Dr. Rajiv Sharma has written an extensive literature review of “sovereign wealth funds’ investment in sustainable development sectors” for the UN sponsored high-level conference on Financing for Development.
Sharma is research director, global projects center, at Stanford University.
He writes in this review that there are “a number of issues that are inhibiting the flow of capital into Sustainable Development Sectors,” from sovereign wealth funds. Some of these obstacles arise from public policies. Stabilization funds, in particular, are those which have to be ready for a drawdown request on short notice, and this forces upon them a bias for lower-risk, highly liquid, passive investments. They are not good candidates for the sort of capital infusions into highly illiquid long-term projects that development requires.
On the other hand, “pension reserve funds, savings funds or reserve investment funds” all have longer term horizons and can be sued to support growth and development, and in particular in support of the U.N.’s sustainable development goals (SDGs).
With pension (or “superannuation”) funds in particular there is also the issue of the size of the inflows. How many workers are paying steadily into the pool, and are many of them young and healthy, likely to keep doing so? Sharma cites a study by Cummings and Ellis (2014) that indicates that the funds flows of institutional investors influence the weight that their managers place upon illiquid investments. The Cummings/Ellis study chiefly involved the portfolio decisions of superannuation funds in Australia in the period 2004-2010.
Obstacles and Opportunism
Yet even if the risk appetite is there, and the regulatory/political context would allow for investment in the SDGs, other considerations may prevent or limit it, such as “group-think, escalating commitment and social structures within firms.” Sharma cites K.J. Laverty1996 piece, “Economic ‘Short Termism’” on this. Laverty also says that managers have opportunistic reasons to concern themselves with short term results, building their own reputations thereon.
In order to see the connection between institutional short termism and careerist opportunism, it helps to observe that the “average tenure of a chief investment officer is approximately four years” and “the tenure for more junior staff may be shorter and there can be significant pressure to perform within this period to achieve career progression.”
Four Investment Styles
Sharma also discusses how the SDGs fit in amongst the various “investment styles and trends”: in the world of SWFs. There is, for example, the Norway model. Norway’s SWF invests chiefly in traditional public market assets, both equities and fixed income instruments, in a quite traditional 50/50 or 60/40 mix. This contrasts with the Yale endowment model, which invests in private market asset classes such as PE, realty, infrastructure, and hedge funds, using a top down model of allocation. Both of these (the Norway and the Yale approach) rely largely upon external managers, and in this they contrast again with the Canadian model, employed by the large pension funds in that country, which invests directly, often in alternative assets, on the decisions of its expert internal staff.
Most recently Sharma says, a fourth model has emerged which he calls the Collaborative Model, which recognizes “that private market investing in assets like infrastructure, and development projects is consistent with a long-term investment strategy, that the direct method of investing is the most cost effective … and that alternative external investment managers are required but the governance needs to be redefined for more alignment.”
SWFs are developing platforms and vehicles by collaborations among themselves as peers, and these allow them to combine the Canadian and Yale approaches “to get as close as they can to the direct method” given the practicalities that force external managers upon most institutions of their size.
The Abu Dhabi Investment Authority, the New Zealand Superannuation Fund, and the Alberta Investment Management Company have all joined together to invest in Silicon Valley, and Sharma cites this as an example of the collaborative model.
A Word on Fees
Sharma’s review also has some cautionary words about fees. SWFs would probably invest more in alternatives whose strategies advance the SDGs but for the cost. Adding the 2 + 20 fee structure to portfolio construction costs means that “an alternative investment program can run as high as 5% to 6% a year,” and “”SWFs hoping to earn an illiquidity premium of 5% on their alternative strategies may end up spending the entire premium on fees.”
Sharma cites Kalb’s recent (2015) paper for the CFA Institute for the way in which SWFs are “exploring better ways to work together with external managers that is fair and equitable.”