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Future of Finance

AS SOON AS HIS TEACHING DUTIES END WITH THE academic year, Eric Parrado, a professor of economics and finance at Adolfo Ibáñez University in Santiago, Chile, hits the road. Since completing a three-year stint in 2010 as international financial coordinator for the country’s Ministry of Finance, where he managed as much as $22 billion in assets for Chile’s sovereign wealth and stabilization funds, Parrado has blazed a new career as an independent adviser to resource-rich countries. The 42-year-old, who is also an active member of the financial advisory committee overseeing Chile’s sovereign wealth funds, travels the world, collaborating closely with governments to help draft fiscal policy and design new sovereign wealth funds in anticipation of future windfalls. Over the past two years, he has worked with Colombia, Mongolia and Nigeria, and he recently began advising Panama.

“Among the lessons I’ve learned is that these countries realize that fiscal discipline is extremely important,” says Parrado, who spent two weeks in Ulaanbaatar, Mongolia, in July, helping the newly elected coalition government lay the foundation for a new sovereign wealth fund framework. “In the wake of the financial crisis, their governments see sovereign wealth funds as a key mechanism for attaining and retaining fiscal discipline, as well as a means of providing self-insurance in a volatile and unfriendly global economy.”

The need for greater fiscal prudence is obvious and pressing. Even as the European sovereign debt crisis rages on, threatening to derail the fragile global economic recovery, a quiet revolution is sweeping through resource-rich emerging and frontier markets. From Israel to Tanzania an unprecedented number of sovereign wealth funds are being established as governments seek to protect their domestic economies from macroeconomic risks, mitigate the potentially destabilizing effects of sudden resource wealth — such as hyperinflation and a decline in manufacturing (so-called Dutch disease) — and save for future generations. If anything, the global financial crisis, which has hit debt-ridden developed markets hard, has only served to catalyze those goals, adding momentum to a decadelong trend that has sparked a flurry of fiscal policymaking in some of the farthest reaches of Asia and Africa. The changes are happening slowly, but the trend is discernible in every public consultation period, legislative proposal and parliamentary vote now taking place.

The surging popularity of sovereign wealth funds can be attributed to a rare convergence of risk factors and opportunities. As early as 1999 a gravity-defying market trend took hold as secular demand drivers in emerging markets — including population growth, income expansion and industrialization — started to nudge commodity prices higher. By late 2001 they were soaring. Although the prices of oil and metals plunged in 2008 with the global financial crisis, those fundamental drivers are still in effect. Commodity prices have recovered strongly, if unevenly, over the past four years. Faced with historically high prices and the potential for greater volatility, many resource-rich countries are now choosing to act quickly and take advantage of a rare commodities supercycle by creating sovereign wealth funds for a variety of purposes: fiscal stabilization, future savings or economic development.

“The life span of a commodities supercycle is typically about 15 to 20 years,” says Michael Lewis, global head of commodities research at Deutsche Bank in London. “If you use that as a metric, we are now halfway, or slightly beyond the halfway point, in this cycle.”

The other, more traditional driver of modern sovereign wealth fund creation relates to a fund’s functional use as an economic risk buffer, which can be tremendously effective in either diversifying excess currency reserves or stabilizing national budgets. Traditionally, the commodity of choice for catalyzing sovereign wealth fund creation was oil. The oldest fund, the Kuwait Investment Authority, was founded in 1953 to help mitigate the disruptive effect of oil price volatility on the country’s economy and now boasts $290 billion in assets under management. Oil and natural gas are still powerful catalysts for sovereign fund creation, but the current supercycle has also driven up prices across a range of nonhydrocarbon hard commodities, including aluminum, bauxite, copper, iron ore and zinc. Those price increases have allowed a handful of countries rich in mineral deposits, including Australia and Chile, to form new sovereign wealth funds. Since 1999 some 30 new sovereign wealth funds have been created, compared with just 16 in the preceding half century.

Judging from the total number of funds already under discussion or development around the world, in places like Colombia, Cyprus, Israel, Panama, Peru and Tanzania, “we could see the emergence of as many as 20 new sovereign wealth funds in the next five years,” says Sven Behrendt, founder and head of Geneva-based Geo­Economica , a political-risk management and consulting firm, who has undertaken a proprietary study of emerging sovereign wealth funds exclusively for Institutional Investor. Behrendt sees resource-rich countries using the trend of sovereign wealth fund creation as a compelling rationale for creating their own funds: “Sovereign wealth funds have become important symbols for the sovereignty of the state and contribute enormously to a sense of national identity.”

Nowhere is that sense of pride more evident than in oil-rich Norway, whose Government Pension Fund Global tops our 2012 ranking of the world’s biggest sovereign wealth funds , with $612 billion in assets under management. (For the full ranking see the map on pages 54 and 55.) Since its founding in 1998, the Norwegian fund has become a model of good governance and transparency, sparking copycat efforts around the world. Unlike the more reticent Abu Dhabi Investment Authority , which moves down to the No. 2 spot this year because of a change in II’s research methodology, the Norwegian fund is completely open about its profits and losses, and makes headlines when it changes its investment policy. But the Government Pension Fund Global, which is run by Norges Bank Investment Management, an arm of the central bank, on behalf of the Ministry of Finance, often welcomes the media attention, using it cannily to generate support for its investment rationale among politicians and the public at large — its ultimate stakeholders.

Global Sovereign Wealth Ranking
Sovereign wealth funds exist on every continent. Since 1999 the total number of funds has increased threefold. This year Institutional Investor has ranked the largest funds that are owned directly by national or state governments, have no explicit current pension liabilities, are managed in a way to grow the funds' capital and invest in a diverse array of assets for commercial returns.
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As the number of sovereign wealth funds and their total assets rise, the global significance of this diverse group of investors is poised to expand dramatically. Today the most conservative estimates suggest that sovereign wealth funds manage roughly $3 trillion in assets, one third more money than the $2.1 trillion managed by the global hedge fund industry and roughly equivalent to the assets held by private equity. As hefty as that total may be, it is still far less, in absolute terms, than the $27.5 trillion in global assets overseen by public and private pension funds in the world’s 13 largest markets in 2011, according to a study by industry consulting firm Towers Watson. But sovereign funds are doing well. Over the past five years, Behrendt estimates, sovereign wealth funds’ total assets under management have grown by an annualized 5.7 percent, and if these growth rates continue, these funds could manage $4.5 trillion or more by 2020.

The total assets managed by the youngest sovereign wealth funds are considerably smaller than those of their older, more established peers — Behrendt estimates that the funds created in the past three years manage just $42.4 billion — and it will likely be many years before they begin to rival the size of more-mature funds. But their emergence in the aftermath of the financial crisis is significant. As Western governments tighten their budgets and traditional providers of long-term finance shrink or adopt more-conservative profiles, some of the most experienced, market-savvy sovereign wealth funds, as well as a handful of newer, innovative funds, are coming to the fore as providers of unconstrained capital.  

“The true consequence of their creation is that capital market development is not going to be limited to major financial centers anymore, like London and New York,” says Hendrik du Toit, London-­based founder and CEO of Investec Asset Management and a native South African. “It will proliferate, and — in those countries where substantial pools of risk capital meet competitive physical and financial infrastructure — new markets will develop, spreading investment expertise around the globe.”

MARKET PARTICIPANTS AND PUNDITS HAVE BEEN fascinated with sovereign funds because of the size — and source — of their wealth. But the power of these funds derives from their role in the global capital markets, not from the depths of their pockets. Unlike their pension fund peers, sovereign wealth funds have tremendous latitude to invest as they please and few explicit liabilities. Subject only to the rules and restrictions imposed by their governments (and those of the countries in which they invest), sovereign wealth funds are among the purest long-term investors left in the financial markets. Able to commit capital for years, if not decades, they wield a freedom that attracts policymakers, asset managers, consultants and would-be co-investors.

Before the financial crisis sovereign wealth funds were easily misunderstood. Given that many of them have never been required to disclose information publicly about their assets or strategies, some in emerging markets, particularly Asia and the Middle East, chose not to do so, until their lack of transparency began to spark highly politicized responses in the U.S. and Europe. Stung by the rising resistance to their global investing ambitions, some of the leading sovereign wealth funds met with representatives of the U.S., European governments and the International Monetary Fund in 2008. Tasked with developing a code of conduct, the International Working Group of Sovereign Wealth Funds, as it was then known, came up with a set of guiding principles that called on funds to adhere to good governance standards, be more transparent about their investing activities and invest on economic, not political, grounds.

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