For some countries, the wealth generated from natural resource extraction has been squandered by politicians for short-term gains, sometimes damaging the economy’s long-term competitiveness. As a result, some countries have created wealth funds to ensure longer-term benefits are achieved. But these funds can still be used for political goals. The authors analyze how wealth fund performance has varied depending on its investment management structure.
What’s Inside?
The authors survey different types of sovereign wealth funds and describe some historical examples in which wealth generated from the extraction of natural resources was spent for politicians’ short-term goals. The authors describe several alternative methods for allocating a nation’s wealth and then use a historical dataset to determine how funds managed by politicians are invested differently from funds managed by external managers. The authors conclude that when politicians are involved, investments are more likely to be allocated in the home country and in sectors with relatively high price-to-earnings ratios (P/Es) and that these investments are associated with lower subsequent returns.
How Is This Research Useful to Practitioners?
Sovereign wealth funds have increased rapidly over the last two decades and seem to provide a good way to allocate a nation’s wealth across many generations and avoid simply spending it for the benefit of the current generation.
The ownership structures and mission statements of such funds are not always transparent, which makes them vulnerable to political influence. The authors identify three kinds of wealth funds. First are the funds that acquired wealth from oil, such as some of the Middle East and North African countries and Norway. Second are the funds that are based on such other commodity revenues as diamonds and copper. Last are funds created by some Asian economies, such as China and Singapore, from persistent trade surpluses.
Funds can have several goals: the provision of capital for future generations, the smoothing of government revenue volatility, or the acquisition of strategic investments. Nevertheless, wealth funds encounter agency problems in that they can be used to support local industries or subsidize local firms. The authors assess whether these types of investments are profitable.
Although investment transparency is desirable, the authors stress that transparency of wealth fund investment exposures could be impractical because it might result in the imitation of its investment strategy by others. Furthermore, it can be challenging for very large funds to generate above-average returns; and because of a lack of market liquidity, a profitable investment might not be implemented in its entirety.
How Did the Authors Conduct This Research?
The authors use information on publicly traded target companies from Datastream to assess whether sovereign funds in which politicians are involved have a different direct investment strategy compared with funds that use external managers. The authors assess the P/Es of target companies before the investment and one year after the investment. The data show that direct investments have become more common in recent years and sovereign wealth funds have become central in private equity investing.
When politicians are involved, more funds are invested in the home country compared with when external managers are involved. Using regression analysis, the authors show that these results are statistically significant. The politicians might use funds to bail out underperforming firms or industries. Also, politicians tend to choose investments with relatively high P/Es, whereas external managers invest more in investments with low P/Es.
Furthermore, the politician-influenced funds are associated with lower returns. Interestingly, the high P/Es and low returns effect is independent of any strategic objectives. Finally, by removing some of the smaller funds and performing the same analysis, the authors show that the results are robust throughout the entire sample.
Abstractor’s Viewpoint
This article is very interesting and on a topic that is not commonly addressed in the media. The authors give a good overview of historical events and the reasons for establishing a sovereign wealth fund. They then test their hypothesis that politically managed funds invest differently. It would be interesting to assess whether the poor results for funds managed by politicians persist over such longer time horizons as five years or more. Nevertheless, this article would be especially interesting for financial professionals involved in wealth and portfolio management.