In September, Norwegian Finance Minister Sigbjørn Johnsen made an interesting statement about the time horizon over which his country’s $443 billion sovereign wealth fund allocates its money. During an interview about the Government Pension Fund Global’s investments in the sovereign debt of struggling European economies, he said, “One could say we are investing for infinity.”
Infinity? If only! An investor with a truly infinite time horizon, backed by the scale of a SWF, would be unbeatable in long-term illiquid asset classes. If a long-term investor could move beyond the zero- to 24-month period where the vast majority of intellectual horsepower in professional money management is focused — and thereby avoid the asset classes with disproportionate levels of competition — it could, in theory, develop market-beating skills in long-term illiquid asset classes.
However, Norway’s fund has yet to really capitalize on its infinite horizon, as its exposure to illiquid assets, such as infrastructure and timberland, is still somewhat limited. (The sovereign debt cited above doesn’t qualify as illiquid.)
To be fair, Norway is hardly alone. The overall exposure of sovereign funds to illiquid asset classes remains relatively small. Compared with family offices, endowments and foundations, which have similar liability profiles, SWFs significantly underweight illiquid assets. According to a recent report by the World Economic Forum, family offices invest 35 percent of their assets in illiquids; endowments and foundations invest 20 percent; and sovereign funds invest just 10 percent.
It seems that sovereign funds are focusing more on short-term returns than their time horizons would suggest. As China Investment Corp. vice chairman Gao Xiqing recently put it: “Theoretically, we are a long-term investor. . . . but you can’t really function on a ten-year horizon.”
But why not, Mr. Gao? If SWFs really do have infinite time horizons, shouldn’t a ten-year time frame be easy? And more to the point, why would sovereign funds give up the risk premiums that can be reaped from long-term illiquidity?
Multiple factors are shrinking the time horizons of sovereign funds. To begin, public officials can be just as demanding of short-term performance as their private counterparts. So rather than take the chance that a single bad year could prompt politicians to shut their funds down, SWF managers focus on short-term returns that bolster their legitimacy.
In addition, sovereign funds face serious principal-agent problems with external managers in long-term asset classes, as managers’ incentives are understandably based on a much shorter time horizon. To circumvent managers, some sovereign funds have decided to launch internal investment programs for long-term assets. As one SWF executive told me earlier this year, “Why should I pay all of these fees if I plan to hold the investment for the life of the asset?”
Sovereign funds must do several things to fulfill their potential as the true kings of long-term investments. First, they must communicate with and engage their domestic constituencies. If the public understands and supports the operations of a sovereign fund, then it will not — in theory, at least — question its legitimacy during market downturns.
Next, sovereign funds will have to be creative in structuring their manager agreements. For example, a fund might cap the amount of leverage an infrastructure manager can use, or it might choose to drop the typical 2-and-20 compensation structure — a 2 percent management fee and a 20 percent performance fee — and instead establish a model that rewards managers for keeping volatility low and cash flows steady.
Last, those funds intent on setting up direct investment programs should plan on allocating considerable resources to organizational design, institutional governance, management and talent. Interestingly, the allure of certain asset classes — namely infrastructure — has already driven a handful of funds to develop sophisticated internal capabilities for sourcing, structuring and managing multibillion-dollar infrastructure assets.
Whatever the path chosen — internal or external — sovereign funds should be investing for the long haul. In line with Norway’s Finance minister, I think sovereign funds could have infinite time horizons. With the right design and governance principles, a time horizon stretching out for decades is within their grasp. As it currently stands, however, only a select few SWFs have managed to achieve this.
And so, to sovereign funds everywhere, I say, “Go long.” It will be well worth it.
Ashby Monk is a research fellow at the University of Oxford, co-director of the Oxford SWF Project and a visiting scholar at Stanford University.
