SWF Asset Allocation after the Financial Crisis Increased Diversification Requires Enhanced Political Risk Management Dr. Eliot Kalter President, E M Strategies Senior Fellow, The Fletcher School EKalter@EMStrategies.com March 2012
Presentation Topics I. Emerging Market Strength Continues After the Financial Crisis II. EM Financial Markets Still Have Significant Room to Grow III.Why do SWFs matter? Factors Driving Their Growth IV.Asset Allocation Diversifies Beyond Traditional Geography and Asset Classes for SWFs and Other Long Term investors V. Global Implications of SWF Growing Resources VI. Socio Political Risks Faced by SWF and Other Long Term Investors
Overview Presentation I. EM Countries Weathered the Financial Crisis Better than Advanced Economies
Drivers of Global Growth As a result, EM countries will drive most of global growth through 2016
II.EM Financial Markets: Sizable Room to Grow There is a clear relationship between rising income and the depth of financial markets 2010, end of period 60000 Per Capita Income 50000 40000 30000 20000 Argentina Hungary South Korea United States Japan Portugal Spain Switzerland 10000 0 Kenya Peru Colombia Vietnam Russia India Brazil China Malaysia 0 100 200 300 400 500 600 700 Financial Depth (% of GDP) Financial depth measured by Debt and Equity outstanding/gdp; Per Capital GDP at PPP $ per person log scale; Source: BIS, S&P, McKinsey Global Banking
Global Share and Growth of Capital Markets Emerging markets account for small (18%) but rapidly growing share of global financial markets Source: BIS, Dealogic, S&P, McKinsey Global Banking
III. Why Do SWFs Matter? Factors Driving SWF Growth International reserves reached levels beyond those needed to buffer external vulnerabilities in many EM countries Reserve accumulation must be sterilized to be non inflationary; domestic cost of sterilization greater than return on central bank investments SWFs do not face same investment restrictions as central banks Growth of SWFs also driven by need to insulate economy from volatile commodity prices, share wealth across generations and fund priority projects SWFs long term investment horizon helps global financial stability
Global Imbalances Global imbalances are driving the growth of SWFs; they are projected to continue
IV. Asset Allocation Diversifies beyond Traditional Geography and Asset Classes Many SWFs noted during discussions with Sovereign Wealth Fund Initiative that they are increasing their asset allocation in emerging and frontier markets, as well as in new investment vehicles Factors driving diversified asset allocation: Mandate of SWFs gives them advantage with ability for long term investment Impact of global crisis with less faith in advanced economy financial systems Low returns from advanced economy fixed income Benefits of asset diversification
SWFs have diversified across all asset classes with increasing allocation to alternatives
SWF Investments are Geographically Diverse SWF s investments shifted out of N. America and to Europe following the 2008 financial crisis Need for broader understanding of risk management as asset allocation diversifies
Pension Funds have also diversified across all asset classes with increasing allocation to alternatives 1995-2011 Throughout the period, pension fund asset allocation: declined for equities and increased for alternative assets a fall earlier in the decade in the allocation to bonds reversed in recent years in recent years, risk management included increased exposure to alternative assets mainly coming out of equity investments
40 Percentage of European Pension Plans with Emerging Market Exposure 35 30 Percent 25 20 Specific Allocation Included in Global Benchmark Manager has Discretion to Invest 15 10 5 0 2010 2011 2011 2011 2010 2011 2011 2011 2010 2011 2011 2011 Emerging Market Equity Emerging Market Debt Infrastructure/Property
V. Global Implications of Growing Resources of SWFs Increasing resources of SWFs (with transfer from Central Banks) could affect relative price of equities to fixed income securities SWFs will increasingly play a stabilizing role in global markets with their long term investment horizon Facilitate broadening of markets in EM Countries and upward pressure on EM prices (1% shift in long term investor allocation to EM countries would result in $600 billion inflow, equivalent to 2 ½ % of EM market capitalization much of which is still not liquid) Need for broader understanding of risk management as asset allocation diversifies
VI. Social Political Risks Faced by SWFs with Diversification Beyond Traditional Geography and Asset Classes SWF investments require organizational and leadership capabilities to effectively manage risk in potentially difficult socio-political environments, while at the same time ensuring that their basic objectives are met Effective risk mitigation aimed at optimizing a successful long-term investment outcome requires: Traditional risk management for liquidity and solvency risk Socio political risk assessment in target country and country of origin Incorporating social and political risk scenarios into the strategic plan Gathering a deeper understanding of perspectives of recipient country and company Developing strategies that align with stakeholder interests and priorities Enhancing internal governance and implementing prudent operating practices Creating architecture for managing multiple external relations Incorporating risk mitigation considerations into actual operations
Political Risk Management Must Keep Up with the Rapid Diversification of Asset Allocation Political risk is commonly defined in terms of unexpected political climate investors must take into account underlying causes for adverse political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives. Political risk can also stem from investors not well understanding the eventual impact of existing political climate In a macro sense, investors did not fully incorporate the financial implications of the political/social system in the EU which lead to unsustainable budgets in the face of structurally low growth. Similarly, investors did not take into account the impact of the anti regulatory bias that existed in the main financial center countries with competition for business leading to sub optimal regulatory frameworks. In the micro sense, political risk exists, inter alia, if there is not a clear understanding of the existing relationship between governments and their labor unions, or the judiciary system that may be biased or underdeveloped with consequences for business operations and growth.
Global Importance of Getting Risk Analysis Right Political risk analysis is particularly important for long-term investors: SWFs have the capacity to become increasingly important as a source of long term financing and global stability. However, we have seen that SWFs will quickly withdraw from sectors (reduced allocations to the financial sector following losses after the 2008 crisis) and geographic regions (the current reduced allocation to EU countries) Emphasis must placed on a number of fronts to better equip SWFs and other LTIs to account for political risk consistent with the speed of their asset diversification. need for a clear eyed assessment of a country s political ability to confront growing public sector indebtedness SWFs and other LTIs must deepen their understanding of recipient countries socio political risks and develop strategies that take into account countries financial, political and social interests and priorities
Emerging Markets after the Financial Crisis Perspective of Sovereign Wealth Funds and other Institutional Investors Dr. Eliot Kalter President, E M Strategies Senior Fellow, The Fletcher School EKalter@EMStrategies.com March 2012
I. EM Countries Weathered the Financial Crisis Better than Advanced Economies
EM Economic Growth is Driven by Both Consumption and Investment
Strong Fiscal Policy and Declining Public Debt Underlie EM Strength
Global Growth versus Pre Crisis Average Global growth exceeds pre-crisis levels in EM Countries with particular strength in Latin America
Real GDP in 2011 in Percent of Pre Crisis Trends (pre crisis trend based on 1996 2006 real GDP growth) Advanced Economies are uniformly below pre-crisis growth trends, projected to remain so though 2016; in contrast, most EM countries are above pre-crisis trend and projected to increase growth through 2016
Drivers of Global Growth As a result, EM countries will drive most of global growth through 2016
II.EM Financial Markets: Sizable Room to Grow There is a clear relationship between rising income and the depth of financial markets 2010, end of period 60000 Per Capita Income 50000 40000 30000 20000 Argentina Hungary South Korea United States Japan Portugal Spain Switzerland 10000 0 Kenya Peru Colombia Vietnam Russia India Brazil China Malaysia 0 100 200 300 400 500 600 700 Financial Depth (% of GDP) Financial depth measured by Debt and Equity outstanding/gdp; Per Capital GDP at PPP $ per person log scale; Source: BIS, S&P, McKinsey Global Banking
Global Share and Growth of Capital Markets Emerging markets account for small (18%) but rapidly growing share of global financial markets Source: BIS, Dealogic, S&P, McKinsey Global Banking
III. Why Do SWFs Matter? Factors Driving SWF Growth International reserves reached levels beyond those needed to buffer external vulnerabilities in many EM countries Reserve accumulation must be sterilized to be non inflationary; domestic cost of sterilization greater than return on central bank investments SWFs do not face same investment restrictions as central banks Growth of SWFs also driven by need to insulate economy from volatile commodity prices, share wealth across generations and fund priority projects SWFs long term investment horizon helps global financial stability
Relevance of Sovereign Wealth Funds : Factors Driving Growth SWFs are a small compared with other institutional investors but have grown rapidly
SWFs Not a Homogenous Group Stabilization Funds Insulate Budget/Economy (e.g. Chile, Kazakhstan, Azerbaijan, Algeria, and Venezuela) Savings Funds Inter generational transfer (e.g. Kuwait, Qatar, U.S., Alaska) Reserve Investment Corporations Part of Reserves; Increasing Returns (e.g. Korea) Development Funds Socio Economic Objectives Contingent Pension Reserve Funds Finance unspecified; contingent pension liabilities of governments (Australia, New Zealand)
Portfolios Reflect Investment Horizons and Mandate
Global Imbalances Global imbalances are driving the growth of SWFs; they are projected to continue
IV. Asset Allocation Diversifies beyond Traditional Geography and Asset Classes Many SWFs noted during discussions with Sovereign Wealth Fund Initiative that they are increasing their asset allocation in emerging and frontier markets, as well as in new investment vehicles Factors driving diversified asset allocation: Mandate of SWFs gives them advantage with ability for long term investment Impact of global crisis with less faith in advanced economy financial systems Low returns from advanced economy fixed income Benefits of asset diversification
Impact of Global Financial Crisis on Asset Allocation to Emerging Markets Reinforcing the secular shift of financial and economic power away from the traditional centers of the U.S. and Western Europe and towards emerging markets with varying structure, transparency and accountability Ridding investors of the perception that developed markets in the West are less risky and more secure than emerging markets Gradual shift of asset allocation to alternative assets and emerging market debt and equity to meet public policy objectives Asset allocation to Latin America is expected to increase from low levels; Asia should see significant increases as well
SWFs have diversified across all asset classes with increasing allocation to alternatives
SWF Asset Allocation, 2007 vs. 2009 The type of SWF investments, extent of diversification vary greatly depending on mandate; however, SWFs increased diversification of investments across mandates
SWF Asset Allocation (% of total at 2010) Cash Equities Bonds Alternatives RE PE Infra HF Credit Norway -- 53% 42% 5% UAE/ADIA -- 45-75% 10-20% 5-10% 5-10% 2-8% -- 1-2% UAE/ADIC -- -- -- active strategy China CIC 25-30% 5-10% 50-65% Kuwait KIA 3-7% 55-65% 8-12% 8-12% 3-7% Singapore GIC 8% 38% 25% 12% 15% 5% -- -- Singapore Temasek 70% 30% -- -- Australia 37% 33% 20% 1% 3% 2% 4% -- UAE/Mubadala -- -- -- 100% Korea/KIC 3% 20% 70% 7% Bahrain -- -- -- 100% UAE Istithmar -- -- -- 60% 40% -- -- -- Chile 30% 70% -- -- -- -- -- Alaska 3% 54% 22% 10% 6% 4% -- -- Canada/Alberta 3% 46% 25% 14% 8% -- 6% --
SWFs have diversified across all geographic region Number of SWF Investments by Target Location, 2000-09
SWF Investments are Geographically Diverse SWF s investments shifted out of N. America and to Europe following the 2008 financial crisis Need for broader understanding of risk management as asset allocation diversifies
SWF Investment Moved Toward EM Countries in 2010 as Global Risks Subsided
Top Five SWF Investments in 2010 by Size One example of geographic diversity
Geographic Distribution Own-Region/Global Europe North America Developed Asia Emerging Markets Norway 55% 35% 10% UAE/ADIA 25-35% 35-50% 10-20% 15-25% UAE/ADIC 90/10% China CIC 50/50% Kuwait KIA 35-40% 35-40% 13-17% 4-6% Singapore GIC 25% 40% 25% 10% Singapore Temasek 30/70% 25% 65% 11% UAE/Mubadala 74/26% Korea/KIC 0/100% Bahrain 100/0% UAE Istithmar 30% 20% 40% 10% Chile 40% 50% 10%
Pension Funds have also diversified across all asset classes with increasing allocation to alternatives 1995-2011 Throughout the period, pension fund asset allocation: declined for equities and increased for alternative assets a fall earlier in the decade in the allocation to bonds reversed in recent years in recent years, risk management included increased exposure to alternative assets mainly coming out of equity investments
Shift in Pension Fund Asset Allocation 2001 2011
40 Percentage of European Pension Plans with Emerging Market Exposure 35 30 Percent 25 20 Specific Allocation Included in Global Benchmark Manager has Discretion to Invest 15 10 5 0 2010 2011 2011 2011 2010 2011 2011 2011 2010 2011 2011 2011 Emerging Market Equity Emerging Market Debt Infrastructure/Property
V. Global Implications of Growing Resources of SWFs Increasing resources of SWFs (with transfer from Central Banks) could affect relative price of equities to fixed income securities SWFs will increasingly play a stabilizing role in global markets with their long term investment horizon Facilitate broadening of markets in EM Countries and upward pressure on EM prices (1% shift in long term investor allocation to EM countries would result in $600 billion inflow, equivalent to 2 ½ % of EM market capitalization much of which is still not liquid) Need for broader understanding of risk management as asset allocation diversifies
VI. Social Political Risks Faced by SWFs with Diversification Beyond Traditional Geography and Asset Classes SWF investments require organizational and leadership capabilities to effectively manage risk in potentially difficult socio-political environments, while at the same time ensuring that their basic objectives are met Effective risk mitigation aimed at optimizing a successful long-term investment outcome requires: Traditional risk management for liquidity and solvency risk Socio political risk assessment in target country and country of origin Incorporating social and political risk scenarios into the strategic plan Gathering a deeper understanding of perspectives of recipient country and company Developing strategies that align with stakeholder interests and priorities Enhancing internal governance and implementing prudent operating practices Creating architecture for managing multiple external relations Incorporating risk mitigation considerations into actual operations
Traditional Risk Management for Liquidity and Solvency Risk Sovereign and company risk assessment traditionally take into account solvency risk (the underlying ability to meet obligations) and liquidity risk (sufficient cash flow to meet current obligations) The IMF analyzes macroeconomic, financial and structural factors that result in a country s projected economic growth, debt and debt service and, thus, a country s ability to meet current and future (domestic and external) obligations. Portfolio risk assessment is well covered by financial advisory firms. A good example of this approach is the State Street Global Markets use of five tenets of portfolio construction that take into account, inter alia: non normal return distributions such as fat tails, correlations between fund holdings and the returns from the source of funding, and risk factor analysis to identifying underlying investment risk factors that describe the return variation in a particular portfolio or asset.
Political Risk Management Must Keep Up with the Rapid Diversification of Asset Allocation Political risk is commonly defined in terms of unexpected political climate investors must take into account underlying causes for adverse political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives. Political risk can also stem from investors not well understanding the eventual impact of existing political climate In a macro sense, investors did not fully incorporate the financial implications of the political/social system in the EU which lead to unsustainable budgets in the face of structurally low growth. Similarly, investors did not take into account the impact of the anti regulatory bias that existed in the main financial center countries with competition for business leading to sub optimal regulatory frameworks. In the micro sense, political risk exists, inter alia, if there is not a clear understanding of the existing relationship between governments and their labor unions, or the judiciary system that may be biased or underdeveloped with consequences for business operations and growth.
Political Risk Management Must also Take Into Account Risks in Country of SWF Origin SWFs must not only face political risk in the country targeted by their investments but also political risk in the country of SWF origin Based on the EIU Democracy Index, over half of SWF assets have authoritarian regimes as their origin. This increases the risk of political upheaval or sudden asset allocation shifts with pressure for SWF assets to be used for shorter term investments or public savings, financial sanctions freezing SWF assets, and investments made for political rather than commercial purposes
Global Importance of Getting Risk Analysis Right Political risk analysis is particularly important for long-term investors: SWFs have the capacity to become increasingly important as a source of long term financing and global stability. However, we have seen that SWFs will quickly withdraw from sectors (reduced allocations to the financial sector following losses after the 2008 crisis) and geographic regions (the current reduced allocation to EU countries) Emphasis must placed on a number of fronts to better equip SWFs and other LTIs to account for political risk consistent with the speed of their asset diversification. need for a clear eyed assessment of a country s political ability to confront growing public sector indebtedness SWFs and other LTIs must deepen their understanding of recipient countries socio political risks and develop strategies that take into account countries financial, political and social interests and priorities
Emerging Markets after the Financial Crisis Perspective of Sovereign Wealth Funds and other Institutional Investors Dr. Eliot Kalter President, E M Strategies Senior Fellow, The Fletcher School EKalter@EMStrategies.com March 2012