Stumbling and Mumbling

Author: chris dillow   |   Latest post: Tue, 29 Sep 2020, 4:14 PM


For (and against) a sovereign wealth fund

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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. Hp£

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.

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