May 27, 2010 / 7:16 AM / 9 years ago

Sovereign wealth rewrites old-world rules

LONDON (Reuters) - Sovereign wealth funds — national vehicles created to grow state wealth for the future — have long experience investing in exotic and lesser-known lands. To these funds, many of which originate in what the West calls the “frontier” region, it’s a local market.

This year alone, countries including China, Singapore, South Korea, Kazakhstan, Azerbaijan and Abu Dhabi have invested easily more than $1 billion (688 million pounds) in frontier markets, in such projects as mines in Mongolia and companies in Africa, the Caribbean and Latin America.

The often secretive heavyweights of the financial world, sovereign funds control around $3-4 trillion in assets and include some established players on tricky terrain. Because their investments are so influential, their presence can be manipulated to wrong-foot other investors.

So the sovereign wealth funds’ tendency to be opaque adds to the challenge for investors in frontier markets. But beyond this, they are also having a broader influence, bringing a “frontier factor” to the rest of the world.

“Most SWFs are themselves a creation that should be looked at in the context of frontier markets,” said Alexander Mirtchev, independent director of a sovereign wealth fund from the “frontier” region and a member of the board of trustees on the Kissinger Institute on China and the United States.

“The frontier is part of their DNA, and this ‘frontier make-up’ to a large extent determines their competitive advantages, as well as in some cases the problems that SWFs sometimes face.”

Backed by leverage-free reserves beyond the dreams of most indebted rich-world countries, the funds’ “south-south” investment is more than a sideshow: it’s reinforcing their role as powerbrokers of global markets.

HISTORY LESSON

To get the picture it’s worth considering that in a sense, sovereign funds have been actively investing on the frontiers for at least 400 years.

The East India Company — an English trading company in the 17-19th centuries backed by the state — functioned loosely like a modern sovereign wealth fund. It pursued trade in commodities including spice, cotton, tea and opium in the then-frontier markets of China and India, creating regional markets and helping develop local economies.

Other European corporations including the 17th-century Dutch East India Company, VOC, served as tools of colonial power — an extension of states — just as do some sovereign funds today.

The difference between the pioneers of the past and the present is that today, much of the wealth and influence come not from the modern rich world, but from resource-rich countries with very different values.

SOUTH-SOUTH TIES

Concrete figures are hard to come by, but experts estimate the allocation of sovereign wealth fund assets to frontier markets is less than 5 percent.

That would translate into $150 billion, which eclipses the total market capitalisation of the benchmark MSCI Frontier Markets equity index at $120 billion.

What for the funds is small exposure makes a huge difference to recipients. Their presence brings mutual benefits.

The funds and their targets in poor countries often have shared experience on the economic margins, which fosters a cultural affinity.

Countries on the investment frontiers desperately need long-term capital, which sovereign wealth funds can provide.

Recent economic ructions in the West add to the incentive for stronger ties: the risk in developed-market investments has increased, but the prospect of commensurate rewards has not.

Sovereign funds are keen to diversify into illiquid but higher-yielding assets in frontier economies in the hope of providing returns for future generations. And unlike the quarter-to-quarter reporting required from companies in the West, these funds can wait a long time before showing returns.

“Most SWFs are seeking new and untapped sources of diversification and alpha generation,” said Cynthia Sweeny Barnes, global head of sovereigns and supranationals at HSBC Global Asset Management.

“Frontier markets offer interesting risk-reward dynamics, particularly for investors with permanent capital. The low level of information in frontier markets creates often significant pricing inefficiencies, which active investors can exploit.”

SHHHH

Modern sovereign funds have been thrust further into the global economic limelight since the credit crisis cut funding for the hedge funds and private equity groups that had been cocks of the walk.

Only a few years ago, Western politicians were making headlines with attacks on sovereign funds for their secretive ways: behind this were fears their motives were political, rather than commercial.

Keen to be accepted, many did make an effort to open up. But since the credit crisis, political calls for greater transparency from the funds have quietened.

“Once regarded as subversive agents of state capitalism, they are now sought-after providers of capital,” Sven Behrendt, a visiting scholar at the Carnegie Middle East Centre, said in a study for the centre this month.

“Their growth dynamic suggests that their investment and policy behaviour will resonate across the global economy.”

These funds need a degree of secrecy to function.

Already, their investment decisions are closely followed by the wider investment community, as the global importance of the industry grows. It is forecast by Deutsche Bank to more than double in less than 10 years.

In a fiercely competitive investment environment, others in the market sniff about for deals that anticipate the moves sovereign funds will make. A practise known as front-running, that risks pushing up prices before the funds invest.

“Because we are generally large institutional investors, there is the whole community of investment banks, brokers, analysts and others who want to front-run our investments in the market,” David Murray, chairman of the board of guardians at Australia’s Future Fund, told a news conference last October.

“In doing so they would use all sorts of techniques to find out from us exactly where we are in the market in terms of timing. It is not in the interest of the funds nor our community to be involved in that game because it would be detrimental to our investment returns.”

RISKS OF TRANSPARENCY

As the economic climate has dented rich-world political power, some sovereign wealth funds themselves are sounding more confident about their need for discretion.

“SWFs are not publicly traded companies. We do not have obligations to publish quarterly information to the public,” Jin Liqun, chairman of the board of supervisors at China Investment Corp, told Reuters in October.

“Indeed, this kind of quarterly disclosure has done more harm than good. It has encouraged managers to do reckless things.”

As sovereign wealth funds strengthen their south-south partnerships, this could also feed into a more closed-door culture in broad financial markets, which are already jumpy after a series of shocks.

“South-south investing would not necessarily improve transparency much more due to the nature of the parties involved,” said Efraim Chalamish, who advises various sovereign funds and is a global fellow at New York University Law School.

“Some south-south investing is driven by strategic alliances, which again raises the concern of combining politics and commerce — how much of these investments are driven by politics and other non-commercial motives?”

Just as in the 17th century it was European corporations that laid the grounds of modern global finance, today the sovereign wealth funds are driving the world towards a new financial order. (Reporting by Natsuko Waki; Editing by Sara Ledwith)

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