For (and against) a sovereign wealth fund

In their excellent Angrynomics Mark Blyth and Eric Lonergan recommend that the government borrows at negative yields to establish a sovereign wealth fund. There’s more to be said for this than they think, because the UK is better situated than many countries to have such a fund.

My chart shows why. It shows that sterling tends to fall when house prices do. In the mid-90s, 2008, 2011 and last year weakness in the housing market was accompanied by a weak pound.

Now, I’m using house prices here as a proxy for something more general – bad times for the UK economy generally.  The chart therefore tells us that a UK-based investor makes a profit on foreign currency assets when the UK economy faces hard times. Although house prices didn’t fall then, the Brexit referendum in  2016 is another datapoint in support of this hypothesis: the markdown in UK growth expectations was accompanied by a markdown in sterling.

This isn’t merely because demand for sterling depends upon actual and expected economic activity. It’s also because sterling is regarded by global investors as a riskier currency than dollars, euros or Swiss francs -  which means that in hard times, when risk aversion increases, they dump sterling. This is why sterling fell during the worst of the stock market falls this year.

This means that for the UK a SWF could be a countercyclical asset. In recessions a falling pound would mitigate losses on overseas equities and generate profits on gold, overseas bonds and foreign currency.

This year’s experience demonstrates this. In the day job I showed that a simple portfolio of dollars, gold, global equities cash and gilts would have lost barely anything during the worst of this year’s stock market falls even with half its money in equities – thanks to profits on gold and dollars. Slightly more cautious portfolios would have risen.

Because a UK SWF would hold up in bad times it can be a counter-cyclical device. Payments from the fund could be raised (slightly) in hard times without greatly jeopardizing its long-run returns.

Better still, it needs no skill to achieve this. The weights in my portfolio were based on no more than reasonable round numbers. That vindicates a point made by the LBS’s Victor DeMiguel, that naïve diversification works well (pdf) (which itself is a specific instance of Robyn Dawes point (pdf) that there is a “robust beauty” in improper linear models.) We don’t therefore need a genius to run the fund. All we need is a mediocrity with a plausible manner to lend it authority. And the UK has an abundant supply of mediocrities with plausible manners.

Sadly, though, I fear this oversells a SWF.

One problem is that it will come under political pressure to invest domestically and to bail out struggling UK firms rather than to diversify internationally. I’m not sure Eric and Mark are selling an SWF when they suggest it bails out UK airlines. For the SWF, that should be a pure investment decision not a political one. If you think UK firms are starved of finance – and I’m not at all sure airlines would be exhibit A for this hypothesis - the solution is a national investment bank, not a SWF.

A second problem is that a SWF that was sufficiently cautiously managed to hold up in bad times would under-perform or lose money in good. Logically, this is no problem at all. One of the basic principles of financial economics is that what matters is your portfolio as a whole. If the SWF loses money when our other assets are doing well – our human capital and domestic businesses – there is therefore no problem. Quite the opposite: the SWF is doing exactly what it should.

Sadly, however, economic logic and the media are not often even nodding acquaintances. We can see this from today’s reports of UK government borrowing, which reveal an utter ignorance of the basic facts that balance sheets have two sides and that one person’s debt is another’s asset. The moment the SWF loses money – which of course even the best funds do sometimes – the idiotmedia will run stories of the “scandal” of “taxpayers’” money being wasted.

From a portfolio management point of view, running a SWF is easy. From a political point of view, it is not.

Comments

[Blissex]

«The moment the SWF loses money – which of course even the best funds do sometimes – the idiotmedia will run stories of the “scandal” of “taxpayers’” money being wasted.»

The "idiot media" are largely not idiots, but skilled megaphones for vested interests, and if there were powerful vested interests that would profit from a SWF even when it makes losses then the "idiot media" would not complain. See (or rather don't see) the complaints about the enormous amounts of money donated (or lent forever at 0%) by the government to the City some years ago.

This leads to a deeper issue: in our blogger's view the role of a SWF would be counter-cyclical, that is to maximize expected total gains over the long term.

But what some powerful interests want is for everybody to maximize their potential maximum gain, because they make the most money during booms, not during lulls or falls, because their compensation is a rule proportional to positive beta.

And this leads to an even bigger problem, the one that I keep repeating: that it is not so much that the City is corrupt, or that government policy is corrupt, it is that many *voters* are corrupt, because they have powerful incentives for self-dealing to maximize their maximum (property and share) gains.

They would not want an SWF that invests abroad in a countercyclical way, they would want one that invests in south-east property to pump up property prices as fast as possible before their retire to Spain etc.

Indeed because as Johnson and Haldane have argued that by far the investment with the best returns is south-east property, I have repeatedly proposed for the UK government to stop investing wastefully in low "productivity" areas like schools, roads, hospitals, military, NHS, and invest all tax receipts and borrow at negative rates as much as possible to invest in Home Counties and London property and BTL, because it is an "industry" far more "productive" than any other.

With the massive profits this would generate soon the UK government could abolish taxes and even return a large citizens's dividend to taxpayers, to be made proportional to how much property a citizen owns to reward them for their high "productivity".

I am sure that putting all tax receipts and additional borrowing into a south-east property fund would be far more popular than putting it into a countercyclical fund investing abroad.

Put another way, we have the government that the blindly greedy and mean thatcherite middle classes that elect it do deserve.

:-)

[ltr]

Blissex:

Indeed because as Johnson and Haldane have argued that by far the investment with the best returns is south-east property, I have repeatedly proposed for the UK government to stop investing wastefully in low "productivity" areas like schools, roads, hospitals, military, NHS, and invest all tax receipts and borrow at negative rates as much as possible to invest in Home Counties and London property and BTL, because it is an "industry" far more "productive" than any other.

[ Perfect. ]

[Robert Mitchell]

They should do a crowd-sourced green public hedge fund. Anyone, including the "idiotmedia", could submit trading strategies for peer review. True democratic finance.

[Nick Drew]

What is the correlation on those two curves shown, over a longer period of time??

If you only showed it from 1998 to 2018, you'd just be commenting on the remarkable period 2008-09, the year of the "great correlation" where most asset classes fell (for reasons we know) and diversification wasn't of much help to any portfolio that was unable to include short positions**

It looks like an extremely dirty hedge from where I'm sitting - much as I strongly endorse diversification, both tactical and strategic.

(**of course, as you imply, a Dollar holding is effectively a Sterling short - and I agree: it's what I did in 2007 when the writing was so very clearly on the wall)

[Blissex]

«diversification wasn't of much help»

But even today how can you diversify? "The Markets" are quite dependent on the central banks, both ways. M Pettis among others has pointed out that worldwide economies seem to behave as if the "core"/peripheral" country thesis was true.
Perhaps China will become another "core" country with a different rythm if it is forced to decouple from the USA economy, but then its asset markets will become (even more) inaccessible.

As to sterling, one commenter pointed out there are only two trades on sterling: short and very short.

[Mike]

"And the UK has an abundant supply of mediocrities with plausible manners."

In my darkest moments I fear I am one of them.