This essay draws attention to four areas:
- Investment & Protectionism: Managing Public Opinion and Political Resistance
- Mutual Responsibilities of Providers and Receivers of Funds
- Institutional Design of Investment Funds: Managing Governance, Accountability and Performance
- Investment Objectives & Asset Diversification: Balancing Risk & Returns
Investment and Protectionism: Managing Public Opinion and Political Resistance
An increase in assets placed by Government Investment Funds (GIFs) occurs at a time of increasing protectionist sentiment in developed economies. This development, perhaps more than other salient issues specific to the operation of GIFs, makes the investment climate for such entities more challenging.
For 30 years, beginning with the launching of economic reforms by Deng Xiao Ping in China, Margaret Thatcher in the United Kingdom, Ronald Reagan in the United States, Manmohan Singh in India as well as reforms in many other countries veered global trend towards freer markets. Growing acceptance of foreign investment became part of the global dynamic. The “Washington consensus” led the IMF and World Bank to carry a liberalization agenda to emerging markets. Economic transitions launched in the early 1990s in the countries of the former Soviet Union and Eastern Europe provided second impetus towards a more open investment climate. And privatization expanded the pool of assets potentially open for foreign investment. Cross-border investment in portfolio equity, portfolio debt, and foreign direct investment expanded while banking flows fluctuated without a clear trend. Recently, there has been a change in public sentiment within the G-7 countries – Canada, France, Germany, Italy, Japan, United Kingdom and the United States. As per a Wikipedia entry, as of 2018, these seven countries represent 58% of the global net wealth ($317 trillion) and more than 46% of the global gross domestic product (GDP) based on nominal values, and more than 32% of the global GDP based on purchasing power parity.
Surveys and anecdotal evidence and media reports suggest declining numbers of people within G-7 agreeing that “free trade is good,” that “free markets are good” and “the impact of foreign companies is good.” Majorities still do support free trade and free markets, but acceptance of foreign companies slipped to a minority view within the G-7 in 2019. In contrast, support for globalization has been growing in emerging regions over the past two decades, for global markets are a natural destination for emerging market exports. Foreign firms, operating within the domestic economy, are seen much more positively in the emerging markets than in the older industrial countries. One may logically extrapolate that foreign investors, more generally, are viewed in this way too.
The more protectionist opinions in the G-7 may simply be the inevitable reaction to a long-lasting trend, which eventually runs out of momentum. It also clearly reflects the disappointing economic progress of large parts of the population in the post-industrial countries. The more pro-foreign investment views in most emerging markets suggest that the latter factor is important – improving standards of living have come along with increased foreign investment. The change in climate is also reflected in voices raised in advocacy of government- directed industrial policy and in economic security. This is now also creating pressure to protect sectors that are viewed as strategic in a mindset that sees economic activity in zero-sum terms.
In addition, rapid increases in cross-border investment bring reactions from unfamiliar investors. In part, this has been felt when investors have come from countries with less deep and long-established economic and financial ties, and in part it has been felt by government-affiliated investors – especially in the United States where the Federal government is not a significant holder of economic assets, outside its own debt. These sensitivities have been experienced by GIFs exporting capital to the United States. But, the negative reaction to unfamiliar investors has been broader as shown by political attacks on private equity funds and hedge funds in Europe and Japan. And in general, on forces of free market capitalism. Certainly, mistrust can exacerbate political reactions to investment, but the general climate reinforces such tendencies and creates political problems on a wider front.
Growing anxiety about national security with a new focus on homeland security has also affected the acceptance of foreign investment, especially in the United States. While focus has been on control investments, the public debate has often blurred the distinction between portfolio investment and operation control.
Those who work in global finance are affected by anti-globalization sentiment, and have an interest in countering, by promoting better public understanding of the economic gains from increasing cross-border trade and investment. Lack of public understanding of who foreign investors are, as well as their objectives and their track records are evident in the United States and in other countries today – Jeff Bezos of Amazon received a very lukewarm reception in India, in his visit to India, January 2020. Political leaders often show no greater awareness of the record of foreign investors – evinced by comments of India’s trade minister, Piyush Goyal to Amazon CEO’s visit. Incumbents who stand to benefit, have an interest in promoting policies that build political support for open markets – for example, improving education to prepare people for greater success in globalized markets. But while this climate may persist, it is also necessary to consider ways to minimize the impact of negative sentiment on investment opportunities.
What is needed is, nuanced, more and better discussion of experiences in managing political resistance and to exchange ideas on how this might be done more effectively. Participants in such conversations may wish to address the following:
- Is the difference in attitudes between post-industrial developed countries and emerging markets reflective of experiences making investment in different countries over time?
- What are the differences in the political climate for investment across the G-7, in the developing countries and in key emerging markets? Do these differences call for different approaches?
- Are there particular conditions that heighten the risk of a political response to an investment?
- Are there ways of pre-testing the political climate before an investment is announced?
- What can be done by investors and by countries to keep sensitivities regarding economic security from damaging the climate for investment?
- Is it better to be pro-active or reactive in pursuing a public affairs strategy? Should a public affairs strategy focus first on the political community or directly target opinion leaders and the public? Does this differ from country to country?
- Does working with local investor partners reduce or exacerbate political risk?
Mutual Responsibilities of Providers and Receivers of Funds
As assets managed by GIFs continue to grow and as their risk appetite increases, the responsibilities of both providers and receivers of funds have become intense subjects of discussion. Concerns about rising protectionism, potential reactionary and/or reciprocal treatment, and maintaining the free flow of capital more generally form aspects of the debate. Policymakers, academics, members of the global business community, as well as fund managers have suggested ways to best confront the variety of issues raised by the increasing instances of cross-border investments by foreign government-controlled funds. The IMF and OECD have already produced a draft set of best practices for recipient countries.
Yet, multiple questions remain unresolved:
- Is the development of “best practices” likely to be adequate to keep the critics of foreign investment at bay? And from the investing countries, do the OECD/ IMF and self-adopted best practices provide adequate assurances about rules of the game?
- What means of enforcement of best practices are appropriate, if any? Who decides?
- What institutions should be covered by a “best practices” framework for investment funds? What level of government ownership is “influential,” and how far is “arm’s length” management?
- Some have argued that the absence of an adoption of voluntary guidelines for investment funds could lead to a backlash. Others note that if the funds are needed to support industries in need of capital (such as financial services), the doors will remain open. Which of these realities is likely to prevail?
Institutional Design of Investment Funds: Choices in Governance, Accountability and Performance
It is estimated that over 50 governments now have national investment funds. Institutional designs vary greatly, and many countries in the early stage of developing fund structures are looking to investment funds that have long track records (like ADIA, Norges, Temasek, GIC, and KIA etc.), ostensibly to understand structural and organizational choices. While each government has its own consideration in making organizational decisions, consistent objectives include governance, accountability and performance.
A fundamental governance question is the desirable degree of independence from the government. Some governments, Malaysia – in the news now for the wrong reasons – have prioritized home- country investment and economic development, resulting in an institutional framework that fits within the ministry of finance. Others have created investment corporations, specifically designed to provide some independence from government political intervention, and to emphasize both a commercial and a performance orientation.
A common issue for many governments in the early stages of forming an investment fund is accountability and oversight of the fund; which entity or government officials should have oversight responsibilities?
A common choice is the Central Bank. Close to half of GIFs have some tie or organizational subordination to their Central Bank. Often Central Banks are immediately at the table in these discussions because they are the source of the initial or ongoing funding and often provide the initial staffing needs for new funds. However, even when the source of funding comes from a commodities windfall, or from privatization proceeds, many countries consider the strong governance benefits of the Central Bank to be significant; financial prudence and the political independence of the Central Bank are often seen as characteristics critical to the success of a GIF. There is also a dissonant view, however, that this may impact fund performance as Central Bank professionals bring a conservative reserve management mindset and experience base that is different from that traditionally required to manage an inter-generational, more diversified and complex investment portfolio.
Of course, decisions on governance and oversight can impact transparency issues. For example, the monetary policy decision-making process has often been closely held and guarded. This tendency has, in some cases, carried over in the creation and management of many GIFs. In addition, in some countries, GIFs are considered part of the strategic national wealth and can be viewed in the context of political and national security considerations, as opposed to financial market disclosure standards. In these situations, accountability and oversight may ultimately move to the absolute highest levels of government.
The governance and accountability debate links directly to decisions around the role of a GIF board of directors (including how and by whom board appointments are made), the role of the asset manager, and the source of the original and ongoing funding.
Governance must also necessarily involve accountability for performance against a specific mandate. The clarity of the mandate is an essential early step in the design of any GIF, and can or may include strategic and economic objectives, as well as wealth maximization and performance against specific investment objectives. Important is, there are performance opportunities that relate to the overall management of the fund. For example, many GIFs are exploring innovative solutions and efficiencies in operations and technology, including middle and back office functions such as payments and operating liquidity optimization.
In addition, an issue driving overall performance is the ability to attract and retain high quality professionals. GIFs, with the odd exception, akin to Central Banks and government pension funds have limitations in their ability to properly incentivize performance. While many investment funds have been able to implement innovative compensation schemes, others have had to rely more heavily on well compensated external asset managers, where these entities otherwise, would have preferred to have built in-house competencies.
The following are possible questions worthy of discussion:
- If sovereign entities with substantial experience in managing organizational and governance issues took out a blank piece of paper to help the newer funds design their organizational model, would there be any consensus on where a GIF should sit, to whom it should report and the degree of political independence necessary to perform? Is there a best practice?
- Do transparency issues about fund disclosure come at the expense of performance? If there is a competitive disadvantage or performance downside, is the importance of disclosure of the decision-making process, general investment objectives, size, risk and investment parameters such that it should be done anyway?
- Are compensation and incentive structure limitations of government materially impacting ability to attract and retain appropriate professionals? What has worked most successfully in addressing the need to attract high performance professionals? If appropriate incentive structures are difficult to implement, is outsourcing an appropriate response?
- Should investment in domestic economic development be subordinated to, or allowed to run in parallel to, the risk adjusted return objectives of a GIF? Should there be multiple portfolios with different objectives within the same institution?
- The degree of assets managed internally versus externally varies dramatically across the GIFs. Is there any consensus on the optimal mix? Is the ultimate objective to be able to in-house manage a large portion of the fund’s assets?
- Considering the growing trend among private sector asset managers toward outsourcing middle and back office functionality, should GIFs too move in this direction, while maintaining control of the front end?
- Where more than one GIF exists within a nation, should they compete, as would private sector entities, or should they have clearly differentiated mandates and investment objective delineation? Is there a framework for making this decision?
Investment Objectives and Asset Diversification: Balancing Risk and Returns
There are a variety of portfolio strategy and design principles, funding and allocation decisions and strategic investment objectives that guide the GIF investment process. This note highlights some key issues that currently confront decision-makers, without going into a detailed analysis of each.
One often hears GIFs referred to as ‘the new Global Wealth Managers’ as the size of current and future assets under management makes them comparable to large private asset managers. As the GIF community grows both in number and in assets, the need for methodical approaches to asset allocation has increased. For GIFs, the strategic asset allocation methodology used by many large endowments, may be one useful model, given the often-similar conservative risk-return perspective and the long-term investment horizons.
Of course, not all GIFs are created equal. While many have long-term and even multi-generational time horizons, others have potential short-term liabilities due to a stabilization mandate related to budgetary smoothing objectives. For the latter, an entirely long-term portfolio is not appropriate. The distribution of potential calls on funds has broad ramifications for risk and return objectives, asset mix, and the appropriate liquidity level of investments.
As boards of GIFs debate investment objectives and risk-return hurdles, one of the many macro questions being asked is the degree to which a GIF should take into consideration the underlying risk-return issues and challenges facing the country. This debate is important. But the implications may be interpreted to run counter to mutual responsibility discussions, particularly as it relates to the desirability of pure commercial investment strategies in a narrow sense. In a broader sense, however, it is sound commercial logic to consider return correlations with assets of the same beneficiaries that are outside the fund. The most obvious example of this would be a country that is benefiting from high commodity prices as an oil exporter and makes an investment decision to under-weight energy within its GIF portfolio. The opposite side of that coin, of course, is a non- energy-exporting country over-weighting allocation to the energy sector as a hedge against the country’s resource vulnerability – such decisions, long the preserve of static investment policy statements, ought to be made very dynamic.
One of the central debates within the early-stage GIFs is around the merits of investing directly or indirectly in so-called “alternative” assets. While the growth and importance of alternatives is a given, the pros and cons of investing directly into real estate, infrastructure or corporate transactions, versus investing into funds with those objectives merits serious discussion. Much of the issue centers around experience and comfort levels; some think that there is a logical learning curve that starts with the indirect approach, graduates to co- invest positions and only later moves to hiring professionals and the in-house management of direct investment decisions
Turning to the risk side of the investment debate, periodic market turmoil results in a global re- assessment and re-pricing of risk. Risk measurement best practices are under review as skew, liquidity and correlation assumptions in extreme market conditions are re-evaluated. During market turmoil risk organizations in financial institutions (insurance, banks and asset managers alike) are shaken and revamped on a regional and increasingly a global scale. But where there is turmoil and volatility, there is often also opportunity. One of the more important decisions to be made in times of market dislocation is the degree of flexibility – given to a GIF in tactical asset allocation decisions and the skill required for a GIF to execute successfully in this area. This relates directly to the ability to take advantage of a long investment horizon to make market timing decisions and to significantly overweight a given asset class, sector, region or market segment. Away from the strategic asset allocation investment policy, the tactical asset allocation policy is an important internal decision within the control of any GIF.
An example, during the 2008 financial crisis, large-scale investments in the banking sector represented opportunistic market timing calls in tactical asset allocation. While there has been political attention drawn to the scale and significance of these investments, it has been recognized that the consequences would have been even more severe if these investments had not been made and if the banks not been recapitalized, allowing them to continue to provide global liquidity. But did GIFs know how this would pan out or did they go by gut-feel?
In thinking about the above themes, important questions come to mind:
- What lessons in the area of investment policy can be learned by the GIFs from the relatively evolved asset management industry? What about large endowments that share common long-term investment horizons and limited short-term liabilities? To what extent should the relatively successful asset allocation mix of endowments be replicated by GIFs?
- What are the best practices in the area of evaluation and management of risk within GIFs? How have risk management positions been most successfully staffed? Are the framework, technology and investment mandates clear in order to effectively manage risk?
- How has past turmoil in global financial and credit markets changed perspectives on risk management and measures? Have views of left tail risks, illiquidity risk and correlation and contagion risk been meaningfully altered considering past events?
- How much flexibility should GIFs incorporate in tactical asset allocation policies? Do market dislocations represent an opportunity to make skill-based market timing, over-under weighting decisions that will have a material long-term impact on investment returns? What are some of the largest opportunities?
- How can a government best take account of its economic and financial position (such as trade flows, current account balances and natural resource positioning), as it determines the investment objectives of its GIF(s)?
- Should short-term stabilization funds be broken out and managed differently from the inter- generational funds? Should asset allocation be based on risk-based budgeting at all?
- What responsibility should GIFs have for global financial market stability and functionality? If GIFs were required to make investment decisions as a purely commercial entity, as say would a hedge fund, is there potential for systemic risk?
- When considering accounting and values of holdings, does ‘marking to market’ make sense in very long-lived funds? If not, what is the alternative?