underscoring the growing importance of the latter class. The fund made no changes to its other asset classes: Cash, diversified public equities and fixed income.

In keeping with its long-term strategy, CIC became fully invested last year by deploying $35.7 billion of capital and slashing its cash holdings to 4 percent from 32 percent in 2009. Most of the money went into alternatives and direct concentrated investments. Alternatives, including private equity, real estate and infrastructure, jumped to 21 percent of the portfolio from 6 percent a year earlier, while equities increased to 48 percent from 36 percent. The equity increase reflected growing exposure to emerging markets and to so-­called concentrated investments. Among the latter last year, CIC paid $1.58 billion for a 15 percent stake in AES Corp., an Arlington, Virginia–based power utility; $416 million for a 5 percent stake in Penn West Exploration, a Calgary–based oil and gas company; and $300 million for a 5 percent stake in ­Brazilian investment bank BTG Pactual. The moves helped CIC generate a return of 11.7 percent on the global portfolio in 2010, identical to its 2009 performance.

In tandem with its increased transparency, CIC has stepped further onto the global stage recently. In November 2010 it opened its first office outside the mainland by creating CIC International (Hong Kong) Co. to handle investments in Asia. And in January it opened an office in Toronto, a key location as CIC looks to invest more in Canadian energy and natural resources companies.

CIC gained even greater prominence in May, when Jin succeeded the Future Fund’s Murray as chairman of the International Forum. The move strikes BNP Paribas’s Smith as a significant breakthrough for China politically. “How many international organizations does China lead?” he asks rhetorically. “Not many. The International Forum is an important new club whose membership is growing, and it is not being led by a Western power.”

Jin and CIC’s CEO, Lou Jiwei, grasp the importance of transparency for the fund’s investment objectives in the U.S. and Europe. They have made a determined effort to implement the Santiago Principles and reassure foreign governments that, as Jin puts it, CIC “invests and operates on a commercial basis.” But CIC stands alone in this regard in China. The State Administration of Foreign Exchange, the central bank arm that manages the country’s foreign exchange reserves and runs an international portfolio through a Hong Kong subsidiary, SAFE Investment Co., doesn’t disclose anything about its holdings. That stance frustrates the Peterson Institute’s Truman. “CIC is held up to much more scrutiny than SAFE is, both inside and outside the country, but SAFE isn’t asked to provide anything comparable to CIC’s level of disclosure, which just seems a bit unfair,” he says.

CIC’s adaptability also stands in stark contrast to the attitude of some of the oldest, largest sovereign wealth funds in the world, most notably ADIA. Some other Middle Eastern funds, such as Bahrain’s Future Generations Reserve Fund and the Qatar Investment Authority, are even less forthcoming. The disparity frustrates Jin, considering that some Gulf funds are much larger than CIC, but he expresses hope that CIC’s transparency will eventually persuade others to open up.

“Our global assets are negligible in the context of overall capital flows, but people focus on CIC because it represents China,” Jin says. “They see it as the sovereign wealth fund of this huge, fast-­growing country with a vast population, and they are perhaps more concerned about CIC over the long term rather than CIC as it is today. So we have a lot of work to do, to help people understand our business.”

The need for understanding, both at home and abroad, is bound to grow. Sovereign wealth funds seem almost certain to expand sharply in size and number, and their capital will be much in demand as ­Western governments tighten their budgets and traditional providers of long-term finance shrink or adopt more conservative profiles. “The influence of sovereign wealth funds is necessarily going to increase as they become the largest long-term institutional investors out there,” says David Smart, global head of sovereign funds and supranationals at Franklin Templeton Investments in London. “And, as regulations and accounting practices cause defined benefit pension funds to shift more and more of their assets into bonds, sovereign wealth funds are going to become just that much more important as sources of unconstrained capital.” • •

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