How to Manage $2 Trillion If You're New at It
Saudi Arabia is about to confront a serious challenge: Where and how to invest the money in a gigantic new sovereign wealth fund created as part of an effort to diversify its economy and pivot away from its dependence on oil.
That is going to put a lot of pressure on whoever becomes the chief investment officer for the country's Public Investment Fund, which may end up with responsibility for as much as $2 trillion.
Before the Saudis start putting that enormous pile of money to work, they may want to take a moment to consider a few items related to costs and performance of the new fund. Given the size of that portfolio, likely to be the world’s largest, a few basis points lost here or there may not seem like something to be too concerned about. But those small crumbs might add up over time to many billions of dollars. That could pay for a lot of services for the citizens of Saudi Arabia, who haven't seemed especially happy with the economic performance of their nation, its repressive culture and closed political system. How effectively this fund is handled might figure in whether the Saudi royal family survives, or if it gets eased out by more aggressive modernizers or succumbs to the forces of the most brutal religious fundamentalists .
It behooves the fund managers to think long and hard about how to handle this. Allow me to suggest a few topics for consideration:
Costs: All of the academic data overwhelmingly demonstrates that costs are the single biggest drag on returns. They are also the item over which investors have the greatest control. It is tempting to ignore them. That would be a huge mistake. It is precisely why watching costs very closely from the very beginning is so important. It is all too easy to lose sight of spending due to the sheer size of the portfolio. Look at how Vanguard Group manages its own operations for a good example of what to do.
Advantages and disadvantages: It is important to understand the institutional advantages a fund of this size has, and what that girth may prevent it from accomplishing. The Saudi fund will have an ability to access deals and negotiate costs down that most merely huge funds may not. However, the size means that many deals will not be relevant to you. A 100 percent return on $1 billion will not alter the bottom line. Warren Buffett may be the model for seeking out opportunities -- getting a deal like his investment in Goldman Sachs during the credit crisis -- which are available to almost no one else.
Simplicity: The financial industry has spent decades creating complexity in investment products, but this serves a purpose of little relevance to a giant sovereign fund. Simple, transparent and low cost are what will serve this fund the best. I know there are lots of sexy ideas out there, but history suggests that the expense of managing complexity is problematic. That’s before we ever get to the issue of performance. This is why a basic portfolio of 60 percent equities and 40 percent bonds has beaten almost all of the complicated investment ideas during the past decade.
Venture capital: Assume that the $3.5 billion dollar investment Saudi Arabia just made in Uber yields a 10-fold return during the next five years. Does that move the needle? Not in the least. It’s a 20-basis-point rounding error, unless it can be repeated hundreds of times -- unlikely in the extreme. Besides, a car service doesn't exactly seem like it represents that much real diversification away from oil.
Consultants: Of all the warnings today, this may be the least expected: Beware the investment consultant. Although sometimes considered integral to large investment funds by chief investment officers, consultants tend to promise much more then they deliver.
Organizational Alpha: While many funds look to money managers for their alpha (above-market returns), they neglect a source of gain that is much more within their control: building an on organization from scratch designed to implement a desired investment strategy.
Alternatives: I have long argued that only a handful of so-called alternative investments consistently generate alpha, and these funds have captured most of the industry's assets. The size of this fund means it should have access to these funds, and the ability to negotiate a better fee arrangement. The best model for this is the Yale endowment fund, run by David Swensen.
It will be interesting to see if this huge new fund can avoid many of the errors that seem to trip up existing pensions and endowments. Based on its opening gambit -- the Uber investment -- I have some doubts.
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