SSgA CAPITAL INSIGHTS THE EXCHANGE

Part of State Street’s Vision thought leadership series

Current Issues in Official
Sector Asset Management
by
John Nugée
Senior Managing Director
Official Institutions Group
In effect, the last three years have been an extreme stress test
for sovereign asset portfolios, and for the investment principles
and strategies employed by those managing sovereign funds.
Drawing on many conversations with official sector sovereign
funds management, this essay considers how the major funds
have reacted, what changes they are making and considering
and what remaining matters they feel still need to be addressed.

The Fundamental Long-term Character of Sovereign Asset

Management
The starting point for those managing public sector portfolios
has always been the long-term nature of the assets in their
care. Many sovereign portfolios have an indeterminate life,
The past three years have been extremely difficult for all those
and a good number have in effect an infinite life – they are
entrusted with managing asset portfolios. The financial crisis
funds in perpetuity, like the endowment funds of the larger
that erupted in August 2007 sent markets into turmoil, with
charitable foundations. From this, many commentators in the
many assets falling sharply in value and some ceasing to trade
past have drawn the conclusion that sovereign funds should, in
completely. Few investors will look back on 2008-09 with any
general, also have a long investment horizon, and indeed the
happy memories at all, and although markets and asset prices
identification of sovereign investors with a long-term patient
have latterly recovered some of their former value, 2010 is
investment style came to be seen almost as the fundamental
ending with new challenges, as Europe’s sovereign debt markets
characteristic of public sector investment.
continue to be stressed and yields on safe assets remain at
historic lows. As if to reflect this, for much of the last decade, there was a
gradual but definite lengthening of the average effective duration
Official sector asset managers – central banks, governments
and volatility of official portfolios. This was true both for those
and sovereign wealth funds (SWFs) – have not been immune
funds that remained largely invested in fixed-income securities,
to the challenges posed by difficult markets, and few have
for example central bank reserve portfolios,1 as well as for those
escaped wholly unscathed from the events of the last three
funds that moved into or increased their investments in non fixed-
years or so. But most have survived the ordeal, and now that
income asset classes such as equities, property, commodities and
the fire-fighting phase is receding, many sovereign asset owners
so on: here the concepts of “maturity” and “duration” are less
are taking the opportunity to re-examine how their funds
easy to assess, but the increased effective volatility of the resulting
performed under extreme stress, what lessons they should draw
portfolios is consistent with longer investment horizons.
from the market turmoil and what extra defences or changes
in their approach they need to make to avoid suffering as badly
should markets once more plunge into difficulties.
SSgA CAPITAL INSIGHTS | OFFICIAL SECTOR ASSET MANAGEMENT
This general, but rather sweeping, assumption that holders
of official asset portfolios automatically have long investment
horizons was the first principle of official asset management to
be tested by the crisis. The other side of the coin for portfolios
utilising a perceived tolerance for losses to embrace higher risk
profiles (part and parcel of having a long investment horizon)
is that from time to time losses will indeed be suffered, and on
rare occasions those losses can be very substantial. For some
official funds, these losses were of a magnitude to wipe out a
decade or more of investment returns in one 6-month period.2
The shock and disappointment of results like this encouraged
many official asset owners to reconsider their reaction to losses
from first principles, and the implications for their risk tolerance
and investment stance. In short, the crisis posed the question
of whether sovereign asset owners were correct to assume that
simply because their funds were held long term, they were
optimally invested with long-term investment horizons. And in
general, responses fell into one of three or four categories.
For two types of sovereign funds, the analysis was fairly
straight-forward. Most central banks, especially those running
“traditional” reserves management portfolios (i.e. where the
funds are clearly held only or largely for policy purposes rather
than as a store of wealth, and where security and liquidity
are the dominant objectives), found that their experience
reconfirmed their guiding principles and renewed their
adherence to the classic trilogy of security, liquidity and return,
with return definitely the junior of the three and subject to the
other two. Similarly, most pure store-of-wealth funds, where
the objective is unequivocally investment return and long term
capital growth, found that even the dramatic losses of 2008-09
were not enough to cause them to abandon their adherence to
a long-term investment style.
Two other types of official funds though have had a more
nuanced response to their experiences. In particular, there
is a class of sovereign funds that, despite having no formal
obligations or fixed expiry date, nevertheless faces the
possibility of calls on their assets at any time. The most obvious
group of such funds are the straightforward stabilisation funds,
where the nature of the fund contains a contingent liability
to make good any shortfall elsewhere in the national budget.
Some other funds, however, have also found in the last three
years that they have experienced calls for funding from their
finance ministry sponsors of a magnitude and type that they
had not expected. For the funds facing this possibility, the true
dual nature of their mandate (i.e. part long term savings fund,
part contingency fund required to be available on demand) has
become more apparent and in a number of cases, has resulted
in a reassessment of the optimal investment style, and usually
to a heightened focus on liquidity and capital preservation.
Finally, the crisis has encouraged a debate both within and
between central banks with substantial reserves as to the precise
nature of their portfolios and the optimal governance structure
for their management. Over the last 10 years or so, a significant
number of central banks, particularly but not only in Asia, have
accumulated reserves that are now without doubt beyond the
minimum level needed for policy purposes, and as a consequence,
one of the features of central bank reserves management in this
period has been the addition of investment or store-of-wealth
objectives alongside the more traditional reserves management
objectives.3 This has resulted in a number of reserves portfolios
where the central bank is in effect aiming to achieve two purposes
within the same fund – on the one hand, the classic monetary
policy role of the funds, and on the other, an investment portfolio
for which return is the main objective.
Recent turbulent markets have reignited the debate on how
comfortably these two objectives sit together in the same
overall portfolio, and a number of central banks are considering
making the separation between their policy reserves and
investment reserves more transparent, or going the further step
of establishing a wholly separate structure for the investment
part of the reserves.4 If this debate continues to bear fruit, it
may herald in time a greater clarity between the respective roles
of central banks and sovereign wealth funds, and a greater
distinction between the funds the two types of institutions
manage.
Changes in Investment Style
As described in the section above, most sovereign funds
have now largely concluded their assessment of their general
objectives and strategic stance following the market turmoil of
2008–09, and most have confirmed to their own satisfaction
that despite the extreme shock to their portfolios of the last few
years, their approach is still valid and optimal. But within this,
a number of funds have taken the opportunity to assess their
tactical stance on a number of issues, such as their investment
style, their use of different asset classes and their interactions
with other market participants.
One significant field of debate is a revisitation of the long-
running discussion over the merits of active and passive
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management.5 The extreme difficulty which many active (certainly in comparison to some of the weaker developed
management styles experienced during the worst of the market market sovereign borrowers) while still offering attractive yields.
breakdown has reignited interest in a greater use of passive
Indeed, for some central banks – particularly those from
portfolios. A number of sovereign funds have expressed the
Asia – this interest in emerging economy sovereign bonds and
view that with a finite risk appetite and risk budget, there may
regional debt markets also serves to address a deeper concern
be an advantage in using it to access a more diversified set
over the extent to which investments in US dollars and euros,
of market betas rather than reserving it for active managers
which today dominate official fixed income portfolios, still
seeking alpha.
offer long-term store of value properties. For those concerned
This has undoubtedly been reflected in movements of assets, about the long-term outlook for these two currencies, emerging
where the major trend in the last 12 months has been to market bonds not only offer short-term attractive opportunities
increase the amount of assets within sovereign portfolios that in themselves, but are also seen as a long-term safe haven
are managed passively. And some funds have gone even from what many see as uncertain futures for the major reserve
further. In one case, a major sovereign fund in the Middle East currencies.
has opined6 that “whereas in the past we used to assume that
Ironically, interest from other sovereign investors in their bond
assets should be managed actively unless it was clear that a
markets is not always entirely welcomed by the authorities in the
certain asset class or market did not offer opportunities for
recipient countries, several of whom face the twin challenges
active managers or reward active management, now we tend to
of handling the increasing inflow of portfolio money into their
see it the other way round. We conclude that assets should, as
markets and controlling the resulting upward pressure on
the default, be managed passively unless there is clear evidence
their exchange rates. The challenge is therefore to find ways
that a given asset class has sufficient imperfections that active
for sovereign investors to gain exposure to these attractive
management is likely to be consistently rewarded”.
markets in a “market-friendly” manner, not only when the initial
While this does not imply that active management is never investment is made but also in such a manner that any future
worthwhile or that no asset classes will ever offer opportunities disinvestment would not cause its own problems. Asian central
for asset managers to show superior skill, it is a significant banks in particular are leading the field in the consideration of
reversal of approach and one which – even if they have not these issues, including such concepts as off-market exchanges
expressed it so succinctly – seems to have been followed by a of debt and mutual support regimes.
number of sovereign funds in the last year or so.
Risk Management and the Search for Genuinely Uncorrelated
A second theme to come out of funds’ reviews of the last few
Sources of Added Value
years is an increased search for return. Yields on the traditional
Alongside the changes described in the section above, there is
instruments of many official portfolios – developed country
a growing interest among a few of the more sophisticated funds
government bonds – have fallen to historically low figures, and
in identifying and accessing the ultimate sources of economic
even those funds that do not place return high on their list of
added value. This debate arises from the observed failure of the
objectives are questioning the value of holding G7 sovereign
traditional method of risk management and risk reduction for a
bonds when they offer such an unattractive combination of
large portfolio, that of diversification across many asset classes.
minimal returns now and minimal protection against capital
losses in the future should yields return to more normal levels.7 As has been observed before in times of extreme market stress,
correlations between asset classes which seemed to be stable
The first expression of this concern about low yields was felt in
before the event can change dramatically in a crisis, and assets
the corporate bond market, and sovereign funds have joined
whose prices move independently in normal times all too often
many other investors in looking afresh at the attractiveness of
fall in value together in times of market turmoil. And the result
this sector in the last 18 months. More recently, a number of
– as any investor in the markets during the last few years will
sovereign funds – both formal SWFs and latterly also central
attest – is that diversification too often fails to provide investors
bank reserves managers – have explored the possibilities
and their portfolios with the expected protection against
offered by emerging market sovereign bonds, many of the
valuation losses precisely when it is needed most.
issuers of which display sound and strong debt characteristics

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SSgA CAPITAL INSIGHTS | OFFICIAL SECTOR ASSET MANAGEMENT
The most dramatic example of this in the recent crisis was the
breakdown in the commonly assumed relationship between debt
and equity. For many investors, the general assumption has
been that in normal market conditions, fixed-income securities
will show some negative correlation with equity markets,
allowing an investor to reap the benefit of diversification by
holding a balanced portfolio containing both asset classes.
In severely stressed markets, however, this relationship does
not always hold, and while a flight to quality benefitted those
holding top quality sovereign debt, especially US Treasuries,
investors in corporate securities often found that prices of both
the debt securities and the equity stock of companies were
falling together as economic conditions deteriorated. This was
especially the case with securities of some financial institutions,
where their debt issues fell heavily in price alongside their
equity, and also often started to display equity-like qualities as
doubts about company solvency started to emerge.
For anyone seeking to manage risk, this poses a challenge. If
orthodox or standard diversification does not deliver the risk
reduction it was expected to in a crisis, then it is not just without
value, but even worse than this, it is dangerous, because it can
lead asset managers into a false sense of security. Moreover, it
does not seem to be the case that the diversification strategies
that asset managers were employing were “the right idea, but
just not pursued far enough”: very few sovereign funds that the
author spoke to in preparing this essay think that the answer lies
in further diversification.8
One theory gaining some ground is that if diversification of
instruments and asset classes has failed, it may be because the
different asset types are in fact merely different representations
of the same underlying economic activity. According to this
reasoning, what is needed for a truly diversified portfolio is
not so much different asset classes as access to different and
independent sources of economic value. If these sources of
value are truly independent, then they will stay independent
even in a market crisis, and should preserve the benefits of
diversification for any portfolio they are part of.
This naturally leads to a debate on what these independent
sources of economic value might be. Work on this in the
official sector, and indeed in the asset management industry
as a whole, is still at a very early stage, but some plausible
possibilities include economic value derived from natural
resources, from land and infrastructure (i.e. the contribution
of capital and fixed assets), from insurance-type activity (i.e.
accessing the premium that can be derived from inter-temporal
structures), from intellect (i.e. the contribution of education and
high-value processes), and possibly from other value-streams
such as governance (i.e. the contribution of good practices
and sound management) and even art (valued by many for
its intrinsic beauty and capable over meaningful time periods
of providing substantial rates of return9). But refining these
ideas, promising though they are, into a quantifiable theory and
utilising it to build diverse portfolios remains work to be done.
Issues of Reputation and Insurance
One notable result of the market crisis has been to remind
sovereign asset owners of the possibility of reputational loss and
damage arising from strongly negative financial performance. In
general, most sovereign funds operate in an environment where
their stakeholders (government sponsors, general population)
are well aware of the cyclical nature of the investment operation,
and few sovereign funds face major criticism for the occasional
or minor period of disappointing performance.
This tolerance, and the accompanying understanding of the
constraints that large sovereign investors face, does however
have its limits, and when faced with the scale of portfolio
valuation falls that were experienced in 2009, many funds,
even those operating in traditionally less open societies or
those where a generally more deferential tone to the authorities
tends to prevail, found themselves on the receiving end of
some severe criticism. This reminded those responsible for the
management of such funds that their reputation for competence
is a major asset of their fund, and one which if lost, may not
prove easy to recover. In short, many sovereign funds learned
that there appears to be a level of losses which – while
undefined and not mentioned in advance – is nevertheless
extremely damaging if reached.10
This has led to two things. Firstly, funds’ awareness of the
desirability of protecting against extreme losses has increased.
There has been a renewed interest in “tail” or “disaster”
insurance, protecting a portfolio against extreme losses.
The problem here for most sovereign funds is that what tail
insurance is available is very richly priced, and the scale of the
insurance that large sovereign funds might want to buy would
risk exceeding the private sector insurance market’s ability to
provide it. And even if it was available, for any sovereign fund
buying large-scale insurance, the transaction merely exchanges
market exposure for counterparty exposure, which is not
necessarily an improvement for the insurance purchaser.
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Indeed, on a more fundamental level some commentators have
queried even the idea of the public sector seeking large scale
insurance from the private sector, given that in a financial crisis
the flow of support is more usually the other way, as in a market
crisis the deep pockets of the public sector are called upon to
assist those in the private sector facing difficulties.
Faced with this analysis, most large sovereign funds seem to
have concluded that the search for tail insurance is likely to
prove unsuccessful, and that the defences against damaging
reputational losses will remain the traditional ones employed
by the public sector – education of their stakeholders into the
limitations they face in avoiding loss, plus reliance on their
longevity to repair portfolio damage (“time as the great healer”).
On a secondary level, though, a number of funds have looked
afresh at the various instruments they use. It is well known by
official sector asset managers that it is not only the size of a
loss that matters, but also how it is incurred: a $1 million loss
on a bond portfolio because yields go up is “unfortunate”,
a $1 million loss on a credit portfolio because an issuer
defaults is “highly damaging”, and a $1 million loss because
an opaque structured product fails to live up to its promise is
a disaster which risks major public relations and reputational
consequences – despite the loss in all three cases being the
same size in financial terms.
No sovereign fund or central bank has announced formally that
they are ceasing to trade in instruments which were previously
authorised, but many funds are known to be reviewing their
list of approved instruments with the aim of avoiding the more
reputationally dangerous, and it would be surprising if some
of the more elaborate structures which were available in the
markets of 2006 and early 2007 would find favour with official
sector asset managers if they were offered again today.
Other Issues
One factor that the last few years has shown all those managing
sovereign funds is that they do not operate in isolation,
and that their actions are keenly watched both by other
market participants and increasingly by regulators and those
responsible for overseeing markets. This has now become an
accepted part of the sovereign fund landscape, with initiatives
such as the Santiago Principles produced to address the
11
issues raised.
The Santiago Principles address many of the governance
issues pertaining to how sovereign wealth funds conduct their
business. But there is one subject which remains unresolved,
and which is increasingly coming to the fore, and this is how
shareholders in general – whether public sector or not – should
interact with the companies they own shares in and are
thus owners of. This subject has become the topic of much
discussion and debate in the aftermath of the failure of some
high-profile financial institutions, and in a nutshell, the question
is whether shareholders in the failed institutions could or should
have done more to prevent their companies collapsing.
This essay is not the place to review the full debate on this
subject, which at the moment seems to be revolving around
whether shareholders have a right to manage their company
for their own interest, or in addition, a duty to manage it for
society’s interest. One thing is clear, however, which is that
whichever side of the current debate prevails, shareholders will
be exhorted at the very least and perhaps even compelled by
legislation to take a much closer involvement in companies they
own shares in.12
This “closer involvement” has the capacity to cause some
challenges for sovereign investors. SWFs in particular remain
acutely aware of the sensitivity that many in the markets show
towards their ownership of companies, and there is a thin
dividing line between “involvement in” a company and the
much less desirable “interference with” its management and
operation. Sovereign asset owners have not yet completed the
dialogue among themselves, let alone with other stakeholders,
on the best way to resolve this issue.
A closely connected issue which is only just beginning to
receive attention, but which has the capacity to be even more
fraught with contention, is the question of bond-holder losses in
the event of sovereign defaults. While the number of sovereign
funds that own equities, and thus will be impacted by the
debate over shareholder governance, remains limited, almost
all sovereign funds – central banks and SWFs alike – own
government bonds, and until now developed market government
bonds have largely been assumed to be free of default risk.
The stresses in the European sovereign bond market, and the
suggestions from some quarters that holders of sovereign bonds
should not automatically be immune from sharing in any debt
rescheduling arrangement, threaten to re-open this issue in
a most unpredictable way, and few sovereign funds relish the
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SSgA CAPITAL INSIGHTS | OFFICIAL SECTOR ASSET MANAGEMENT
prospect of being part of a “Creditors’ Council” deciding on the
degree of losses that creditors might have to accept in the case
of a sovereign default.
Finally in this section, the issue of the re-regulation of the
financial system continues to produce its own challenges.
Most sovereign investors expect not to be directly impacted
by the new rules, although the drafting of Europe’s Alternative
Investment Fund Manager Directive (AIFMD) earlier this year
should serve as a warning that the legislative process does
not always have predictable or even logical results. Sovereign
funds cannot however entirely avoid being indirectly affected by
rules which change the behaviour of their counterparties and
of markets themselves. Initiatives such as the move to central
counterparties, the increase in capital ratios and the general
tightening of liquidity and collateral requirements will change
markets and will inevitably therefore have some impact on
sovereign funds and their ability to invest their assets.
Conclusions
The last few years have shaken many previously firmly held
convictions and beliefs, about markets, about investment theory
and about the correct way to manage asset portfolios. Sovereign
funds have been hit by the turmoil in markets alongside
everyone else. For the great majority of them, their deep
pockets have enabled them to come through the experience,
but they are not unscathed or unaffected, and they have been
given much to think about.
In particular, a number of sovereign funds found that their
decision-making structures and investment processes were
severely stretched by the rapidly changing market events. In
extreme cases, the worst affected funds were virtually forced to
suspend all new initiatives while the storm was raging. One of
the lessons from the crisis for funds so affected is that existing
asset allocation and external mandate decision processes
were not always well suited to the more dynamic markets
environment they have faced over the last three years. As we
move into slightly less turbulent times, but with the possibility
that market volatility may return, this is an area that a number of
funds are addressing.
Overall, the signs are that most sovereign funds have used the
experience of the last few years to re-examine their core beliefs,
to reassess their general approach to their asset management
task, and in many cases, to confirm that their fundamental
approach is still valid. But within that, they have also taken
the opportunity to refine some of their activities, to address
any weaknesses in process and to prepare themselves for
future challenges. In a world where many are still damaged by
the financial turbulence of the last few years, sovereign asset
owners look well placed to continue to develop and prosper.
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ENDNOTES:
1
This lengthening of the average duration of official fixed-income portfolios represents
partly a move into longer maturity bonds, which certainly took place as investors
sought yield. But it also arose from two other factors: firstly the effect of lower yields
on the duration of bonds already held, and secondly the increase in the effective
duration of US mortgage-backed securities (MBS) once their yields started to rise
after 2005. The important point is that in both cases official asset holders accepted
these two effects and did not try to offset them by shortening their position on the
yield curve.
2
 he Norwegian Government Pension Fund – Global, established in 1996, suffered
T disappointment and an illusion, and when you see how all correlations moved to 1
losses in the later months at the end of 2008 and start of 2009 which eliminated
their entire investment gains since inception. As one of their spokesmen commented
to the review conducted by the Norwegian Parliament, it is a challenge to adhere to
a belief in the benefits of a long-term investment approach when faced with results
of this type. Other funds are widely assumed to have lost even more, though they do
not all make public the detail of their investment performance as transparently as
the Norwegians.
3
A good place to study the evolution of this trend is in successive editions of the
annual “Royal Bank of Scotland Reserves Management Trends” publication,
published each year by Central Banking Publications Ltd.
4
For example both the Chinese and the Korean authorities have set up separate
investment institutions for a portion of their national reserves in recent years.
5
For a major review of the role of active management for a long-term fund see the
paper by Andrew And, Ann F. Kaplan, William N. Goetzmann, Edwin J. Beineck
and Stephen M. Schaefer: “Evaluation of Active Management of the Norwegian
Government Pension Fund – Global”, published in late 2009 and available on the
Norwegian Ministry of Finance website: http://www.regjeringen.no.
6
In a private conversation with the author.
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7
The alternative, i.e. that yields on G7 government bonds will stay at their current
levels for the foreseeable future, poses its own challenges of course, not least for
pension funds, whether public or private. Significantly, though, almost no holder
of official assets that the author has spoken with while researching this essay is
building their investment strategy on the expectation that yields will stay low, and
in almost every case, the base scenario appears to include a normalisation of yield
levels in due course.
8
One fund manager commented to the author that “Diversification was a
in the worst of the crisis, I do not think more of the same would have helped us very
much”.
9
An additional point – which I am indebted to my colleague Rick Lacaille for – is that art
prices have the interesting property of being positively correlated with increasing wealth
inequality. That is, as the rich get richer and wealth inequality grows, so does their
ability to bid up prices of art and other luxuries like fine wine at rates faster than general
inflation. For those that believe that income and wealth inequality is on the rise, the art
market is one of a very limited number of ways of expressing this view.
10
C entral banks have long been aware of the importance of their reputation for
financial competence and the damage that can be caused by very large portfolio
losses on their reserves. Indeed when the author was employed at the Bank of
England in the Reserves Management unit, the unwritten but fully understood
instruction from senior management was that “the aim of reserves management is
the avoidance of the unacceptable loss”.
11
T he Santiago Principles – formally, the “Generally Accepted Principles and
Practices” – were published by the International Working Group of Sovereign
Wealth Funds in October 2008, and seek to establish codes of practice for SWFs
investing in public markets. See http://www.iwg-swf.org/pubs/gapplist.htm.
12
In the European Union, the sentiment seems to be strongly towards emphasising
shareholders’ obligations to society, with the European Commission proposing
regulatory powers to ensure that shareholders engage fully with the management of
their companies for the benefit of all. Whether this is adopted world-wide, and how
it will be applied to sovereign asset owners – or any asset manager they appoint as
their agent – remains to be seen.
This material is for your private information.
The views expressed in this material are the views of John Nugée through the period
ended December 22, 2010 and are subject to change based on market and other
conditions. The information provided does not constitute investment advice and it
should not be relied on as such. All material has been obtained from sources believed
to be reliable, but its accuracy is not guaranteed. This document contains certain
statements that may be deemed forward-looking statements. Please note that any
such statements are not guarantees of any future performance and actual results or
developments may differ materially from those projected. Past performance is not a
guarantee of future results.
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