8 min read 15 Dec 17
Summary: Last month, Tristan Hanson and I made a proposal for a sovereign wealth fund (‘SWF’). It triggered a substantial debate. How would it operate in practice? Are we trying to fund investment or earn an equity risk premium? How do we address problems associated with state-ownership? How would it tackle issues of inequality and the UK’s investment needs? What differentiates our proposal from a state-owned investment bank, like KfW in Germany? Is it just a leveraged hedge fund?
This first thing to clarify is why the UK and other developed economies currently have a unique opportunity to do what we are proposing.
A number of thoughtful commentators objected to calling our proposal a ‘sovereign wealth fund (SWF)’, on the basis that these funds are typically associated with large oil discoveries or other sources of balance of payments surplus, the proceeds of which are recycled into a state-owned investment fund – the classic examples being the Gulf states, Singapore and Norway.
Our proposal differs from these examples, but primarily in terms of how it is funded. The U.K. runs a small trade deficit (the larger current account deficit is mainly due to spurious accounting). Oil-producing countries fund their SWFs by selling oil, we suggest doing so by selling gilts.
What is very clear from many of the responses that we have received is that the wealth-creating opportunities opened up by the ability to borrow at zero or negative real interest rates for 30 years are staggering.
For example, if the Fund created a diversified portfolio of assets (more on this below) with an expected return of 4% real, funded with the issuance of £100bn equally spread across 10-year, 15-year and 30-year gilts, it would have created net wealth of more than £80bn in 15 years. This means that it could repay all the debt and would have an unleveraged stock of wealth of £80bn. Thanks to the power of simple compound interest, the current cost of funding available to the U.K. is indeed analogous to discovering oil. This is an historically unique opportunity, and is unlikely to persist.
Some will counter that in order to earn this higher return on assets, the government must take on inappropriate risk. This is incorrect. A portfolio of diversified domestic and global assets with an objective of a 4% real total return does not require an aggressive portfolio because of the special advantages a SWF has over most private investors related to risk and time horizon.
By funding with debt the SWF can choose the profile of its liabilities. This is an advantage that other portfolios rarely have. Most mutual funds have daily liquidity, while pension funds – despite having longer time horizons – are ultimately beholden to their liability profile. The freedom that an SWF would enjoy allows for a long-term view on compounding returns and exploiting the risk premia associated with illiquidity. Moreover, it could diversify risks that would be damaging to the UK, if a portion of assets is held overseas.
Equally important, the liabilities of the government have unique properties. No other significant entities can borrow for 30 years at negative real interest rates. As an issuer of safety assets, when recessions hit, the government’s cost of debt declines, the private sector’s cost of capital rises through a higher cost of equity and higher credit risk premia. This point has been stressed by other economists, including Roger Farmer and Miles Kimball.
Another way to think of this is that one consequence of the control of inflation is that developed governments are near-monopoly issuers of insurance assets. This is absolutely analogous to discovering oil.
There are two other reasons for us proposing an SWF. Critically we want the Fund to operate at arm’s length from central government. It should be completely transparent, have an independent board of trustees, a clear investment mandate, and be run by investment professionals. If universities, charities and other countries can run large pools of assets professionally, why can’t the UK government, with direct access to one of the world’s largest financial centres?
Reflecting the collapse in the government’s cost of capital, interest payments on government debt are at historic lows as share of GDP.
As we and others have suggested previously, the surplus generated over 15 to 20 years could be returned to the private sector to tackle wealth inequality. To emphasise: this Fund does not involve an increase in the government’s net debt. Indeed, as illustrated above, using conservative assumptions, the fund could repay most of the government funding within 15 years and operate without significant leverage.
Everyone agrees that the current real cost of debt should be exploited for infrastructure spending. Great work has been done on the housing, educational and physical infrastructure needs of the UK.
This raises a number of challenges which an SWF is optimally placed to solve. Physical infrastructure cannot be timed to coincide with opportunistic changes in the government’s real cost of debt. Planning and approval for infrastructure projects often takes many years. The current funding opportunity of the government is immediate.
In addition, there are many ways that a sovereign wealth fund could invest in housing, education, physical infrastructure immediately, through already existing investment vehicles – such as direct lending funds, private equity funds, listed infrastructure funds and social impact mutual funds.
Over time and subject to proper oversight and independent investment management, a portfolio of directly owned assets, including loans, physical property and infrastructure could be developed. This has been the strategy of other asset managers with long-term time horizons, such as university endowment funds, sovereign wealth funds and charities. Allocating a significant share to the rapidly growing class of ‘social impact’ funds would also make sense.
On day one, you would expect the sovereign wealth fund to have a portfolio similar to a multi-asset fund, with something like 60-70% in diversified holdings of domestic and global equities – acquired through low cost ETFs. Within 18 months a significant share of the assets could be invested in a broader range of assets, using existing fund structures (e.g. investment trusts, mutual funds, limited partnerships etc.) or segregated mandates. The balance would be held in liquid low risk private sector credit and cash. Gradually the fund could deploy its cash to less liquid and more direct investments consistent with its mandate.
A critical difference between the SWF and other forms of government investment would be for all allocations of capital to have a required investment return. The model for management of this fund should not be that of a department of state run by civil servants. There are many other models which could be replicated such as highly successful endowment funds run by Ivy League universities in the US, or charities, such as the Welcome Trust.
A number of thoughtful commentators have objected to calling the fund a “Sovereign wealth fund,” so have argued it is more analogous to a government run investment bank. Ultimately however, arguments over ‘wealth’ in the name and the use of debt rather than commodities for funding, is really semantics and not a debate over the merits of the idea.
Our proposal is definitively not for a UK public investment bank. Public sector banks typically provide subsidised finance. We are proposing the creation of an independent asset manager of sovereign wealth.
The global demand for ‘safety’ assets and the government’s near-monopoly position as issuer is a highly valuable resource. We should take advantage of it and act quickly. The UK investment share of GDP is low, both public and private combined. All political parties agree that raising investment in housing and infrastructure is critical to future prosperity, but there are huge lags in implementation, major practical obstacles, and fundamental problems of governance and transparency.
We provide a clear solution to these problems: deploy a combination of investment approaches:
Over a decade or so, this will help address fundamental economic needs and create wealth for the nation.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.