How does a sovereign wealth fund operate?

Jeffrey E. Garten: Sovereign wealth funds are very much in the news today, and one of the challenges, I think, is to distinguish one from another, because most of the commentary has really lumped them all together. Could you give us a sense of the origins of GIC and what the rationale was for setting it up?

Ng Kok Song: I’ve been involved in the investment of Singapore’s foreign reserves for 37 years. When I graduated from university in 1971, I joined a department in the Ministry of Finance that was managing our foreign reserves. This was six years after Singapore became an independent country in 1965 and we had a very small sum of foreign reserves, which had been inherited, you might say, from British colonial rule. A year after I joined the Ministry of Finance, the Monetary Authority of Singapore was established, and the reserve management function was then transferred to the central bank. Then in 1981, the government decided to set up a specialized organization, separate from the central bank, which is the present-day GIC, to focus on this task of managing the foreign reserves.

This historical backdrop is helpful to understand why and how the reserves have been managed. It has a lot to do with the economic development philosophy the government had adopted since independence. This recognizes that Singapore is a highly open economy where external trade is several times our GDP and hence the economy is very much exposed to the occasional volatility in international trade and vicissitudes in the global economy. So, there was a desire to accumulate savings to provide a cushion for a rainy day, should the economy fall into a period of prolonged difficulties. We also wanted to be as self-reliant as possible. From the very beginning, the government pursued policies of thrift and high savings. We financed our economic development initially with domestic savings until we were able to command enough confidence among the multinational companies, who then began to invest in Singapore.

Because Singapore’s economy is highly dependent on us providing services, such as financial services, it is extremely important for us to have a strong national balance sheet so that we can foster confidence in Singapore. It’s like a bank with a very high capital ratio to inspire confidence. These are basically the reasons why we felt it was important for the stability and long-term growth of our economy to build up a store of national savings, and to manage these funds prudently.

Garten: Does GIC manage all of Singapore’s foreign reserves?

Ng: No. As far as the foreign reserves of Singapore are concerned, roughly speaking, you can say that they are being invested by three entities. GIC is the largest, followed by Temasek Holdings, bearing in mind that Temasek Holdings has both domestic as well as foreign assets whereas the GIC invests only overseas. Finally, the central bank itself holds foreign assets as part of its liquidity reserves.

The way that we decide what goes into which pot is basically driven by an analysis of the government’s liabilities. What we have done in Singapore is to clearly segregate our foreign assets into two pools. One pool, which is very much for the central bank’s exchange-rate management purposes, is held by the Monetary Authority of Singapore. The assets which are managed by the GIC and also by Temasek Holdings could be deemed to be longer-term, higherrisk assets, which are basically unencumbered by specific liabilities. Therefore these two pools of funds can be invested like in a perpetual endowment.

Garten: How is GIC itself aligned organizationally with different kinds of investments?

Ng: We are a fund management company. The government is the owner of the funds, and we manage the funds as an agent for the government. The government determines the investment objective and the risk tolerance for the portfolio. The investment objective is that the GIC is expected over time to produce an investment return which would at a minimum maintain the global purchasing power of our reserves and hopefully enhance it. So we take as our investment objective a real return over global inflation of about 4 to 5%. That’s our investment objective. It is very clear. As far as the risk tolerance is concerned, the government has established risk parameters which basically determine the maximum draw-down that the government would be comfortable with in extremely negative market environments.

The investment objective, as well as risk tolerance, then guide the asset allocation policy for the portfolio. In recent years, we have basically had a portfolio which is equity-centric, because if you are going to achieve those kinds of real returns you will need to capture the risk premiums which only public equities or other forms of equity can provide. We also have a meaningful allocation to private equity assets, to real estate investments, to hedge funds, and to commodities. Then for diversification, about a third of the portfolio is held in lower-risk assets such as nominal bonds and inflation-linked bonds.

Garten: Is it fair to say that GIC, even though it has a private equity component, is not in the business of buying and controlling companies?

Ng: That is correct. We’ve got to go back to the underlying objective. The underlying objective, as I’ve mentioned, is a very clear financial return objective. It has nothing to do with wanting to have control. In the main, we are a passive portfolio investor. For example, in the private equity area, almost two-thirds or even three-quarters of our private equity investments are invested through funds managed by external managers. In practically all of the invest-ments that we have made, there is no desire for control. In some cases, we can make a contribution to the companies that we invest in by adding value in terms of advice where it’s solicited or in terms of helping the companies to exploit investment opportunities, especially in Asia, but control is not on the agenda.

Garten: I think a lot of people are interested in the link between a fund like yours and the government. You made it very clear that you are an agent of the government. But how should we think about the management structure insofar as major decisions are concerned? Where is the line between GIC, as a very commercially minded entity, and the government?

Ng: Our corporate governance is very clear in this regard. The government gives the GIC an investment mandate which spells out the investment objective and risk tolerance. The government leaves all investment decisions to the GIC. The only other involvement of the government in the affairs of the GIC is to appoint the members of the Board of Directors of the GIC. The government does not get involved in the asset-allocation policy of the GIC, but leaves it to the Board of Directors to decide on that. And in regard to particular investment decisions, the government does not give any instructions and we do not have to consult the government. The government does not get involved in specific investments or the appointment of external mangers who are involved in managing a part of the GIC’s funds.

Even within the GIC, the GIC Board of Directors’ primary responsibility is to approve our asset-allocation policy, by which we mean the asset classes that the GIC can invest in and the proportions of the portfolio that should be allocated to each of these asset classes. The Board of Direc-tors does not get involved in individual investment decisions or specific investments, which are delegated to GIC management.

Garten: Can you give us some sense of the kind of people that are selected to be on the Board? I assume that the Ministry of Finance is represented.

Ng: Yes. The Board of Directors of the GIC comprises both representatives from the government and from the private sector. For example, the chairman of the board is Mr. Lee Kuan Yew, whom you might know because I know that you were involved in the Lee Kuan Yew School of Public Policy here in Singapore.

Garten: Yes. I am on the board.

Ng: Mr. Lee Kuan Yew has been the chairman of the GIC since the time when he was prime minister. The current prime minister, Mr. Lee Hsien Loong, is the deputy chairman. The minister for finance is also a director. We have four directors who are business leaders from the private sector. And finally we have senior management members, led by Dr. Tony Tan, who is deputy chairman and executive director.

Another point I need to make is that the GIC board in discharging its responsibilities for asset allocation policy takes advice from an investment committee. This investment committee comprises a subset of the directors on the board, but it also includes advisors from outside Singapore. These include Charley Ellis [founder of financial services consulting firm Greenwich Associates], whom you probably know; Bob Litterman from Goldman Sachs; and Paul Myners, who is the chairman of Land Securities in the UK. These foreign advisors play a full part in the deliberations of the investment committee and provide a valuable external perspective.

In terms of implementation of policy, this is done through three operating com-panies. There is one operating company for the public markets area, there is one for global real estate, and there is one for private equity and infrastructure. Each operating company has a combination of management members as well as foreign experts who serve on their boards.

Garten: I am going to change the focus from organization and structure to strategy and challenges. Let’s say we look at the last 10 years — what were the three most notable changes in the strategies of GIC?

Ng: I think it may be more useful to go back further in time.

Garten: Okay.

Ng: In the early 1970s, when our reserves were tiny, there was no alternative but to pursue an investment strategy which emphasized safety and liquidity. So, our assets were invested substantially in treasury bills, relatively low-risk government bonds, and bank deposits. But by the time the GIC was established in 1981, the reserves had accumulated to a level where the government could set aside a sum of money which was surplus to our liquidity and safety requirements and which could be invested with a longer-term orientation in order to earn better returns. So at that point the portfolio began to move from relatively low-risk assets into equities. We moved to something more like a balanced pension fund portfolio. In the last 10 years, to answer your question, we have taken that further by having an increasing exposure to alternative investments, including private equity, hedge funds, and real-return investments, such as commodities. We have also extended the coverage of public equity markets from purely the developed markets to emerging markets, both in Asia and outside Asia. These changes have occurred because the funds have increased in size and therefore there is a greater capacity to take risk in order to generate better returns.

Garten: It sounds like, once GIC got beyond the almost exclusive focus on safety and liquidity, you track many of the basic changes that are going on in global finance and in the world economy. I am interested, for example, in the move from developed to emerging markets. Particularly in light of all of the discussion of the growing importance of developing Asia and the so-called BRIC [Brazil, Russia, India, and China] countries, could you say a little more about how GIC is thinking about the emergence of so many different markets and what the implications are?

Ng: We have been moving incrementally up the risk spectrum, you might say. This has come about in part because we were lucky. GIC started investing in 1981, near the bottom of the bear market. They say it is very helpful to be born at the right time. So, we had the tailwind of a very powerful bull market not only in equities but also in fixed income, because of the disinflationary trend that took place from 1981 until very recently. It was a very favorable period of time for us to be moving into risky assets.

In the last 10 years, we began to consider how the world economy is changing. After the Asian currency crisis in 1997, I think it gradually became clearer that the emergence of China and India was going to make a great difference to the prospects for the global economy as a whole, as well as for the emerging economies. Of course, there were other factors at work. Since the Asian currency crisis and the Russian crisis, quite a number of the emerging economies have vastly improved their economic governance; there has been a distinct improvement in their macroeconomic fundamentals. So we felt that the risk-reward tradeoff favored moving a portion of our funds from developed equity markets to the emerging markets. We are now exploring where the next frontiers will be.

Garten: This is a hypothetical situation, but let’s say you and your senior colleagues were sitting around a table, maybe after a board meeting, and you were all relaxing and talking about the next ten years and the two or three big challenges that you face given your thoughts about the way the world economy is moving, plus the growth of other sovereign wealth funds and all the discussion that’s taken place about sovereign wealth funds. What would some of the challenges be that would likely arise in that discussion?

Ng: This subject is not one that we discuss in a very relaxed way around the swimming pool, Jeff.

Garten: Well, say you’re still in the office.

Ng: This is an issue which engages us constantly. I think there are several key drivers for global financial markets over the next 10 years. One, of course, probably the key one, is what is going to be the growth-inflation mix for the global economy. We think it will not be the same as over the last 25 years, so that has enormous implications for the proportion of funds that you want to have in financial assets vis-à-vis real assets. The second issue as we look at geographies for investing is whether we will continue to see the major emerging economies clearly outperforming the developed economy, including the United States. As we sit here today, we find that the markets are all highly correlated. But I think some of these correlations could look different over a much longer period of time — let’s say five years and beyond. So we are assessing what should be our relative exposure to the developed markets vis-à-vis the emerging markets. The third issue is the implications for markets arising from the deleveraging of the international financial system. It seems to us that this deleveraging might throw up plentiful opportunities in the area of opportunistic assets — good assets that have been sold by distressed sellers. We must be mindful that there are investment opportunities which may arise not necessarily from growth but from distress.

So, GIC is adjusting its investment strategy to a different economic environment. What’s becoming clearer to us is it will be easier for us to exploit a lot of these opportunities if we can strengthen further our internal capability. We will continue to use external managers to capture some of the alphas and the betas, but it’s limited. We feel that we have built up a strong capability, particularly here in Asia, not only in the public markets but also in the private markets. This internal capability, supplemented by external managers, can position us better to exploit opportunities, particularly if the deleveraging of the financial system over the next few years implies a scarcity of long-term capital.

Garten: On that point of enhancing your internal capability — historically, so much financial talent has gravitated to London or New York. Are you confident that, given the shifting center of gravity of the world economy toward Asia, when it comes to the recruitment and the retention of great investment talent that GIC, given its record and given the high opinion that people have of the Singapore financial and legal system, is going to be able to increasingly attract the talent that you need?

Ng: This is a very important issue, because the success of building our investment capability depends on our ability to recruit, develop, and retain talent. We invest in over 40 countries around the world. Our operating capability on the ground depends on our having investment management talent that is global in character. Today, 40% of our investment professionals are non-Singaporeans, and we operate in eight overseas offices, the principal centers being London, New York, Shanghai, Beijing, San Francisco, and Tokyo. Now, the challenge for us is that even though we are a sovereign wealth fund owned by the Singapore government and managing the funds of the Singapore government, the way that we want to run this company is to be a world-class global investment management company. It is very important to emphasize the commercial motivation of the GIC in terms of the way that we recruit, develop, and reward talent. Fortunately, we are able to provide very exciting growth opportunities for our investment professionals. The GIC is a growing fund; it is investing globally with a very strong presence in the fastest growing part of the world, which is Asia; and it is a multi-asset-class investor that provides a lot of exchange of knowledge and synergy.

Garten: Last spring, I was taken aback when, in one of my classes, one of the students was describing his future professional plans, and he said, “I either want to work in private equity, hedge funds, or sovereign wealth funds.” I am sure that, two years before, he had never heard of a sovereign wealth fund. The category has received so much attention, and there is a sense that the category of sovereign wealth funds — and I realize that it is a very rough category — is becoming a very major one. Obviously, there is an upside to it in the sense that a lot of talent will now be looking at sovereign wealth funds as a really interesting place to work. But on the other side there has been a lot of public-policy discussion about whether sovereign wealth funds could be politically motivated down the road. I don’t think anyone is saying they are now. Have all of the discussions that have taken place in the U.S. and Europe about potential political motivation or lack of transparency or special hurdles for sovereign wealth funds had any impact in terms of GIC and its view of where it will be over the next several years?

Ng: We have been participating actively in this international debate about sovereign wealth funds. We have been working with the U.S. Treasury on some of their initiatives and we have participated in discussions led by the IMF. We feel there is a great need to clarify the issues. Sovereign wealth funds are not a homogenous group. I don’t think any government in the world would seriously think that Singapore could be a dangerous investor, because we are a small participant in the global economy and because of the way we have conducted ourselves. So we are concerned that we might get unfairly tainted in the current controversy.

We have been operating for 27 years and I think it is probably better for you to get an opinion about the GIC from the people we do business with or people who know us than to listen to propaganda from me. At the same time, although we do not wish to be a high-profile investor in any way, we are willing to make certain disclosures which would improve things in the area of transparency. But I think such disclosure standards have to take into account the particular circumstances of each sovereign wealth fund, and certainly we feel that a one-size-fits-all approach is inappropriate. We think that it is in the interest of both sovereign wealth funds and recipient countries to avoid restrictions on free trade and free investment, which would be undesirable for both parties.

Garten: Is there anything that you would like to add by way of clarifying the GIC’s role, insofar as you think it is not well under-stood by the public outside of Singapore?

Ng: I think by and large the external world understands GIC quite well. As a long-term investor I think we have a contribution to make to global market stability. Our primary goal is to achieve long-term returns responsibly. There is a lot to be said for having a set of market participants who are concerned with long-term invest-ment results as opposed to short-term, mark-to-market gains. I feel that we have fulfilled that role, and our record stands for itself. In the last 25 years, we’ve been able to accomplish quite satisfactory investment returns. We have made 9.5% in U.S. dollar terms per year on average, and that’s a real return over global inflation of about 5.3%. We want to be able to continue to discharge our responsibility to the people of Singapore.

It is not part of our responsibility to go and advise other people on how to manage their sovereign wealth funds, but we do get a lot of requests from new sovereign wealth funds who would like to learn from the GIC’s experiences, as well as our mistakes. We basically feel that there are some fundamentals that need to be in place. The number one is to have clarity of objective. It is very important for any investment portfolio to be clear about its investment objective, because that will enable it to hold on to its long-term character. Secondly, I think, as a sovereign wealth fund, it is so important for us to be able to demonstrate to the world that our corporate governance ensures that our fund is invested in a commercial way with no government interference or intervention in specific investment decisions, that we have no control agenda, and that we have no political objectives in the way we invest our money.