Thursday, April 1, 2010

Soverign Wealth Funds: Risk and Reward

Norwegian Risks Pay Off

Jim Allen

So what’s the big deal about Norway? “It’s a hereditary monarchy and parliamentary democracy, cold, and has universal health care, but what’s risky about that”, is what one might pronounce. The Norwegian Sovereign Wealth Fund (SWF) performed better than its private sector counterparts with a higher associated risk, according to a recent study published by North Carolina State researchers in The World Economy. Funds like the one in Norway are large and growing, and are just recently coming into public light.

Sovereign Wealth Funds are basically large government investment funds which function like mutual funds in terms of risk and return on investment. While not all SWFs are the same, they each have a similar goal: “to achieve maximum income subject to a level of risk and certain portfolio constraints specified by its Ministry of Finance.” In Norway, the Fund allows government spending to be smoothed out relative to the volatile pattern of the nation’s oil revenue. SWFs are essentially savings accounts for governments; citizens have banks, and now government entities do also. Many nations which have SWFs are also oil producing nations; SWFs provide a stabilizing effect for nations which have erratic economies related to fluctuations in oil prices. These nations include the United Arab Emirates, Saudi Arabia, Norway, and even the U.S.

According to the research, “Total assets held by SWFs have been estimated to be around US$3 trillion (Jen, 2007)” (See the figure below). This value is greater than the total assets of hedge funds (US$2 trillion) but less than total official monetary reserves of central banks (US$6 trillion).” By 2013, the holdings of SWFs are estimated to exceed US$6 trillion. These are just approximations because the literature on SWFs has been limited and descriptive at best, up till now. The large amount of money held Worldwide by SWFs was quite alarming to the researchers at NC State when they looked at the relative return ratios and how much risk the SWFs were taking to achieve these returns.

Researchers found that the Norway Fund had average monthly returns of 0.36%, while the Social Choice Fund (generally accepted as a balanced and fiscally responsible fund) had a return of 0.16%. To explain this, the research also included data on return on investment versus risk. Not surprisingly, the increased returns also carried increased risk. More specifically, the Norway return to risk ratio was 0.14 while the Social Choice Fund had a much lower ratio at 0.07. Critics also point out mistakes made by SWFs in recent years, and in particular investments in American corporations such as Citigroup, Morgan Stanley, and Merrill Lynch.

This research effort with the Norwegian SWF Fund (referred to as “The Fund”) is one of the first of its kind since the Norwegian government has allowed a high level of transparency unrivaled by other Funds. Researchers stated that “The Fund demonstrated transparency by providing detailed and reliable information about its activities in a timely manner.” Because of this, researchers were able to analyze important data about how The Fund affects global markets and what kinds of returns its investors receive.

Caner, Mehmet, and Thomas Grennes "Sovereign Wealth Funds: The Norwegian Experience." World Economy 33.4 (2010): 597-614. Wiley Interscience. Web. 1 Mar. 2010. .

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