Month: March 2020

Sovereign Wealth Funds (SWFs) have lost hundreds of billions of $ ever since the Coronacrisis gathered speed. Revising Fund’s investment guidelines is vital to repairing the damage done. A wait and hold approach is hardly prudent. Such guidelines are going to be a key decision for it both flows from as well as impacts the fund’s form, governance, links between actors and the applicable law. I believe that investment guidelines should follow from the basic principles and core values of the Fund, as well as its general entrusted mission.

Sovereign Wealth Funds (SWFs) have in March 2020 alone, cumulatively lost hundreds of billions of $ in citizens accumulated wealth. Attributing this to adverse market movements is hardly an excuse. I observe that most SWFs have been on ‘auto pilot’, driven by inertia after they were formed. Meanwhile much has changed in their external and internal country environments. This naturally has ramifications on the legal framework within which such vehicles now operate, as well as their initial objectives and macroeconomic linkages with national economies. This in turn influences their investment policies and risk management frameworks.  In my view the Coronacrisis should catalyze fundamental rethink of a Fund’s institutional framework and governance structure.

I believe that this is a good time for soul searching. For whether a SWF is placed under the supervision of the Ministry of Finance, or the Central Bank, or is run as an independent entity has enormous importance going forward. Something that I highlight here, as well as will build upon in subsequent postings.

Sovereign Wealth Funds (SWFs) have lost hundreds of billions of $ ever since the Coronacrisis gathered momentum, beginning March. I believe it the largest destruction of accumulated citizens wealth in history. Having advised multiple SWFs I am acutely cognizant that each has its own specificity, governance, asset allocations, risk levels and special objectives. A Fund’s institutional framework too has great influence over managers, both internal and external, and therefore has an impact on its management and returns. A SWF’s legal status also is a key decision point,  since it impacts the fund’s form, governance, links between actors and the applicable law.

I am of the view that recent market events highlight the importance of managing risk holistically even more so.  I draw attention to five issues in this visual.

SWFs Need to Revisit Objectives During Coronacrisis

I hold the view that nations that have already set up a Sovereign Wealth Fund (SWF) now ought to revisit every aspect – the mandate, mission statement: the very objectives of the Fund, the institutional and legal framework, the way it should manage and monitor the investment process going forward, investment guidelines that may no longer serve well, risk management/ benchmarks, the governance framework, the optimal mix between internal and external managers as well as myriad of issues including evaluation and performance assessment. Recent huge losses suffered may itself generate a public debate on topics of investment of “excess” reserves, the level of future risk and more important spill-over implication for macro-economic policies.

I believe that the more transparent and the more professional they are, the more open will be capital markets and their own citizens to their activities. We present a visual by way of catalyzing conversation.

I had polled global central bankers in January/February – around 47 OECD and non-OECD banks participated with multiple respondents each to the survey.  While the names of the banks are known (albeit concealed as I don’t have permission to reveal)  the respondent profile was anonymized to ensure better disclosure. At that time I did not sense the severity of the impending Coronacrisis, so questions related to it were not asked – a mistake I feel, in retrospect.

Attached is an excerpt.

Central Bank Survey1

The cost of holding high levels of foreign exchange reserves can be estimated as the difference between the interest rate paid by the central bank on domestic securities and the interest earned on foreign exchange reserves, adjusted for any exchange rate change.

Guan Seng Khoo, PhD and me are of the view that during the coronacrisis this spread is likely to change very fast. We hold the position that the close relationship between SWFs and country central banks will come under pressure, especially for the petrodollar SWFs as oil prices have tanked to less than $30. Of course not all SWFs are created equal: they lie along a spectrum of risk appetite. Those that in the past demonstrated a strong willingness to lever up and make strategic purchases, serve dual objectives of wealth creation and support of their country’s policies will now need to rethink their mandates. In order to do that, we recommend that they need to think in terms of the larger eco-system and not silo mandate, as we showcase in this visual.

A recent #ActiveAllocator survey shows that central banks rate “avoiding default” as their most important objective. That hope for serendipity is now likely over. Central banks now face heightened concern from the economic slowdown, rising deficits, currency debasing and assorted other risks.

Guan Seng Khoo, PhD and me recommend that they should further increase reserves in conjunction with greater currency and instrument diversification, and invest in new asset classes. Guan Seng has spoken extensively on the merits of indexation towards an ALM centric model, the need to arrest funding shortfalls, to monitor high levels of Surplus at Risk (SaR) as well as create a central bank liability index, interalia. His approach represents a paradigm shift away from asset, sector or horizon-driven selection and allocation. We draw attention to developing a new benchmark, by encouraging thinking through first principles in a visual here.

The need to be able to properly quantify risks, particularly those “fat tail” risks that present a special challenge to policymakers has never been more important, than in 2020. Guan Seng Khoo, PhD and me in our long careers have come to understand that transparency on risk/return and data availability allows better bench-marking and control. We feel that moving away from recognized benchmarks can help central banks achieve a better match of assets and liabilities. Internally created benchmarks can be effective in meeting safety and liquidity requirements, measuring performance and increasing accountability. All of this needs to be explicitly tied to the risk management function.

In 2020 central banks ought to consider a more active reserve management strategy; one that incorporates modern innovations in asset management which bring intensified focus on returns. While counter intuitive perhaps to conservative central banking mindset, Guan Seng Khoo, PhD and me recommend a gradual expansion of the range of credit and duration of instruments held. We also suggest hedges to key risks, including commodity risks as well as consideration towards agency paper and investment tranches of collateralize mortgage securities supported with more active currency positioning and securities lending. Their FX policies should be geared towards paying greater attention to boosting market confidence in the context of float/managed float. We further feel moving away from recognized benchmarks can achieve a better match of assets and liabilities. Internally created benchmarks can be effective in meeting safety and liquidity requirements, measuring performance and increasing accountability.