sharing in governance of extractive industries
Governments around the world held about USD 3.7 trillion in oil, gas and mineral wealth in sovereign wealth funds (SWFs) at the end of 2016. There are many reasons why they have saved so much money. Some, like the Kuwait Investment Authority, have created an endowment for future generations. Others, like Chile’s Social and Economic Stabilization Fund, are meant to be used during economic downturns or crises. Still others are used for under-financed spending priorities. The U.S. state of Texas, for example, invests a large portion of its oil, gas and mineral revenues in global markets through its USD 21 billion Permanent University Fund. It then supports public university education using the interest earned on the fund’s asset placements.
Research suggests that more than 90 percent of the variation in investment performance over time is explained by strategic asset allocation. In theory, a fund’s asset allocation ought to be directly derived from its purpose, investment objective and target return. A more risk-averse SWF, with shorter horizons and a high preference (or need) for liquid assets, would favor a relatively higher allocation to bonds and cash (or money market instruments). A stabilization fund for example, needs access to funds at short notice to stabilize fiscal revenues in the event of shocks in commodity prices and cannot afford sharp fluctuations in the value of its portfolio. Managers of stabilization funds may therefore wish to limit investments in volatile assets (e.g., listed equities) and illiquid assets (e.g., alterative or private assets, such as private equity and real estate).
While greater risk-taking can lead to higher long-term returns (if asset purchases are truly based on risk-return criteria), it can also generate greater year-to-year volatility. For example, the Timor-Leste Petroleum Fund has earned approximately 3.5 percent annually since 2010, though it did not exceed 6.6 percent return in any given year. On the other hand, the Alaska Permanent Fund lost money in 2012, though the average rate of return over the same period was higher than Timor-Leste.
Chart: Fund volatility in Alaska and Timor-Leste
As countries like Guyana and Lebanon develop new sovereign wealth funds, and as existing funds revise their investment guidelines, they may wish to heed the lessons of New Zealand and Trinidad and Tobago: a government does not need to take excessive risks in order to make a decent return. Higher risk asset classes require expertise to properly oversee transactions and protect a fund’s integrity. Instruments without credit ratings or other types of alternative assets require additional due diligence in the form of legal advice, financial analysis and knowledge of specific market conditions. Purchasing publicly traded instruments, on the other hand, requires fewer specialists and may generate similar returns to alternative assets, as the New Zealand case shows. In low- to medium-capacity environments, lawmakers and senior fund managers ought to prohibit outright the riskiest types of investments and the ones most susceptible to mismanagement, such as derivatives and commodities.
Andrew Bauer is a consultant to the Natural Resource Governance Institute (NRGI).
Note: This content first appeared as a post on the Natural Resource Governance Institute’s blog on 13 June 2018.
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