Sovereign wealth funds: The new rulers of finance

SOVEREIGN WEALTH FUNDS are reshaping the financial markets. Although the estimated $2 trillion of assets that they manage is small beer compared with the $53 trillion that mature-market institutional investors oversee, the speed at which the state-owned funds are accumulating assets is astonishing. Powered by high commodity prices and surging foreign exchange reserves, they will grow by $1.2 trillion a year to reach $7.9 trillion by 2011, reckons Merrill Lynch.

Analysts might dispute the precision of these figures but few dispute that sovereign wealth funds are becoming a force in the financial markets. On an individual basis, the six biggest funds are quickly catching up in size with the leading global portfolio managers, such as Barclays Global Investors, State Street Global Advisors and Fidelity. Already the unleveraged portfolio sizes of these sovereign funds are about as large as the leveraged portfolios of the three biggest private equity firms or hedge funds, according to Citi, assuming a typical leverage ratio of between four and seven times.

Former IMF chief economist Kenneth Rogoff even believes that if sovereign wealth funds continue to grow at their present phenomenal rate then they will be the financial system within a decade.

Their importance does not lie solely in the amount of money they have at their disposal but also in the way they are choosing to deploy it. Sovereign wealth funds invest across all asset classes and in all geographies. They are "increasingly involved in acquisitions and strategic transactions", according to a report by Citi. "They are also becoming a principal driver of the alternative investment industry." The US bank should know. It has just received $7.5 billion in new capital from Abu Dhabi Investment Authority to help strengthen its balance sheet. The coupon at 11% may appear to be high but it is tax deductible for Citi and, so, similar to the yield on its equity.

With stock markets in Europe and the US tumbling, credit markets in dislocation and M&A activity drying up, the influence of these funds will become even more evident. "At a time when deleveraging is taking place and potential providers of capital, such as banks, hedge funds and insurers, are reducing their risk levels, sovereign wealth funds, by keeping their powder dry, can undertake a deal when others cannot," says Dino Kos, a former senior official at the Federal Reserve Bank of New York and now a managing director at Morgan Stanley Investment Management in Hong Kong with responsibilities for sovereign wealth funds and central banks.

Given sovereign wealth funds’ emergence as power brokers in the global capital markets, financial institutions are busy trying to understand what makes them tick. That analysis, which is still at an early stage, is made harder because, unlike other official institutions such as central banks, there is no uniformity about the way sovereign wealth funds manage their money. "There is an agreement about how central banks should manage their reserves. Most central banks follow the general tenets of reserves management of seeking security and liquidity first and only then do they seek returns," says John Nugee, head of the official institutions group at State Street Global Advisors in London. "In contrast, there is no agreement about how sovereign wealth funds should manage their money." Indeed, he adds, one of the problems in analysing sovereign wealth funds is a tendency to treat very different funds as if they were all the same.

These funds are not an homogenous group acting in concert. "When we talk about sovereign wealth funds they are not a pack that operate in exactly the same way with exactly the same needs," says Cynthia Sweeney Barnes, global head of sovereigns and supranationals at HSBC Investments in London. "There are varying levels of sophistication and varying levels of appetite for risk. Like all institutional investors they are evolving."

The Citi report, Sovereign wealth funds: a growing global force, adds: "Some sovereign wealth funds invest purely to achieve financial returns and portfolio diversification while others have a broader economic or social agenda." What that agenda is – be it the development of the domestic economy or certain industries or the promotion of national champions – depends on the specific fund.

Old funds, new funds

Sovereign wealth funds are not new. The first such fund was established in 1953 by the Kuwaiti government. But their sheer scale and their diversity of activity over the past 12 months has catapulted them into the limelight.

So far, most of the market’s focus has been on the commodity-based Middle East funds, as well as the more established Asian investment vehicles, such as Singapore’s GIC and Temasek. But attention will increasingly turn to some of the newer funds, especially to the $200 billion China Investment Corporation (CIC), which was created earlier this year.

Funds are also cropping up in eastern Europe, Latin America and Africa. Russia, for example, will split its Stabilization Fund next year into a Reserve Fund to which revenues from oil and gas up to 10% of GDP will accrue, and a Fund for Future Generations, which will invest in riskier assets. Brazil, too, has announced that it will establish a state investment vehicle. Even Libya, a country still recovering from years of sanctions, has got in on the act, with a $40 billion fund.

One of the problems in analysing sovereign wealth funds is a tendency to treat very different funds as if they were all the same John Nugee, State Street Global Advisors