The Investment Allocation of Sovereign Wealth Funds

The Investment Allocation of Sovereign Wealth Funds Vidhi Chhaochharia (University of Miami) and Luc Laeven* (International Monetary Fund, CEPR, ECGI, and CentER, Tilburg University) May 2010 Abstract: Sovereign wealth funds have emerged as an important investor of global equity, attracting growing attention. Despite concerns that these funds serve political objectives, little is known about their investment allocation. We collect new data on close to 30,000 equity investments from a diverse group of sovereign wealth funds over the period 1996 to 2008. Using investment-level analysis, we show that these funds exhibit strong investment biases compared to global investors: they tend to chase past returns and hold equity portfolios that are conservative and not well diversified, both geographically and across industries, with large holdings in the oil sector and large-cap firms, though there is much variation in investment behavior across funds. These results raise concerns about the efficiency with which sovereign wealth funds allocate their assets when investing abroad, and, given the growing importance of these funds, about the efficiency of global capital allocation more generally, though many of these biases could disappear as these funds grow in size and become more diversified in search of higher yields abroad. JEL classification codes: G3 Keywords: Sovereign wealth funds, Institutional investors, Asset allocation, Capital flows, Government ownership, Information, Diversification * Corresponding author: Luc Laeven, Deputy Division Chief, Research Department, International Monetary Fund, 700 19th Street, N.W., 20431 Washington, DC. Tel. 202-623-9020. Fax: 202-623-4740. E-mail: llaeven@imf.org. We are grateful to Olivier Blanchard, Paul Cashin, Stijn Claessens, Udaibir Das, Giovanni Dell’Ariccia, Joseph Fan, Paolo Fulghieri, Luigi Guiso, Steve Kaplan, May Khamis, Robert Kosowski, Ross Levine, Adnan Mazerai, Abdelhak Senhadji, Antoinette Schoar, Per Stromberg, Vikrant Vig, Yishay Yafeh, Luigi Zingales, numerous colleagues at the International Monetary Fund, and seminar participants at American University, the International Monetary Fund, London Business School, Oxford University, University of Miami, Vanderbilt University, and participants at the ISB emerging markets conference for useful comments and/or discussions. We would like to thank Supreet Arora and Masha Galeb for excellent research assistance. This paper’s findings, interpretation, and conclusion are entirely those of the authors and do not necessarily represent the views of the International Monetary Fund, its Executive Directors, or the countries they represent. 1. Introduction Sovereign wealth funds (SWFs) are a large and growing group of global investors. Their assets under management have grown to about US$ 3 trillion, on the back of rising commodity prices and trade imbalances, and are expected to increase further (e.g., IMF, 2008). As they gradually rebalance their portfolios from mostly fixed income instruments toward global equities, they will soon hold a significant fraction of the US$20 trillion global equity market. For example, if they were to move 50% of their assets into global equity – a typical asset allocation for institutional investors – they would end up holding about 7.5% of global equity. In principle, this search abroad for higher returns and asset diversification should be encouraged as it increases the wealth of future generations in countries with SWFs and improves the efficiency of global asset allocation. Yet, fear that SWFs could become a dominant player in global equity markets has raised concerns in recipient countries about SWFs’ transparency, investment strategies, and political objectives (e.g., Summers, 2007; and Gieve, 2008). One concern is that SWFs target militarily and technologically strategic industries, such as the oil and commodity sector, conflicting with national interests.1 A second concern is that SWFs as government-owned investment funds are used to serve political objectives, thereby distorting the allocation of global equity (e.g., Johnson, 2007).2 A third concern is that SWFs have objectives that are in conflict with those of private shareholders. These concerns have prompted calls for greater transparency of SWF holdings and strategies (e.g., Truman, 2007) and for the suspension of voting rights by SWFs to mitigate concerns that SWFs will distort the 1 In 2005, for example, a United Arab Emirates-owned company, Dubai Ports World, stirred controversy in the US by purchasing P&O, a British-owned shipping company, giving it control over parts of several US port facilities. A year after the acquisition, the company was forced to divest the US operations out of national security concerns. 2 In response to these concerns, multilateral organizations have developed best principles and practices for SWFs (see IMF, 2008; OECD, 2008; and International Working Group of Sovereign Wealth Funds, 2008). 1 corporate strategies of domestic firms to satisfy the objectives of foreign governments (e.g., Milhaupt, 2008). Yet, this debate takes place while little is actually known about the investments of SWFs. Given these concerns, an emerging literature examines the stock price effects of SWFs.3 For example, Dewenter, Han, and Malatesta (2009), Bortolotti et al. (2009), Kotter and Lel (2009), and Fernandes (2009) all find that firm valuations respond favorably to SWF investments upon announcement. In the long run, however, Kotter and Lel (2009) find no significant impact of SWF investments on firm abnormal returns, while Bortolotti et al. (2009) find that these investments exhibit significantly negative long-term abnormal returns. All of these studies focus on announcement dates of SWF investments and are limited by the availability of stock return data on these investments. Bernstein et al. (2009), instead, focus on private equity investments of SWFs, and find that they tend to invest when equity prices are relatively high. The focus of all these studies is much on the implications of SWF investments for the stock performance of firms rather than on determinants of SWF investments. Rather than focusing on stock returns, we examine the asset allocation of SWFs and provide a detailed analysis of the biases of SWF investments relative to those of other global investors. We construct a new, large dataset on public equity investments of SWFs that includes information on 29,634 foreign equity investments by SWFs over the period 1996-2008, unlike existing studies that mostly use cross-sectional datasets. We also collect information on the investment strategy of each SWF and classify funds depending on their investment style, transparency, and governance. We use these data to identify the investment biases of SWFs by 3 These papers build on the more general literature on the investment strategies and performance of institutional investors (see, e.g., Karpoff, Malatesta, and Walkling, 1996; Carleton et al., 1998; Del Guercio and Hawkins, 1999; Giannetti and Laeven, 2008; and Ferreira and Matos, 2008). 2 comparing their investment strategies with those of the overall market and other global investors, and to test the validity of existing policy concerns about SWFs’ transparency, investment strategies, and political objectives. This paper builds on the literature on international portfolio allocation and capital flows, including research on the home bias of investment and the determinants of foreign asset allocation (e.g., Falkenstein, 1996; Kang and Stulz, 1997; Grinblatt and Keloharju, 2000; Dahlquist and Robertsson, 2001; Froot et al., 2001; Edison and Warnock, 2004; Gelos and Wei, 2005; and Portes and Rey, 2005). A large literature has argued that the benefits from international portfolio diversification are large (e.g., French and Poterba, 1991; and Obstfeld, 1994), though some have argued these gains from international diversification can largely be achieved indirectly at home through investments in stocks of multinational firms (e.g., Rowland and Tesar, 2004) or country funds and depositary receipts (e.g., Errunza et al., 1999). Over the past decades, most countries have lifted investment restrictions, thereby fostering trading in assets abroad by implicitly reducing the tax on investment abroad (e.g., Stulz, 1981).4 Despite potential benefits from international portfolio diversification, investors typically still invest a large fraction of their wealth in domestic assets. This home bias of financial assets has been well documented in the literature, and is generally ascribed to transaction costs, informational advantages, or terms of trade responses to supply shocks that provide risk sharing (e.g., French and Poterba, 1991; Lewis, 1996; Baxter and Jermann, 1997; and Coval and Moskowitz, 1999, 2001). 4 Several governments have recently encouraged SWFs to diversify internationally, lifting restrictions on foreign equity investments. The move from domestic to foreign equity, together with an increase in assets under management on the back of rising commodity prices, are key drivers of the increased importance of SWFs in global equity markets. 3 Similarly, investors often prefer to invest in familiar investment opportunities as opposed to foreign or unfamiliar investments (e.g., Huberman, 2001; and Grinblatt and Keloharju, 2001). Such investments into the familiar could entirely be driven by informational advantages, or simply be an expression of affinity with the familiar. For example, Portes and Rey (2005) find that global equity flows are in large part determined by geographical distance and telephone traffic, a proxy for informational asymmetry, while Coval and Moskowitz (1999, 2001) show that investors often prefer to invest in companies that are located nearby. Similarly, Kim and Wei (2002) show that differences in information sets between domestic and foreign investors are also important determinants of asset allocation, and Ahearne, Griever, and Warnock (2004) find that a proxy for the reduction in information asymmetries—the portion of a country’s market that has a public US listing—is a major determinant of US cross border portfolio flows. Finally, Lane and Milesi-Ferretti (2008) also find that equity investments are associated with proxies for informational proximity between countries. Focusing on the investments of SWFs as a special class of public investment funds is of interest because previous research has found that the investment of such government-owned funds exhibits significant biases relative to the investment of private institutional investors. For example, Grinblatt and Keloharju (2001) find that government-owned institutional investors display strong biases to invest into the familiar and subscribe this to less sophistication or direct government interference. Additionally, Giannetti and Laeven (2009) find that public pension funds target high-performance firms and that their impact on firm valuation critically depends on whether they become large, active shareholders or not. Our main findings are as follows. SWFs exhibit strong investment biases compared to global investors: They tend to chase past returns and hold equity portfolios that are conservative 4 ... - tailieumienphi.vn