Poverty, SWFs and Oil

An article from The Economist raises the issue of which countries with SWFs also have large numbers of people living below or near the poverty line. 

ECONOMISTS Abhijit Banerjee and Esther Duflo describe the results of a number of household surveys they carried out in developing countries in their new book “Poor Economics”. Their data allow comparisons of the full distribution of consumption per person in a number of developing countries, in addition to the more commonly available figures on the fraction of people living on less than $2 a day. In some of these countries, many of those who consume enough to ensure they do not count as “poor” are in fact only a bit better off than those who do. Nearly 80% of the 30.6% of Bangladeshis who consume more than $2 a day in fact consume only between $2 and $4 a day—still very little indeed. A little bit of bad luck—a single bad harvest, for example—may be all it takes to send them back to living below the poverty line.

Here are same countries showing their SWF status (data from the SWF Institute or fund websites) and an indication of each country's oil production (noting of course that SWFs also arise from non-oil wealth):

Country	SWF status	Oil Production bbl/day
India	None	878,700
Ghana	New SWF March 2011	7,081
Pakistan	None	59,140
Bangladesh	None	5,733
Tanzania	None	No oil
Timor-Leste	US$7.7 billion ($7,600 per capita)	96,270
Cote d'Ivoire	None	58,950
Indonesia	US$0.3 billion ($1 per capita)	1,023,000
Morocco	None	4,053
Nicaragua	None	No oil
Guatemala	None	13,530
Papua New Guinea	None	35,090
Mexico	None	3,001,000
Peru	None	148,000
Brazil	$8.6 billion ($45 per capita)	2,572,000
Ecuador	None	485,700
South Africa	None	191,000
Panama	None	2

If you add them up, these countries between them produce just short of 10% of the world's oil. Because oil is a non-renewable resource it can be viewed as the property of both current and future generations.  Only Timor-Leste amongst The Economist's list of poor nations seems to be taking serious steps towards viewing oil as an intergenerational resource.  Then again, its people are still living in poverty.  But so are those in countries that have far greater petroleum wealth. 

How should we define a Sovereign Wealth Fund?

This question is posed by the SWF Institute in a recent post.  The Institute offers the following definition:

A Sovereign Wealth Fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets. These assets can include: balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports. Sovereign Wealth Funds can be structured as a fund, pool, or corporation. The definition of sovereign wealth fund exclude, among other things, foreign currency reserve assets held by monetary authorities for the traditional balance of payments or monetary policy purposes, state-owned enterprises (SOEs) in the traditional sense, government-employee pension funds, or assets managed for the benefit of individuals.
Some funds also invest indirectly in domestic state-owned enterprises. In addition, they tend to prefer returns over liquidity, thus they have a higher risk tolerance than traditional foreign exchange reserves.

This definition raises some issues.  First, are these funds necesssarily "state-owned", i.e. by national governments?  The SWF Project, in a recent article, Who is the King of SWFs?, identifies a number of qualifying funds at the individual state level.  Further, is an SWF defined by the nature of its target investments, in this case restricting SWFs to those that own financial assets and financial instruments (though generously including real estate under that umbrella and leaving infrastructure somewhat out of the picture). 

In the search for a brief definition most sources, including the definition above, feel the need for some explanatory material, such as what types of assets should be excluded, e.g. central bank reserves.  Is is possible to find a better definition?  Unsurprisingly, the experts have been working on the subject.

Wikipedia offers the following definition:

A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals or other financial instruments.

The Santiago Principles provides a fairly general definition,

Sovereign wealth funds (SWFs) are special purpose investment funds or arrangements that are owned by the general government.

The European Central Bank, in its Occasional Paper No 91, July 2008, suggests:

Sovereign wealth funds (SWFs) [are] broadly defined as public investment agencies which manage part of the (foreign) assets of national states.

Although there exists no commonly accepted definition of SWFs, three elements can be identified that are common to such funds: First, SWFs are state-owned. Second, SWFs have no or only very limited explicit liabilities and, third, SWFs are managed separately from official foreign exchange reserves.

The International Monetary Fund, which has an interest in ascertaining what pools of money exist and who controls them in the context of international financial management and balances of payments, keeps to the definition in the Santiago principles:

SWFs are defined as a special purpose investment fund or arrangement, owned by the general government. Created by the general government for macroeconomic purposes, SWFs hold, manage, or administer financial assets to achieve financial objectives, and employ a set of investment strategies which include investing in foreign financial assets.  SWFs are commonly established out of balance of payments surpluses, official foreign currency operations, the proceeds of privatizations, fiscal surpluses, and/or receipts resulting from commodity exports.

And what is this 'general government' whereof the IMF speaks?  The European Central Bank provides this definition:

A sector defined in the ESA 95 as comprising resident entities that are engaged primarily in the production of non-market goods and services intended for individual and collective consumption and/or in the redistribution of national income and wealth. Included are central, regional and local government authorities as well as social security funds. Excluded are government-owned entities that conduct commercial operations, such as public enterprises.

So, there we are.  While there seems to be a focus on the assets and mentions of purposes, none of the definitions seems to capture the idea that sovereign wealth funds have beneficiaries.

The Sovereign Investor therefore offers its tuppenceworth with this definition:

A Sovereign Wealth Fund is a special purpose fund or arrangement set aside from official foreign exchange reserves and maintained by a central, regional or local government authority, whereby funds are invested at least partially in international assets over the longer term for the benefit of current or future generations. 

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UK Pensions Industry disapproves of IFRS accounting proposals

From Global Pensions

Just a quarter of the UK pensions industry supports plans to make all schemes compliant with International Financial Reporting Standards, a poll shows.

A poll - conducted by Deloitte - revealed 75% of trustees, administrators and accountants did not support the Accounting Standards Board's plans to classify pension schemes as ‘publicly accountable' entities to comply with IFRS.

The poll of 80 respondents also showed a further 43% said pension schemes' financial reporting requirements did not need changing at all.

Deloitte audit partner Sue Barratt said: "We are surprised that all pension schemes are being proposed as publicly accountable entities, given that there are many small schemes with few members.
"It is doubtful whether such schemes hold assets for a ‘broad group of outsiders', which is part of the ASB's definition of ‘publicly accountable'."

Under the proposals, pension schemes would be classified as tier 1 in the ASB tier structure, putting them on par with a listed company in their accounting requirements.

The survey also found 29% thought accounting standards needed changing, with 28% saying they were unsure.

A concern expressed by many respondents was that the potential administrative burden and expense of changing existing frameworks may not lead to a greater understanding of pension scheme accounts by members.

Barratt added: "While the ASB has indicated minimal changes in reporting by pension schemes, examples from other countries that have adopted the equivalent IFRSs for pension scheme accounts have led to significant, additional disclosures in financial statements.

"Considering this, there is likely to be more debate as to which accounting standards would be most relevant for pension schemes, in advance of the ASB's consultation period closing on 30 April."

Sovereign Investor:   The great majority of UK trustees, administrators and accountants believes that managing money on behalf of others does not make them publicly accountable.  It seems worth exploring the possible reasons why, because the same principles may apply - in a more general way - to sovereign funds.

The Chartered Accountants in Canada have this definition of 'publicly accountable':

A publicly accountable enterprise is an entity, other than a not-for-profit organization, or a government or other entity in the public sector, that:

• has issued, or is in the process of issuing, debt or equity instruments that are, or will be, outstanding and traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets); or  

• holds assets in a fiduciary capacity for a broad group of outsiders as one of its primary businesses. 

In the United Kingdom, the definition provided by the Financial Reporting Council is very similar:

An entity has public accountability if:

• (a) at its reporting date, its debt or equity instruments are traded in a public market or it is in the process of issuing such instruments for trading in a public market (a domestic or foreign stock exchange or an over‐the‐counter market, including local or regional markets); or
• (b) as one of its primary businesses, it holds assets in a fiduciary capacity for a broad group of outsiders and/or is a deposit taking entity for a broad group of outsiders. This is typically the case for banks, credit unions, insurance companies, securities brokers/dealers, mutual funds and investment banks.

In both cases, the holding of assets in a fiduciary capacity for a group of outsiders is expressly included in the definition of public accountability, and so it ought to be.  The Sovereign Investor wonders, then, whether the trustees have a problem with IFRS per se or, whether having taken hold of their members' money, they regard the funds as somehow being their own property, at least for the time being.


They wouldn't understand more comprehensive reporting, anyway

The argument that more comprehensive reporting may not be understood by members is an old chestnut.  In many countries sovereign funds hold assets on behalf of people who may not even be literate, and this should make them more accountable, if anything.  The fact that not everyone is financially literate merely provides an excuse for the trustees and their colleagues to try and avoid accountability to those members, other stakeholders and industry commentators, who do understand these matters.  In finance, as we know and was proved during the GFC, the devil is always in the details. 

Yes, IFRS reporting can be bulky.  It's just as well that in December 2010 the International Accounting Standards Board issued a Practice Statement about having a management commentary.  The Practice Statement provides a broad, non-binding framework for the presentation of management commentary that relates to financial statements prepared in accordance with IFRS.

Management commentary is a narrative report that provides a context within which to interpret the financial position, financial performance and cash flows of an entity. It also provides management with an opportunity to explain its objectives and its strategies for achieving those objectives. Management commentary encompasses reporting that jurisdictions may describe as management’s discussion and analysis (MD&A), operating and financial review (OFR), or management’s report.

We don't have to understand the technicalities of air bags, advanced braking systems and other safety features before being allowed to drive our cars.  The Sovereign Investor would, however, like to think that its ignorance on these matters shouldn't be used as an excuse by car manufacturers to avoid accountability to the relevant authorities for compliance at a technical level with safety standards.

Linaburg-Maduell Transparency Index Ratings - Q1Y2011

For the record.  

 

(Click for full sized image)

For more information on the Linaberg-Maduell Index, see the SWF Institute.

Proxy firms move to centre stage

From the Financial Times

Annual meeting season is in full swing on both sides of the Atlantic. This year, a new player is being dragged onstage to perform alongside traditional characters such as the generously-paid-off former executive and the lone campaigning investor. The proxy adviser’s moment is here.

Proxy firms’ reluctant move from their behind-the-scenes role has two causes.

In the US, it stems from reaction to the first annual meetings to be subject to advisory “say on pay” votes. As shareholders have persuaded some companies to change pay policies and voted against the remuneration reports of a handful who were not listening hard enough, attention has shifted to the firms such as ISS and Glass Lewis & Co which advise institutional investors how to vote.

In Europe, meanwhile, regulators have started looking at proxy firms because institutional shareholders are becoming more dependent on them. This reliance comes as investors must respond to criticism that they were too dozy during the financial crisis, while managing widely diversified portfolios: Norges Bank Investment Management, the Norwegian state fund manager, has holdings in more than 8,000 companies, for example.

Sovereign Investor: Only the beginning of the FT's article on proxy voting companies has been reproduced here.  Email ftsales.support@ft.com to buy additional rights or use this link to reference the original FT article - http://www.ft.com/cms/s/0/976fd594-6e89-11e0-a13b-00144feabdc0.html#ixzz1KVhxoMSZ

The primary issue with transparent sovereign funds, and Norway is an example, is that the funds' voting records may be published.  Relying on proxy advisors is a useful administrative measure for sovereign investors, but efforts would seem to be justified in understanding the published policies of the proxy advisors (see, for example, the ISS policies) to be sure that stakeholders understand the reasons for the voting record.  Note that these policies, again looking to ISS for example, are subject to an annual consultation process and perhaps those institutions who rely on proxy voting companies should consider advising stakeholders to participate in that process.  

Reflecting on Ghana's new Sovereign Funds

By Ashby Monk, from Oxford SWF Project

Back in March, Ghana’s Parliament passed the Petroleum Revenue Management Act, formally creating two new Ghanaian sovereign funds: the Ghana Heritage Fund and the Ghana Stabilization Fund. I’ve finally had the time to read the Act in its entirety, and I found it rather interesting. Given Ghana’s consistent high scores for good governance, you won’t be surprised to learn that the Act has many of the ‘best principles’ of design and governance. Still, there were a few aspects of the Act that have caused controversy. But before I get into that, let me catch you up.

As their names imply, the Stabilization Fund will help smooth petroleum revenues, while the Heritage Fund will be an inter-generational savings fund. The Minister of Finance will be responsible for overall management of the funds, but the Central Bank will be responsible for the day-to-day operations. If this setup sounds familiar, it’s because this is pretty much a carbon copy of the Norwegian design: the NBIM manages the money (Central Bank) and the GPF-G has oversight for policy (Ministry of Finance).

In Ghana’s case, the Central Bank will be constrained in its investment options. Basically, the new SWFs can only invest the assets in investment grade fixed income securities (although the Act does offer quite a bit more detail as to what that actually means). This reminds me of the approach adopted by Timor-Leste, which decided to start slow (with fixed income) and diversify over time (which it is doing now). It’s a sensible way to go about things, as top notch institutional investors do not emerge overnight.

And yet, while the Act is quite sophisticated and solid, it has not been without controversy. For example, there is a provision that allows the government to borrow against the oil assets in the funds. That’s not something I would have included because it reduces the disciplining effect the funds should have on politicians’ spending habits. In short, while the Act does a good job of defining what the fiscal rules are for fund contributions and withdrawals, the ability to borrow unconstrained money (even if it is backed by a highly constrained, rule-bound SWF) undermines the power of the SWF’s rules and governance practices.

In addition, many were against the Heritage Fund, on the grounds that the country faces serious developmental challenges that require capital investment today. And it’s a fair point. I’ve noted before that (setting aside capacity constraints and Dutch Disease) there is a very good case to spend the money on domestic infrastructure with lasting economic benefits for developing countries.

Whatever the case, all credit to Ghana for taking some initial steps to prevent the resource curse. But there are many more steps to come. Next up on the agenda: implementation and operation.

Sovereign Investor:  It is interesting to compare the new Ghana Act with the equivalent law in Timor-Leste, on which the Ghana Act appears to have drawn heavily.  Both provide strong division of duties between the investment policy role (Ghana's Advisory Committee and Timor-Leste's Investment Advisory Board), the overall management (Ministry of Finance), and the operational management (central bank).  This structure has the effect of removing (as far as possible) political influence in both the setting of the investment policy (by the Advisory Board) and the implementation of the investment objectives (by the central bank).  Both laws have transparency as a fundamental principle.  Both countries have a committee (Ghana - Accountability Committee; Timor-Leste - Consultative Council) that assists parliament and the population monitor compliance with the relevant laws.  Both countries require the detailed publication of who has paid into the fund - Ghana requires quarterly publication, Timor-Leste requires the information to be published annually.  There are a number of other parallels too. 

By adopting robust governance structures and transparency, both countries appear committed to avoiding the inevitable risks associated with a large fund being solely and opaquely under the influence of a single person or ministry, and have instead adopted a system of institutional checks and balances at the highest level as an effective means of overall governance.  

The Characteristics of Factor Portfolios

From MSCI Factor and Risk Modelling Insights

Research from MSCI's Jose Menchero was recently published in The Journal of Performance Measurement. This paper provides an intuitive foundation for understanding and interpreting factor models. It shows every factor can be represented by a factor-mimicking portfolio, whose return exactly replicates the payoff to the factor. Pure factors provide a way of placing surgical bets and disentangling the often confounding effects of multi-collinearity. Read this paper.

Abstract:

 A key to deeper understanding of factor models lies in the concept of factor-mimicking portfolios, whose returns exactly replicate the payoffs to the factors. Factor-mimicking portfolios can be used to generate real-time factor returns and in principle could serve as the basis for exchange traded funds for capturing passive alpha or hedging risk. Simple factor portfolios are obtained by considering each factor in isolation, whereas pure factor portfolios are constructed by treating all factors jointly. In this paper, we derive the holdings of simple factor portfolios for the World factor, as well as for countries, industries, and styles. We also discuss the characteristics of pure factor portfolios and how differences between simple and pure factor portfolios arise due to collinearity between factors.

We introduce several intuitive measures of collinearity in factor models and present their empirical distributions in the context of a global equity model. Finally, we describe how collinearity can be reduced through factor rotation and discuss the interpretation of such factors.

AsianInvestor picks its 2011 winners

AsianInvestor is currently announcing its 2011 award-winners over a period of four days.  

Awards with a global theme include:  

Distributor of the year, commercial bank
HSBC

Global fixed income, hedged
Credit Suisse Asset Management

Global fixed income, unhedged
Amundi

Global equity
Schroder Investment Management

Real-estate investment trusts, global
LaSalle Investment Management Securities

There are regional and country awards too.  Find out who all the winners are at AsianInvestor. 

India opening up to Sovereign Wealth Funds

From  SWF Institute

Historically, investment access to India’s equity markets has created several problematic issues and headaches for sovereign wealth funds. Currently, sovereign wealth funds are grouped under the category foreign institutional investor or FII defined by the Securities and Exchange Board of India (SEBI).

A few current sovereign-entity FIIs registered include:

• Abu Dhabi Investment Authority
• Abu Dhabi Investment Council
• Australian Future Fund
• Provincial Government of Alberta (AIMCo)
• China’s National Social Security Fund
• Fullerton Fund Management Company LTD (SWE of Temasek Holdings)
• Kuwait Investment Authority
• New Zealand Superannuation Fund
• Norges Bank
• Queensland Investment Corporation
• Singapore’s GIC

Sovereign entities can also invest as a Foreign Venture Capital Investor. FII’s are under strict regulation and cannot hold large positions in listed Indian companies. Times have changed, India wants to increase foreign investment in companies and attract foreign capital. There is a heavily-debated plan underway to create a new defined class of investor for sovereign funds which will be fundamentally different from the FII classification. This new class for sovereign funds would allow them to hold a much larger stake within a publicly traded Indian firm. The plan must be approved by SEBI and receive permission from the Reserve Bank of India. India’s fear was that foreign governments could create numerous sovereign entities to bypass the 10% rule and thus effectively control the company for geopolitical reasons.

Recently, the Government of Singapore Investment Corporation opened up an investment office in Mumbai. This was after India and Singapore signed an economic agreement. The Indian Government would also treat Temasek Holdings and GIC as separate investors, not acting in concert in potential large stake undertakings. Sovereign wealth funds are warming to investing in the Indian equity markets as the Government of India begins to warm up to foreign investments.

How to survive stock market crashes without getting screwed

By Mark Hebner, President, Index Fund Advisors. 

It happens every time.

Toward the end of long bull markets, when stocks finally begin to feel safe and everyone’s making money, folks that are nervous about investing in the stock market finally begin to relax. They put their money in the market and, lo and behold, for a little while, they do well. They tell themselves they’re in it for the long haul. They promise themselves that they won’t be scared off by the inevitable “dip.”

Then the “dip” finally comes. And they lose 10%-15% of their money. They don’t feel great about that, and stocks don’t seem like such a good idea anymore, but they hang in there. Stocks for the long run! But then the dip becomes a “bear market” — down 20%. And then it becomes a bad bear market — down 30%. And then it becomes a once-in-a-generation bear market — down 40%. And suddenly everyone is saying that stocks are going to fall another 50% from there because the world’s headed to hell in a handbasket.

And, eventually, the folks who put their money in the market near the top can’t take it anymore. So they yank their money out. Better to save what little they have left, they think, than to see all of their hard-earned savings get flushed down the drain.

For a few weeks or months, they feel vindicated: The stock market drops some more. But then it turns around and rallies, and a year later, disgusted, they note that if they had only hung in there, they’d be back to even. And they vow never to invest in stocks again.

This, unfortunately, happens to lots of casual investors. It happens, in part, because investors get bad investment advice. It also happens because investors haven’t learned the history of the stock market and prepared themselves for its gut-wrenching volatility.

But the good news is, it doesn’t have to happen. As long as investors understand how the market behaves and have a concrete plan for dealing with this volatility, they can actually benefit from market crashes rather than get destroyed by them.

In this video, I talk with advisor Mark Hebner of Index Funds Advisors about how IFA has handled the past decade. Like other disciplined asset managers, IFA constructs portfolios designed to match the risk-tolerance of each individual investor and then uses portfolio rebalancing to keep this risk constant, regardless of what the market is doing.

IFA’s funds have done very well over the past decade, despite the S&P 500 having been down over the period. Because IFA prepared its clients for the market volatility, they did not freak out and sell everything at the bottom.

Source: http://finance.yahoo.com/blogs/daily-ticker/survive-stock-market-crashes-without-getting-screwed-according-143507867.html#more-id


Sovereign Investor:   With the rise of dynamic asset allocation, will sovereign/institutional investors really be any better off, or will they and up (supported by weighty presentations and recommendations from asset advisors) behaving like the individuals described in this article as they try to pick market trends?  To what extent is the dynamic asset allocation approach funadamentally in conflict with developing and sticking to a long-term strategy supported by periodic rebalancing? 

Diversification by omission

From Fama/French Forum

Can investors build a better portfolio by combining asset classes that have low correlations? It is possible, explains Ken French, but not in the way that most investors attempt it. Some think they can enhance diversification by eliminating mid caps and concentrating on only large and small cap stocks because these asset classes are less correlated. Ken explains that portfolio variance is determined not only by correlation, but also by variance of the individual asset classes and, critically, by their weighting in the portfolio. He emphasizes that throwing out mid caps is equivalent to doubling up on the risk of large and small caps, which is the opposite of diversification.

 (View the video)