"...Fox mentions that sovereign wealth funds are diversifying out of bonds and bank bailouts and into broad portfolios of common stocks..." Source: CNN Money Story on Ken Heebner of Capital Growth Management
This (the quote above) begs the question of effects this 'diversification' may have (in general)...
William Megginson, author of the research paper titled: The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies, defines a Sovereign Wealth Fund as; 'a pool of domestic and international assets owned and managed by governments to achieve a variety of economic and financial objectives, including the accumulation and management of reserve assets, the stabilization of macroeconomic effects and the transfer of wealth across generations'
SWFs originated from government investment vehicles established for revenue stabilization. The governments that set-up these 'stabilization investment entities' invariably depended on revenue streams from one underlying commodity e.g OIL.
According to Andrew Razanov's paper titled: Who Holds the Wealth of Nations (Central Banking Journal, Volume XV, Number 4), governments that set-up SWFs essentially aim to:
...Firstly (for the benefit of the uninitiated), what is a Sovereign Wealth Fund (previously called 'stabilization fund')?
William Megginson, author of the research paper titled: The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies, defines a Sovereign Wealth Fund as; 'a pool of domestic and international assets owned and managed by governments to achieve a variety of economic and financial objectives, including the accumulation and management of reserve assets, the stabilization of macroeconomic effects and the transfer of wealth across generations'
SWFs originated from government investment vehicles established for revenue stabilization. The governments that set-up these 'stabilization investment entities' invariably depended on revenue streams from one underlying commodity e.g OIL.
According to Andrew Razanov's paper titled: Who Holds the Wealth of Nations (Central Banking Journal, Volume XV, Number 4), governments that set-up SWFs essentially aim to:
- 'insulate their budgets and economies from excess volatility in revenues'
- 'sterilize unwanted liquidity'
- 'build up savings for future generations'
From the graphical illustration above, you can see that there are 20 major SWFs in the world; 60% of which manage revenues originating from commodities; and that SWFs generally rank low on transparency.
SWFs manage an estimated USD2-3.5 trillion; 2% of the total size of equity and bond markets globally. In his paper titled: How Big Could Sovereign Wealth Funds Be by 2015?, Stephen Jen (Morgan Stanley Research Global), estimates that the AUM held by SWFs will grow at the rate of USD40 billion per year and that the total pool of assets managed by SWFs could reach USD12 trillion (10% of the current total of Global Financial Assets) by 2015. In my opinion, Jen's estimates are extremely conservative: the rapidly appreciating price of oil (and other commodities) could fuel an annual growth rate (in AUM) of at least USD50 billion per annum.
...On effects
In his research paper titled: The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies, William Megginson suggests that the involvement of SWFs in listed companies is something to be worried about because (and this is according to his findings):
In his research paper titled: The Financial Impact of Sovereign Wealth Fund Investments in Listed Companies, William Megginson suggests that the involvement of SWFs in listed companies is something to be worried about because (and this is according to his findings):
- 'SWFs are particularly likely to impose agency costs on acquired firms, since as state-owned funds their motives might not always be consistent with risk-adjusted profit maximization. In addition, by virtue of their lack of transparency, they could impose agency costs simply because of the uncertainty associated with their behavior as shareholders. Additional agency costs would then lead to a decrease in the value of equity'.
I believe that he may have arrived at the wrong conclusions because: 1) His research is based on a very small sample, 75 SWF transactions to be exact, and it is very unlikely that the analysis of a sample this small would produce statistically valid conclusions 2) He tracks the abnormal returns of SWFs for a period of 2 years; which I believe is too short a period. I believe that a period of at least 5 years would reflect the true impact of SWF investment.
In my opinion SWF investment into common stock can have the following effects:
1) Stabilizing markets:
Investment by SWFs in (public) equity markets may increase the stability (reduce volatility) of equity markets: Sovereign wealth funds typically 'go long' on sizeable chunks of shares, and, hold onto those shares for longer periods of time than most investor classes. These enormous share-purchases reduce the number of shares available for active trading--in the short to medium term--on the markets, which limits the extent to which share-prices fluctuate (upwards or downwards) in the short-term to medium term. Otherwise stated: this reduces share price volatility.
Secondly, SWFs typically invest large amounts of capital in times of acute market turmoil (they like buying cheap): which helps to moderate financial market downturns. For instance: during the 2007-2008 credit crisis, SWFs blunted--by replenishing eroded capital--the effects of the 2007-2008 credit crunch on financial service firms (and their share-prices): Citigroup raised about USD$20 billion from a consortium of SWFs from Abu Dhabi Kuwait and Singapore; UBS received a capital injection of around USD$10 billion from a Singaporean SWF fund; Merrill Lynch received a USD$11 billion capital injection from consortium SWFs from Kuwait, Singapore and South Korea.
Gopal Ramanthan KPMG’s Global Head of Transaction Services supported this viewpoint when he said:
“I don’t think the SWFs have been given full credit for the supportive role they played during the credit crunch. They helped prop up the financial services sector with some timely investments. They refused to be panicked into exiting their share-dealing positions and they were similarly resolute about their real estate holdings at a time when other investors were looking for an exit route. Admittedly, the potential business benefits mean that their reasons were not entirely altruistic but their investment strategies have arguably diminished the full effects of the credit crunch. No-one could have simply ‘solved’ the credit crunch but the SWFs went some way to making it a less uncomfortable journey than it could have been.”
The hypothetic graphical illustration below depicts the 'stabilizing effect' SWF investment has on a firm's share-price (during a financial market downturn)
1) Stabilizing markets:
Investment by SWFs in (public) equity markets may increase the stability (reduce volatility) of equity markets: Sovereign wealth funds typically 'go long' on sizeable chunks of shares, and, hold onto those shares for longer periods of time than most investor classes. These enormous share-purchases reduce the number of shares available for active trading--in the short to medium term--on the markets, which limits the extent to which share-prices fluctuate (upwards or downwards) in the short-term to medium term. Otherwise stated: this reduces share price volatility.
Secondly, SWFs typically invest large amounts of capital in times of acute market turmoil (they like buying cheap): which helps to moderate financial market downturns. For instance: during the 2007-2008 credit crisis, SWFs blunted--by replenishing eroded capital--the effects of the 2007-2008 credit crunch on financial service firms (and their share-prices): Citigroup raised about USD$20 billion from a consortium of SWFs from Abu Dhabi Kuwait and Singapore; UBS received a capital injection of around USD$10 billion from a Singaporean SWF fund; Merrill Lynch received a USD$11 billion capital injection from consortium SWFs from Kuwait, Singapore and South Korea.
Gopal Ramanthan KPMG’s Global Head of Transaction Services supported this viewpoint when he said:
“I don’t think the SWFs have been given full credit for the supportive role they played during the credit crunch. They helped prop up the financial services sector with some timely investments. They refused to be panicked into exiting their share-dealing positions and they were similarly resolute about their real estate holdings at a time when other investors were looking for an exit route. Admittedly, the potential business benefits mean that their reasons were not entirely altruistic but their investment strategies have arguably diminished the full effects of the credit crunch. No-one could have simply ‘solved’ the credit crunch but the SWFs went some way to making it a less uncomfortable journey than it could have been.”
Source: Sovereign wealth funds, KPMG Article, 1 April 2008
The hypothetic graphical illustration below depicts the 'stabilizing effect' SWF investment has on a firm's share-price (during a financial market downturn)
Explanation of the graphical illustration: The illustration above shows a stock whose price is on a free-fall (due to turmoil in the underlying corporation's micro and macro environment). The vertical axis represents the price movement of the share, the horizontal axis represents the period of time that the price of the stock is tracked; from T1 to T2. The red trajectory shows the normal price fluctuations of the share i.e the price movement of the share without a SWF capital injection in the underlying firm. The green trajectory shows the price movement of the stock after a capital injection in the underlying firm by a SWF. In the diagram above, the share falls from point a to b until a SWF injects capital in the firm at point b (T1+1 : P3) . The share price then takes the green trajectory labeled b, f, g, h instead of the red trajectory labeled c, d, e. From the graphical illustration, you can see that the green trajectory has fewer peaks and dips; i.e it is more stable than the red trajectory. The most important thing to note is that prices on the green trajectory are generally higher than prices on the red trajectory. This implies that the SWF capital injection restored public faith in the firm and stopped the firms price from falling further.To calculate the stabilizing effect of the SWF capital injection, you would have to:
- Calculate the gradient on the red trajectory between points c,d,e
- Calculate the gradient on the green trajectory between points b,f,g,h
- Find the difference between the gradients and express it as a percentage of the gradient between points c,d,e
To calculate the short-term financial effect (in a standard unit of currency eg dollars or euros) of the SWF's investment on the firm's share price:
Which reads the financial effect of a SWF's investment on a firm's share price is the total sum of; the difference between chronologically corresponding share prices on the green trajectory and the red trajectory; during the time period TI to T2
Where:
Assuming that SWFs will replicate the investment strategy they employed in bank bailouts to the broad portfolios of common stock they are now diversifying into: it can be argued that their involvement will help to stabilize equity markets in the same way it stabilized the financial services sector during 2007-2008 credit crunch.
2) Negatively impact the provision of Social Goods:
The diversification of SWFs out of bond markets spells doom for most borrowers--especially the US government. SWFs were a major player in the markets for US government issued bonds; where they purchased bonds that most investor classes wouldn't touch. Their exit from (government issued) bond markets will make it cumbersome (if not impossible) for the US government to raise cost-effective funding through bond issues. Simply put: The US government faces the strong risk of failing to raise adequate funding for the provision of social goods. This implies that the social welfare of US citizens may be compromised by SWFs' diversification out of US bond markets.
Where:
- Feff is the financial effect of a SWFs investment
- t is any time period between T1 and T2
- Pgt any share price on the green trajectory between the time period T1 to T2
- Prt any share price on the red trajectory between the time period T1 to T2
Assuming that SWFs will replicate the investment strategy they employed in bank bailouts to the broad portfolios of common stock they are now diversifying into: it can be argued that their involvement will help to stabilize equity markets in the same way it stabilized the financial services sector during 2007-2008 credit crunch.
2) Negatively impact the provision of Social Goods:
The diversification of SWFs out of bond markets spells doom for most borrowers--especially the US government. SWFs were a major player in the markets for US government issued bonds; where they purchased bonds that most investor classes wouldn't touch. Their exit from (government issued) bond markets will make it cumbersome (if not impossible) for the US government to raise cost-effective funding through bond issues. Simply put: The US government faces the strong risk of failing to raise adequate funding for the provision of social goods. This implies that the social welfare of US citizens may be compromised by SWFs' diversification out of US bond markets.
