Cerulli Global Edge: The next wave of sovereign wealth funds

Cerulli Global Edge, March 2011

It’s no surprise that sovereign wealth funds capture the attention of the world’s asset managers. Estimates of the total wealth these enterprises manage typically range from $3-4 billion, and in most cases they outsource generous amounts of that wealth to external managers.

Attention typically focuses on a handful of the biggest names such as the Abu Dhabi Investment Authority, Kuwait Investment Authority, Government of Singapore Investment Corporation, Norway’s Government Pension Fund Global, or newer arrival the China Investment Corporation. But one of the most interesting trends in this area is the emergence of a newer wave of secondary sovereign entities: far smaller than the more famous behemoth famous, but representing either the emergence of a new bloc of capital, a newfound sophistication in investment technique, or both.

In this article we take a look at three institutions that illustrate the trend: the Petroleum Fund of Timor-Leste in East Timor; the Abu Dhabi Investment Council; and the endowment fund of KAUST, a new science and technology university in Saudi Arabia.

PETROLEUM FUND OF TIMOR-LESTE

To find the next generation of sovereign funds one most go to some obscure parts of the world. A prime example is East Timor, whose sovereign fund is a fascinating story reflecting the emergence of the country itself.

East Timor is one of, if not the, newest countries in the world (depending on how one views the status of Kosovo, and whether you’re reading this after South Sudan becomes a sovereign state). But when it came into being in 2002, it did so as a miserable new entrant into the world economy. Neglected by Indonesia when it was part of that country, and cruelly damaged on the road to independence, Timor had (and largely still has) an infant mortality rate of almost one in 10, a male life expectancy of 47, and 40% of the national population in poverty.

But it had a bounty: plentiful oil and natural gas reserves in the Timor Sea. Hammering out sharing agreements with Australia took several acrimonious years, but today East Timor gets 90% of the Bayu-Undan oil and gas field (being exploited by a ConocoPhillips-led conglomerate which expects the field to be good until 2023 and to provide 4 trillion cubic feet of natural gas and 500 million barrels of condensate); 50% from the Greater Sunrise field, with almost twice as much gas and 300 million barrels of condensate; and 90% from any further finds within the Joint Petroleum Development Area. One way or another East Timor is likely to get at least $20 billion from these fields, and possibly much more.

Many new countries have found themselves with the gift of hydrocarbon reserves and have then destroyed themselves as a consequence. But from the outset, Timor has stood out for the prudence of its approach to its assets. The Petroleum Fund was set up in 2005 in order to build up its assets for the future. It has certainly not been without controversy: in a country where there is not enough money to educate or heal people, it is highly contentious to put all the money from commodities away for the future, and today there is something of a compromise with some funds withdrawn for expenditure and the majority saved for the future. And since oil and gas account for 170 times more than the second-biggest national revenue provider (coffee), based on official 2008 numbers, it’s very clear that these commodities are the country’s only shot.

But, in this poor and unlikely location, the fund is among the world leaders for transparency, accountability and governance: when the Peterson Institute for International Economics tried to put together a scorecard for sovereign wealth funds based on those criteria, East Timor’s fund ranked 3^rd behind New Zealand and Norway, ahead of democratic and transparent beacons like Canada, Alaska and Australia, and an absolute mile ahead of anything in Asia or the Middle East (ADIA ranked 32^nd).

So, today, a visit to the fund’s website, hosted within the central bank, reveals precise assets under management, holdings, allocation and performance, all of it revealed on a quarterly basis. Absolutely everything is spelled out: what can be withdrawn and in what circumstances; what external mandates might be announced; how the benchmark is composed. It’s perhaps not surprising to hear that one of the Norway sovereign fund’s senior management serves on the Timor fund’s investment advisory board.

At this stage, the fund is deeply conservative: it got up and running just ahead of the financial crisis and was in no rush to diversify out of treasuries – a decision that may have made it the best performing sovereign fund in the world during the worst months of the crisis. Whether because of nervousness, lack of expertise or conscious decision, it still hasn’t. Its global benchmark today is 90.4% US government treasuries in a 0-5 year duration; a further 2% in 5-10 year treasuries; 2.6% AAA government or supranational dollar debt; 1.4% AA; and then a sprinkling of Australian, euro, UK and Japanese government bonds. Until recently BPA, the central bank, ran 80% of that portfolio (most of the short-dated Treasuries), while the Bank for International Settlements ran 20%, including the non-US holdings.

While that’s hardly the most exciting allocation, returning just 1.6% in the quarter to September 30 2010, it has served the fund well: given that modest performance but mostly because of new revenues from the oil fields, it has grown from US$3 billion in 2007 to $6.6 billion in September 2010, even after a quarterly withdrawal of $175 million for the quarter to the state budget (which doesn’t sound much but is substantial in a poverty-line country with a population of just a million).

That conservatism might suggest little reason for foreign asset managers to get excited, but there are gradual signs of that wealth being ready to be trusted to external managers. Back in 2009, the Ministry of Finance asked the BPA to consult a manager for an equity portfolio – and on September 7 2010, that finally happened, with Schroders getting a contract to put 4% of the fund into global equities. That chunk, about $260 million, was apparently deployed in October.

And this is exactly the reason international managers ought to look off the beaten track. Timor’s fund will never be ADIA, but it’s very likely to hit $20 billion within the next decade or so; that’s not so far short of, for example, the Korea Investment Corporation. And, over time, as confidence and sophistication grow, it is likely to put more and more of its capital to work in a structure in line with other sovereign wealth funds around the world. Plus, it’s highly unlikely to feel it has that expertise available in the national capital, Dili, which suggests that most of the non-Treasury allocations will be outsourced.

ABU DHABI INVESTMENT COUNCIL

ADIA obviously gets the headlines, but there are a host of other sovereign wealth entities in the United Arab Emirates. In Abu Dhabi alone, for example, there is Invest AD (formerly the Abu Dhabi Investment Company), Mubadala Development Company and the Abu Dhabi Investment Council (known as The Council, or sometimes ADIC 2).

A look at the last of these illustrates the possibilities for international managers in sovereign vehicles beyond what you might call the mother ship. The Council is one of the newer ones, and was set up only in April 2007. Like ADIA, it is an investment arm of the government of Abu Dhabi, and again like ADIA it is responsible for investing government surpluses for the future good of the people, by achieving strong returns and diversifying the economy away from oil. It also has a direct investment mandate to broaden Abu Dhabi’s economic base and help local companies to develop internationally.

In some respects The Council looks a bit like a holding company or a Temasek, in that it holds major stakes in several of Abu Dhabi’s leading businesses: National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Union National Bank, Al Hilal Bank, Abu Dhabi National Insurance Company, Abu Dhabi Aviation Company, and Invest AD (which is itself a sovereign investment vehicle).

In other ways, however, it looks like a more nimble version of ADIA. It has a dedicated special situations division, for example, which ADIA does not. And this gets to the heart of the big question about The Council: why is it there? Who needs another sovereign wealth fund in Abu Dhabi?

Many feel that ADIA simply became too big to be able to move quickly. It has never revealed its precise assets under management and estimates vary dramatically, but Cerulli believes the total to be between $400 and $500 billion. With such a large amount, one has to deploy a lot of capital into a position for there to be any point in doing so – and that can be difficult in, for example, small caps or special situations. There are political and personal reasons mooted too, but the idea of a quick-acting sovereign fund as an adjunct to ADIA has a lot to recommend it. Some even say that ADIA is beta and The Council is alpha, but in fact a large part of ADIA’s assets are actively managed.

It’s certainly a more opaque institution than ADIA, which itself used to set the benchmark for opacity. These days ADIA produces an annual report with detailed information on asset allocation ranges, governance and even long term performance; at the time of writing, The Council’s web site contained only a picture of some buildings and a brief mission statement: “To assist the Government of Abu Dhabi in achieving continual financial success and wealth protection while sustaining prosperity for the future”, and “to increasingly participate and support sustainable growth in the Abu Dhabi economy.”

We have not yet seen many more satellites come off established sovereign funds, but it’s not impossible that we could do in future. Many of the biggest institutions – Norway’s, Kuwait’s, Singapore’s, China’s – face these scale issues, and a free-reined lower-asset think tank could be a smart way for all of them to deal with it.

KAUST

On a 36 million square metre custom-built site on the Red Sea 80km north of Jeddah, a remarkable new educational institution is taking shape. The King Abdullah University of Science and Technology opened its doors in September 2009 and was by then already an exceptionally well-equipped research university, with specialisms distinct to Saudi Arabia such as water desalination. But that’s just the start, and by 2020 it aims to be among the top 10 universities of its type worldwide.

Ambition like that requires a lot of money to realise, particularly since one of the stated ambitions within the university’s mission and vision statements is to have “a diversified and sustainable revenue base that supports both its operating and capital requirements.”

For this purpose, and with the endowment funds of Yale and Harvard very much in mind, KAUST Investment Management Company was set up. In March 2009, it made a landmark hire as its chief executive and chief investment officer: Gumersindo Oliveros, who was previously the director of the pension plan and endowments at the World Bank.

Although the figure has never been confirmed, it is believed that the new fund was seeded with $10 billion of assets. The board at the time of Oliveros’s appointment makes for interesting reading and shows the scale of the ambition: alongside the Saudi royal family (Prince Khalid bin Adbullah bin Abdulaziz) and government (Ali Ibrahim Al-Naimi, who is the minister of petroleum and natural resources as well as the chairman of KAUST’s board of trustees) are local private sector leaders (Lubna Olayan, the CEO of Olayan financing group, and senior representatives of Saudi Aramco and the Abdullatif Jameel Group) and a couple of striking foreign names: John Brennan, chairman of Vanguard; and Charles Ellis, chairman of the investment committee at Yale University.

Yale is clearly a role model, and those asset managers who have had discussions with the new endowment fund say that it appears to be every bit as sophisticated – at least in what it is talking about doing – as its American cousin. Managers going in for pitch meetings talk about discussions in which typical asset allocation models are discarded in order to talk in detail about thematic investment styles, which might include themes distinct to the Gulf such as water or food scarcity.

The Gulf is not short of well-funded trophy projects, and while we tend to associate these with tall or grand buildings, a commitment to world class education is a logical and laudable way of deploying oil wealth. KAUST could be mirrored by similar institutions in the region.

For the moment, all eyes are on two other Saudi institutions that have been announced but don’t yet appear to be doing a great deal. One is Sanabil al-Saudia, formally launched in 2008 under the supervision of the Public Investment Fund, another state entity. The other is Hassana Investment Co, approved in 2009, to manage the assets of the General Organization for Social Insurance (GOSI), a key Saudi pension fund.

It’s not yet clear whether these new funds will be closer to KAUST’s thinking, or to that of the Saudi Arabian Monetary Agency, the country’s central bank which fulfils some sovereign wealth roles with its considerable assets but is by its nature conservative (and does not at all like being described as a sovereign wealth fund). Either way, these new pools of capital being created around pension funds, academic endowments and other sovereign wealth all suggest opportunity for foreign fund managers.