This year for the first time CFA Institute held its global fixed income conference in Toronto. Speakers included Felix Chee, the chief representative of the China Investment Corporation in Toronto. The following is a brief snapshot of sovereign wealth funds in general and more specifically, China Investment Corporation.

Sovereign wealth funds (“SWFs”) are defined broadly as state-owned pension funds and investment entities. Their funding comes from central bank reserves that have accumulated from budget and trade surpluses, and which have been set aside for investment purposes that will benefit the country’s economy and citizens.

Generally they are characterized by a long-term investment horizon, no immediate liabilities or liquidity requirements and a strategic economic focus. That said, these institutional investors are not always clearly understood by global financial markets, with greater clarity being sought regarding their economic impact. SWFs can also be an important source of early stage institutional backing – something that typically institutional investors are unwilling to do.

Some countries have created SWFs to diversify their revenue streams. For example, the United Arab Emirates (U.A.E.) relies on oil exports for its wealth; therefore, it devotes a portion of its reserves to an SWF that invests in other types of assets that can act as a shield against oil-related risk.

A report prepared by the UK-based consultancy Monitor Group estimated that total assets under management at 30 sovereign fund entities from 22 nations amounted to U.S.$2.7 trillion in June 2011.

Investments maintained by these sovereign funds included a wide variety of international holdings. Out of the total funding of $2.7 trillion, about $1.65 trillion or 61 percent were from oil and gas related revenue. Chart 1 below summarizes the proportion of investments made by these funds by major asset class.

Investment activities at sovereign funds started in the 1980s, and by 2010, the group overall executed on investments totalling $53 billion. This included a larger number of smaller investments in 2010 than in 2009 and greater participation through direct investments. Also in 2010, there were investments reported in manufacturing sectors and infrastructure projects that were more developmental in focus. In addition, there were signs that investments had expanded into new geographies, such as Latin America (Brazil), Russia and, and with a greater focus on renewable energy and clean technology initiatives¹.

Example: China Investment Corporation

The China Investment Corporation (“CIC”) was set up in 2007 by the state Chinese government with initial investment capital of U.S.$200 billion. Its investment objective was to achieve higher risk adjusted returns from a diversified portfolio for its international reserve account. As of 31 March 2011, the Chinese international reserve account was about U.S.$3 trillion.

Toronto became the first overseas office for CIC in January 2011. Similar to other sovereign funds, the core team at CIC Toronto is operating under the two general guiding principles:

1. maintain a significant minority interest in investments, due to the large investment size but without a controlling interest on the investee, and
2. maintain investment goals of earning high commercial returns from investing in strategic assets

CIC benefits from its long-term investment horizon and its single owner structure provides a better ability to withstand higher volatility and illiquidity in its portfolio. However the emphasis on alternative assets imposes certain operational challenges for the CIC Toronto team. Specialty sector knowledge and deal structuring skills are required at the underwriting stage followed by intensive proactive monitoring and surveillance functions.

In terms of governance structure, CIC reports to a governing board. The day-to-day function is executed by the teams which report to the Investment Committee and Risk Committee. The representative in the Toronto office is responsible for sourcing new opportunities, portfolio oversight, monitoring and surveillance on existing investments, and to maintain a local relationship with the business community and government regulators.

Comprehensive risk metrics and analytics are utilized using an integrated risk management system. However, alternative assets (including private investments, hedge funds and larger direct investments) require more proactive monitoring of each individual investment given specific risk factors not easily captured or measured under standard risk management systems. Key risks include investment risk, credit risk, market and liquidity risks as well as reputation risk, country risk, policy and other non-commercial risks.

¹ The definition on SWF referred to in this article is based on the criteria established by the UK Monitor Group. The U.S. Sovereign Wealth Fund Institute defines SWFs similarly, excluding government-employee pension funds and assets managed by entities for the benefit of individuals.