How Should SWFs Assess Their Own Competency?

Ashby Monk

As an increasing number of SWFs look to take greater charge over the day-to-day investment decision-making necessary to run a large diversified financial institution, as well as bring assets in-house, many have been looking for tools or metrics that can help them understand their success in this domain. In short, there is a nagging question as to whether SWFs’ ‘value added operations’ actually, well, add value.

The obvious tool to use in this situation would be benchmarking; this is a process whereby an organization compares its operations and performance against the “best” firms in a given industry. The idea is simply to learn how to be more efficient by understanding how peers achieve their success. It’s pretty straightforward stuff, and it’s an extremely common practice among institutional investors.

However, SWFs do not lend themselves as neatly to this form of ‘peer review’. Most SWFs are idiosyncratic, which means there are few (if any) actual peers upon which an internal review could be based. For example, you might be tempted to liken the Canada Pension Plan Investment Board to the New Zealand Superannuation Fund. After all, these are two large pension reserve funds. However, in reality, these seemingly similar funds have fundamental differences. One example is their return targets: CPPIB has a 4.2% real return target, while the NZSF has to beat the risk free rate by 2.5% per annum. This difference affects the risk profile of the funds, which in turn makes comparables between them less meaningful.

So, what to do? Well, one option is to follow the path of Norway, which conducted a detailed and rigorous investigation into the specific principles and practices underpinning its SWF’s operations. However, while the report makes for fascinating reading, this is a costly and cumbersome process that, ultimately, confirmed that the fund was pretty much doing what it should have been doing.

As such, I’m inclined to look elsewhere for inspiration on this. In particular, I think the NZSF offers a useful case study, as this SWF is almost manic in its internal performance evaluations (which is another way of saying that it is a good steward of its country’s wealth). The Kiwi SWF tries to benchmark itself on many, many different levels (see Adrian Orr’s introduction in this year’s annual report). In short, this fund really wants to understand how its performance stacks up, and it has expended considerable effort trying to understand which benchmarks work, such as fee structures, and which don’t work, such as coffee consumption in the cafeteria (actually I made up the coffee benchmark, but you get the idea). All this is to say that this SWF is a useful starting point for thinking about how SWFs should assess their own competency.

Anyway, here’s how NZSF CEO Adrian Orr explains the problem of finding appropriate benchmarks:

“Unfortunately, it is not easy to find organisations which match the Fund closely in even some, let alone most or all, respects. What the Fund is for and hence how it works are completely different from any retail balanced or growth fund, and from any other Crown Financial Institution. It is also different to most other countries’ Sovereign Wealth Funds. So, comparing how we run it, and how it performs, with any of those funds is problematic.”

So, then, what can you do? The answer is to set up a Reference Portfolio. I’ll let Orr explain:

“In essence, it is our best effort at designing a ‘shadow’ portfolio which is appropriate to the Fund’s long-term horizon and associated risk profile, and is capable of achieving the Fund’s objectives. The Reference Portfolio is weighted towards growth assets, as is the Fund, but it is comprised of simple, low-cost investments (primarily listed equities and fixed income).”

Basically, the reference portfolio is just a pretend portfolio with exposures to simple, low-cost and passive assets that seeks to match the risk profile of the fund. The idea is to create a bespoke benchmark that can be used to assess a unique fund’s internal operations. And, for that reason, it’s really quite brilliant…which is why it’s popping up in SWFs around the world (even the China Investment Corporation has one).

Thus, in my view, if a SWF is going to be moving the responsibility for investment decision-making in-house, it should think hard about using a reference portfolio (in combination with a variety of other generic assessments) to benchmark performance. After all, if the SWF can’t beat the simple, low-cost and passive reference portfolio, it’s clearly doing something wrong.

1 Response to “How Should SWFs Assess Their Own Competency?”

  1. 1 Weekend Reading « Oxford SWF Project Trackback on October 15, 2010 at 10:45 am

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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