A sovereign wealth fund or SWF is an investment fund created and owned by the national government of a sovereign country and managed by a government-appointed board of directors or management committee. The fund invests in real and financial assets like real properties, stocks, and bonds or alternative investment options like private equities.
The government is responsible for legislating and executing laws relevant to the fund. It is also responsible for setting the overall fund objectives, appointing the management team, and providing oversight to ensure responsible management.
Specific management functions fall under the purview of the appointed management team. The team is responsible for setting the investment strategy, approving investments or investment allocations, monitoring the performance of the entire investment portfolio, and overseeing a team of investment professionals or fund managers.
Capital usually comes from surplus revenues from the exportation of commodities like oil and gas. Some funds draw capital from foreign-exchange reserves of central banks while others come from proceeds from privatization and sales of government assets.
Exploring and Understanding the Upsides and Downsides of a Sovereign Wealth Fund: A Balanced Perspective
The primary purpose of a sovereign wealth fund is to preserve and grow the wealth of the nation and benefit future generations. This stated purpose is why most investment funds are created by countries with budgetary surpluses and have little or no international debt. The rationale behind investing lies in the fact that it is not always desirable to hold excess liquid assets or channel them into immediate expenditures.
Countries that have budgetary surpluses usually possess substantial reserves of natural resources or generate significant income from exporting commodities such as oil and gas. Some countries earn surplus revenues through efficient tax collection, the operations of government-owned enterprises, or the sale of government assets. Participation in international trade also enables a country to build foreign currency reserves.
There are two main types of sovereign wealth funds categorized according to their general purpose: savings funds and stabilization funds. Savings funds are created to accumulate savings for future generations or future uses. Common examples include national pension funds and war chest funds. Stabilization funds, on the other hand, are created to mitigate the risks arising from uncertainties in government revenues.
Understanding the specific purpose, goals, and objectives behind the creation of a sovereign wealth fund is crucial for comprehending its particular advantages or benefits and applications. Numerous examples in the real world have demonstrated how these investment funds have aided countries in achieving their stated national goals, and desired objectives, helping in fiscal management, and resolving economic issues.
It is still important to note that there are risks to investing and investments are not guaranteed. These might represent the main disadvantage of a sovereign wealth fund. Investing exposes the investor to different risks unique to specific assets that have the potential to result in significant losses. This general principle of investing is the reason that expertise is required to lessen risks and maximize the growth potential of investments.
There are several instances in which sovereign wealth funds either lost a portion of their value or collapsed. The reasons behind this unfavorable performance can stem from incompetent management, exposure to widespread economic downturns, or corruption in the government. Critics have noted that creating and managing these funds should be reserved for countries with relevant expertise and sound political environment.
Advantages of a Sovereign Wealth Fund: Stated Purpose and Real-World Example of Benefits
1. Safekeeping Excess National Wealth
One of the advantages of a sovereign wealth fund is that it provides a mechanism for governments to manage excess wealth resulting from budgetary or revenue surpluses and to avoid the pitfalls that arise from holding and spending liquid assets
The time value of money is a core principle in finance that explains how the value of a certain amount of money in hand today can be worth more than its value tomorrow if it is channeled through suitable investments. However, that same present value can erode over time if unmanaged, resulting in less purchasing power in the future due to inflation.
It is also important to note that spending money on hand all at once to stimulate economic activities runs the risk of overheating the economy. This occurs when government expenditures exceed the productive capacity of the entire country
Asset diversification is another example of how countries manage their excess wealth through a sovereign wealth fund. It provides a means of reducing dependency on traditional sources of revenue and the liquid assets they generate. This helps mitigate risks associated with relying on a single market or the possible depletion of resources.
The Emirate of Abu Dhabi in the United Arab Emirates established the Abu Dhabi Investment Authority in 1976 with the primary purpose of managing its excess revenues from its fossil fuel reserves and reducing its reliance on its oil and gas industry.
2. Generating Income For Future Use
Remember that savings funds represent one of the two main types of sovereign wealth funds. The intention of these funds center on inter-generational wealth transfer or preserving and transferring wealth for future generations.
The Government Pension Fund of Norway which includes domestic-centric and global-centric investment funds was established in 1967 and expanded further in 1990 as a vehicle for investing the surplus revenues from the Norwegian oil and gas industry and with the intention of financing welfare state services such as pensions, healthcare, and education.
Sovereign wealth funds can also be created to build and expand the war chests of certain countries. A war chest is a reserve of funds used to address possible expenses in the future such as response to calamities, pandemics, and wars.
Most investment funds in the Middle East were created as income-generating war chests. The Qatar Investment Authority has a war chest of over USD 300 billion while the Saudi Arabia Public Investment Fund has over USD 500 billion. The Abu Dhabi Investment Authority holds one of the largest war chests in the world with over USD 800 billion.
It is important to underscore the fact that purchasing and holding real and financial assets through investment activities have the potential to generate income through capital appreciation, passive income generation, and active trading.
3. Stabilizing The National Economy
Another advantage of a sovereign wealth fund is its possible role in safeguarding and generating funds that can be used to stabilize a distressed economy. These stabilizing funds are similar to war chests that become useful during adverse economic conditions.
The investment funds of oil and gas producers and exporters in the Middle East also function as a mechanism for stabilizing emerging economic downturns due to fluctuations in the global price of oil and gas or disruptions in international trade due to widespread financial crises or economic downturns affecting or transpiring in other countries.
China invests its currency reserves in high-graded government bonds such as U.S. Treasuries to set and control the exchange rate of its Renminbi currency. The State Administration of Foreign Exchange oversees its foreign exchange market activities.
The sovereign wealth fund of Singapore, managed through its entity GIC Private Limited, aims to preserve and enhance the international purchasing power of its reserves by investing in a diverse range of financial and non-financial assets. Additionally, it serves to protect the country from economic shocks and reduce reliance on foreign capital.
A sovereign wealth fund can stabilize the national economy in numerous ways. Investing in foreign assets helps prevent the currency from weakening. Earnings from these investments can be used to support fiscal policies aimed at economic stimulation.
4. Promoting Economic Development
The Deposits and Consignment Fund of France is the largest sovereign wealth fund in the world in terms of total assets. Part of its responsibilities is to support small businesses and foster innovative pursuits through loans and other financial support.
China established the China Investment Corporation in 2007 to support its long-term economic growth. The fund it manages has provided a platform for businesses to raise capital and conduct international trade. The GIC Private Limited of Singapore also serves as a platform for empowering and supporting domestic businesses.
Norway channels excess revenues from its petroleum industry to other Norwegian companies. The domestic investment fund of its Government Pension Fund invests in domestic and homegrown companies listed on the Oslo Stock Exchange.
Part of the income generated by the sovereign wealth funds of countries like Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates have been used to support productive economic activities. The Investment Corporation of Dubai has a portfolio comprising of businesses and assets either wholly or partially owned by the Emirate of Dubai.
An obvious advantage of a sovereign wealth fund is that it enables countries to have another stream of income that it can use to finance economic development pursuits like infrastructure projects and empowerment of domestic sectors and industries.
Disadvantages of a Sovereign Wealth Fund: Main Criticisms and Notable Instances of Failures
1. Governance and Political Interference
Remember that sovereign wealth funds are owned and controlled by the government. This means that gains from these funds can be abused and misused or the proper management of these funds might be neglected due to lack of real accountability.
Some critics have argued that these funds can create a moral hazard problem that arises from the fact that the government has access to a large pool of capital and is not exposed to the same risks as private investors. This problem can result in a higher potential for losses as fund managers take on more risks than they otherwise would.
There are several reasons why managers of sovereign wealth funds might gamble on high-risk investments. These include the lack of accountability and transparency, pressure to generate high returns from the government, and lack of experience.
Others have expressed concerns over the role of potential political influence. Political considerations can influence the operations of the fund. This happens when the government decides to invest in certain favored businesses or sectors and industries that would benefit involved certain political actors and their cohorts.
Government interference in the management of the fund to favor certain groups rather than the entire country bypasses or disregards the authority and expertise of appointed fund managers. This can lead to unwise investment decisions and significant losses.
2. Risk from Corruption and Political Instability
Another disadvantage of a sovereign wealth fund is that its creation is a pointless pursuit for countries where corruption across the national government and among political leaders is rampant and the unstable political environment remains unresolved.
The Malaysian Sovereign Wealth Fund or 1MDB was established in 2009 to manage revenues from the oil and gas activities of Malaysia. However, in 2015, it was revealed that the fund was used to embezzle billions of dollars by corrupt officials. The scandal has been described as one of the greatest financial scandals of all time.
Libya also experienced a similar situation. The Libyan Investment Authority was founded in 2016. The removal of Muammar Gaddafi from office in 2011 resulted in the emergence of corrupt officials that looted billions of dollars from the fund.
Other notable examples of sovereign wealth funds that lost their value and marred with corruption to poor governance include the Sovereign Fund of Brazil, the Mineral Revenue Stabilization Fund of Papua New Guinea, the Macroeconomic Stabilization Fund and the Fund for National Development of Venezuela, and the Angolan Sovereign Wealth Fund.
Critics have argued that unstable countries are not fit for sovereign wealth funds. Economic determinants have an important but inconsequential role and the main reason the aforesaid funds were exhausted was the problematic political environment.
3. Impact of Widespread Economic Downturns
The Kuwait Investment Authority lost over USD 100 billion in value due to the 2007-2008 Global Financial Crisis that started from the subprime mortgage crisis in the United States and spread further to create the Eurozone Debt Crisis of the European Union.
Iceland also lost more than USD 6 billion in value in its Icelandic Investment Fund due to the collapse of the Icelandic banking system. The collapse was due to the widespread bank runs that emerged as a consequence of the global crisis affecting the European Union. The fund was exposed because of its investments in several Icelandic banks.
The Government Pension Fund of Norway lost about USD 164 billion in 2022 due to the global economic slowdown due to the coronavirus pandemic, the escalation of the Ukraine-Russia conflict, and the Global Inflation Surge that began in 2021.
It is important to underscore the fact that the examples above demonstrate that even the largest and most sophisticated sovereign wealth funds are not immune to the risks in the global financial markets and issues arising from global economic downturns. This is true for funds with large investments in foreign assets and deeper exposure to global markets.
The risks also arise from more specific sources. These include volatility in different financial markets, fluctuations in the global prices of commodities, currency exchange rate risks, impacts of geopolitical events, and changes in the regulatory environment.
4. Market Distortions and National Security
Another criticism of sovereign wealth funds revolves around the potential global influence that the governments owning and controlling these funds can exert on certain institutions and markets or even other countries and national governments.
The significant capital deployment capabilities of large-scale funds have the potential to distort financial markets. Investments in sectors or companies can impact market dynamics, valuations, and competition. Critics have argued that the ability of these funds to take substantial positions may undermine market efficiency and create uneven playing fields.
China Investment Corporation was accused in 2015 of purchasing and holding large stakes in major European companies to gain control of strategically important companies and industries in Europe for geopolitical gain rather than financial gain.
The Abu Dhabi Investment Authority purchased several real estate properties in the United States in 2008. This move was criticized as an attempt to take advantage of significant price depreciation in the U.S. real estate market during the 2007-2008 Financial Crisis and gain control of critical assets amidst an ongoing economic crisis.
Large-scale investments of governments in recipient countries essentially raise national security concerns because of the potential of these foreign entities to exert political and economic control through their investment holdings and via market manipulation.
Pointers Concerning the Pros and Cons of Sovereign Wealth Fund: A Critical Evaluation and Pragmatic Approach
It is important to note that the aforementioned disadvantages of sovereign wealth funds do not apply to all funds. A lot of funds have implemented measures to address criticism. The potential drawbacks associated with these investment funds are resolved or mitigated through improved transparency, robust governance frameworks, adherence to international best practices, and clear investment mandates of government authorities.
Sovereign wealth funds also have long-term investment horizons and are often structured to withstand short-term market volatility. They may have investment diversification strategies and risk management frameworks in place to mitigate risks stemming from widespread economic downturns. Exposure to global economic risks varies across different funds and their respective asset allocation, investment strategy, and risk management practices.
A sovereign wealth fund can bring forth benefits to a particular country when handled properly. Setting up a particular investment fund is a practical approach and a sound fiscal management strategy for countries with budget surpluses coming from excess revenues from exporting commodities, improved tax collection due to economic prosperity, higher revenues from state-owned enterprises, or sales of government assets.
