Q&A with Massimiliano Castelli at UBS Global Asset Management
Posted on 07/03/2012
This interview will appear in the 2Q Y2012 issue of the Sovereign Wealth Quarterly.
This is a Q&A with Massimiliano Castelli, Head of Global Strategy in Global Sovereign Markets at UBS Global Asset Management.
To purchase The New Economics of Sovereign Wealth Funds, please visit: Book Link
About the Book
In May 2012 Wiley Finance released his last book, The New Economics of Sovereign Wealth Funds, a one-stop guide to the macroeconomic environment within which sovereign wealth funds (SWFs) operate. The book provides a thorough guide to SWFs, covering the drivers of the industry, how it operates and grows, the interest from and in Western markets and the pivotal role that SWFs play in the world economy. The activity of SWFs has often ignited a political reaction and a protectionist backlash. By going beyond discussions based on misconceptions to analyze state capitalism, this book evaluates the role played by SWFs within the dynamics that are reshaping the economic and financial geography in the 21st century. The book argues that the emergence of SWFs represents a major element of the secular shift of power from mature Western economies to vibrant emerging markets. It offers an all-encompassing perspective, from a rigorous analysis of the economic and financial drivers of their growth to an accurate description of how these institutions invest for the long-term in global capital markets in the global economy. Identifying the drivers of the growth of SWFs, the book discusses commodity prices, macroeconomic imbalances and current account surpluses. The book goes on to analyze SWFs in the wider global macroeconomic context and examines their capital allocation across regions, asset classes and currencies. The final chapters identify the challenges for SWFs in the new regulatory framework and explore how they are increasingly investing in emerging markets. Finally the book provides an overview on how the Western world is reacting to the growing role of state-controlled investment vehicles and the initiatives by international institutions to find common ground. Written by two celebrated practitioners working in the industry, The New Economics of Sovereign Wealth Funds presents insights from officials in charge of investing a large pool of assets in global capital markets and includes a preface from John A. Fraser, Chairman & CEO of UBS Global Asset Management.
1. Can you tell me about you and Fabio Scacciavillani’s latest book, The New Economics of Sovereign Wealth Funds?
The book is the result of several years of research on Sovereign Wealth Funds (SWFs) I carried out at UBS in various positions. In my earlier years at UBS, as a senior economist for the Middle East region, I witnessed the rapid growth in the wealth accumulated by Gulf commodity-exporting countries. This experience provided me with the opportunity of understanding the key drivers of the accumulation of assets held by commodity-based SWFs.
In my following position as Head of Public Policy EMEA at UBS I dealt with the policy debate surrounding the investment activities of SWFs in Western economies. Following the political controversy surrounding the takeover of British company P&O by Dubai Port World (which is not even a SWF!), several Western governments started a review of their regulations on foreign investments. At that time, the main fear was that the increased investment activities of SWFs in the Western world might lead to a negative political backlash, ultimately resulting into the introduction of protectionist measures against state-controlled investment vehicles.
The eruption of the financial crisis in 2008 substantially reduced these fears and most Western economies are now dealing with deleveraging and have become much more welcoming of SWFs’ investments. Finally, since I took up my current position as Head of Global Strategy in Global Sovereign Markets, the department at UBS Global Asset Management serving sovereign institutions globally, I have been focusing on the investment side of the activities of SWFs.
In the last few years, research on SWFs has increased a lot but most of these publications have focused on the undue influence SWFs might exert through the acquisition of “strategic assets” and on the political backlash that has resulted. When I met Fabio, who is the Chief Economist and a member of the Investment Committee of the Oman Investment Fund, we both felt the need for a different and innovative approach. We have focused on the fact that the rise of SWFs is driven by the shift of the economic centre of gravity from mature economies to large emerging markets (especially in Asia), and to commodity-exporting countries, some of which have been wealthy nations for a long time (e.g. Norway, Canada, Australia). According to this approach, the book discusses in detail the macroeconomic dynamics behind SWFs, their size and growth up to 2016, how and why SWFs invest in global capital markets and the changing geopolitics surrounding the rise of these state-controlled investment vehicles. Finally, the book discusses at length the risk management for SWFs that has become an issue of paramount importance following the global financial crisis.
2. In general, how have the economics of sovereign funds changed after the global financial crisis?
As any other investors in global capital markets, SWFs have suffered heavy losses in their portfolios as a result of the collapse in asset prices. The losses experienced during the crisis have brought into question the “traditional” way of investing, largely based on the stability of risk/return estimates and correlations of asset classes. What recent history has shown is that correlations are unstable, risk premia change, risks from non-traditional asset classes are not always well understood and you need long periods for Strategic Asset Allocation (SAA) assumptions to materialize. Since then, several SWFs have started a gradual upgrade of their investment framework, by incorporating diversification of risk exposure rather than purely across asset classes, “dynamic” allocations to take advantage of the historically high volatility prevailing in capital markets since the crisis and – last but not least – a robust risk framework to better assess drawdown risks.
What the financial crisis has not changed in the economics of SWFs are the drivers of their growth: high commodity prices and the reliance on export-led growth models in emerging markets; both leading to persistent current account surpluses that translate into the accumulation of foreign assets. With regards to commodity prices, the sharp fall experienced in 2008 in the wake of the Lehman bankruptcy proved to be just a temporary pause in a secular trend started in early 2000s for which the underlying rationale is rapid economic growth in emerging markets propelling the demand of natural resources and food commodities and stretching supply to the limit. The second driver has its roots in the aftermath of the Mexican and Asian crises of the mid 1990s which represented the first major hiccups of globalisation. In the painful aftermath of those crises, the authorities in most emerging markets adopted very cautious fiscal and monetary policies translating into the accumulation of foreign exchange reserves. The resilience of most emerging markets during the crisis and their ability to recover much faster than advanced economies provided further support for such a policy stance.
3. Sovereign wealth funds as an investor class continues to grow. How large do you expect sovereign wealth funds to be in 2016?
In the book an entire chapter is dedicated to an estimate of the growth potential of SWF’s assets to 2016. Starting from the optimal management of central bank foreign exchange holdings and having estimated their growth, the growth in the assets managed by SWFs is determined by three factors: the return on the wealth accumulated, the fiscal policy framework adopted by the countries concerned and the new funds transferred from the current account surpluses. Based on this approach, we estimate that by 2016 assets managed by SWFs will be between USD 8.6 trillion and USD 10.8 trillion (reflecting three different return scenarios). Our estimates are made at country level and one important observation concerns the increasing concentration of the assets managed by SWFs in a relatively small number of countries: Norway, UAE, Saudi Arabia (which does not formally have a SWF), China, Kuwait, Qatar, Hong Kong and Singapore will account for 85 per of the total.
4. In the book, you mention an upcoming “war for capital”, could you please elaborate?
Following the 2007-08 financial crisis, at the instigation of the G20 and the Financial Stability Board, a new regulatory framework for banks and other financial institutions started to be developed. The various regulatory initiatives under implementation will lead to a substantial increase in capital requirements for banks. For instance, a 2010 report by McKinsey estimates that by 2019 the European and the US banking systems will need approximately EUR 1.1 trillion and EUR 600 billion of additional Tier 1 capital respectively. This will make bank financing more expensive, banks will be reluctant to lend and alternatives to bank financing will be more palatable for companies, especially non-listed ones.
Furthermore, the fiscal consolidation underway in most advanced economies will reduce the capital made available by governments for investments. In short, the era of “cheap” capital prevailing in the years preceding the financial crisis appears to be over. This is opening up interesting opportunities for SWFs as they have ample liquidity, no leverage and are willing to deploy their funds in the global economy. You can already see the signs of this trend emerging as Western corporates and governments court SWFs to attract their investments.
5. What is the major misplaced fear about sovereign funds?
The major misplaced fear about SWFs is that sovereigns use their financial power to secure large stakes in Western companies with political motivations. Systematic research conducted to analyze the investment track record of SWFs did not detect evidence of any particular bias in their asset allocation choices. A main theme pervading the book maintains that SWFs focus on the long term: the largest SWFs are primarily tools of inter-generational transfer, conceptually not much different from pension funds. Their strategies display a higher risk tolerance than those pursed by, say, central banks that need to keep a liquid pool of foreign assets to stem a speculative attack on their currency. But SWFs strategies are more conservative than those of most private equity funds and definitely would not be on any meaningful level of comparison with the strategies of most hedge funds; although it is well known that some SWFs have invested part of their endowment in large alternative asset funds.
In other words, SWFs follow a wide spectrum of strategies that cannot be characterized precisely. As a final observation we would like to stress another difference between SWFs and privately owned institutions: SWFs are less prone to the accusation often leveled at private equity funds or hedge funds that they are machines for self-enrichment of the partners and are more inclined to foster long-term efficiency and accountability in companies they invest in. This characteristic would display its maximum benefits in countries where markets are not fully developed and governance is in its infancy.
6. There is groundswell for public investors and sovereign funds to increase assets managed internally. What are some major risks of doing this?
There is definitely a trend, particularly among the largest and most established SWFs, to increase the proportion of assets managed internally. From a certain point of view, this makes sense: as SWFs mature and improve their investment and risk framework, they develop in-house capabilities that can be used to manage part of their portfolio internally. It is very unlikely, however, that SWFs, particularly those investing across a wide range of asset classes, can develop effective in-house capabilities covering all types of investments. Therefore, I believe that SWFs will continue relying on external managers for a significant share of their assets.
What I believe should be considered as priorities for most SWFs when increasing the share of assets managed internally is the establishment of an effective governance structure and the setting up of a robust risk framework. An effective governance structure ensures that investment decisions are solely based on financial and commercial criteria, free of any political influence. With regards to risk management, except for few notable cases, until the financial crisis erupted SWFs were not renowned for their risk management culture. The objective of an asset manager is to identify an acceptable level of risk (i.e. tolerance of losses and mistakes, which are inevitable) and then devise strategies, within those parameters, to optimize returns over the investment horizon. Ultimately, risk management is human judgment guided by a set of imperfect (to different degrees) quantitative tools and constantly updated qualitative assessment. Quantitative tools are useful to highlight the relationships between different asset classes and their dependence on macroeconomic dynamics, but they must not be considered to be an auto-pilot system. SWFs and other asset managers who do not constantly monitor the macroeconomic environment are destined to bear severe losses or at best to underperform.
7. Anything you would like to add?
In the book The New Economics of Sovereign Wealth Funds, Fabio and I also discuss at length the issue of the shift of the global economy to a multipolar financial system and the role played by SWFs. This shift in the economic centre of gravity towards emerging markets will inevitably affect global finances. The financial system is a network dominated by two main hubs, Wall Street and the City of London. This arrangement is anachronistic for three main reasons:
1) London and New York rose to prominence because their financial centres served leading capital exporting economies;
2) These hubs are burdened by toxic liabilities and sovereign debt which must be purged through a long and painful process;
3) The concentration of risks in two locations whose regulatory frameworks are in flux constitutes an intolerable hazard.
As a result, the global financial architecture is gradually transmuting into a spider’s web with several interconnected financial nodes scattered across the globe, with enough depth and sophistication to absorb excess capital from their own regions and elsewhere.
SWFs are spearheading this secular shift to a multipolar global financial system. What makes SWFs such a formidable force is their ability to withstand short-term volatility (being barely leveraged) and to deploy fresh capital without being overly concerned about redemptions. While Western banks deleverage and their governments consolidate public accounts, SWFs can provide crucial long-term capital needed to support the global economy.
Furthermore, SWFs are encouraged by their Boards to mimic private equity funds, by channeling funds to capital-starved economies and investing in so-called ‘hard’ assets globally. Hence a sizeable chunk of international capital is directed to high growth economies, away from dollar or euro denominated assets. Historically, creditor countries have influenced the design of financial architecture and this juncture is no exception. Debtor nations, especially those gripped in a debt crisis requiring international support and foreign capital, would be wise to recognize this reality.
About Massimiliano Castelli
MASSIMILIANO CASTELLI, PhD, is Head of Global Strategy in Global Sovereign Markets, the department at UBS Global Asset Management advising central banks and Sovereign Wealth Funds. In this role, he analyzes the market trends affecting the investment behaviour of sovereign institutions and works closely with investment specialists in providing investment advice and developing tailored investment solutions for this client segment.
Since the political debate surrounding SWFs has appeared on the international policy agenda, he has established himself as a global thought leader on the macroeconomic, financial and political trends in sovereign wealth management. He has often been called in by leading institutions and think tanks as an expert on global economic and financial matters, he regularly writes articles and essays on these topics and is often invited as a speaker at international conferences.
In his fifteen year long international professional career, he has been Head of Public Policy for UBS in Europe, Middle East and Africa, Senior Economist for the Middle East region at UBS and an economic consultant advising governments and corporates in emerging markets on behalf of international institutions. He holds a PhD in Economics from the University of Rome where he lectured and an MSc in Economics from the University of London.