Sovereign wealth funds: The new rulers of finance


Sudip Roy
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State-owned, cash-rich and increasingly influential, sovereign wealth funds have emerged as the most controversial players in the financial markets. All the constituents – banks, private equity, corporates, hedge funds – want a slice of their action. Just how powerful will the funds become? Sudip Roy reports.

Getting the basics right
Financial institutions weigh up the opportunities
Fight on for Aussie’s future prizes
Temasek: A fund apart?

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.

John Nugee, State Street Global Advisors

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

Sovereign wealth funds are not just an emerging markets phenomenon. Norway, which has perhaps the most transparent fund, created its investment vehicle in 1990, with the first capital transfer made in 1996. It was originally called the Government Petroleum Fund but it is now known as the Government Pension Fund – Global. The US (through the Alaska Permanent Reserve Fund), Canada (through the Alberta Heritage Savings Trust Fund) and Australia have sizeable funds too.

No generic model

The different economic and political environments, histories, governance structures, levels of transparency, liability structures and investment objectives of these funds means that there is no generic sovereign wealth fund model. Each is unique.

Norway’s fund was established to meet the country’s growing pensions bill after 2015. It is financed by surplus oil revenues. The fund, which invests solely overseas, has a clear objective. Its aim is to achieve the highest returns but within strict risk guidelines. It is similar to an endowment fund.

Contrast that with the Brazil fund, for example, where the authorities are still figuring out the investment objective and strategy. The only concrete decision taken so far by the Brazilians is that the fund will not invest in equities and that it will make strategic investments.

But what does that mean? Will the fund, for example, make domestic investments? Unlike Norway, for example, whose economy has matured to the point where recycling the government fund’s wealth back into the country would probably do more harm than good, Brazil’s emerging economy would be arguably better served if its sovereign fund had a bias towards local investments. That type of policy would provide a boost to economic development, growth and diversification.

Getting the balance right between international and domestic investments is a tricky task for many funds – not least in the smaller Middle Eastern countries. Much depends on what the fund’s responsibilities are: a savings vehicle for future generations, an investment vehicle to improve current standards of living, or a mix of the two.

Some states even have multiple funds to cover all areas. In Abu Dhabi, for example, Abu Dhabi Investment Authority (Adia), which was established in 1976 to manage the emirate’s surplus oil revenues, predominantly invests in international markets. Regional and local investments fall to another institution, Abu Dhabi Investment Council, which was set up last year. To complicate matters further, local media report that a separate UAE Investment Authority opened just last month, with the task of investing the federal government’s surplus funds.

Flexible strategies

Given their heterogeneity what, if anything, do sovereign wealth funds have in common and what influence do these traits have on their investment strategies? Stephen Jen, an economist at Morgan Stanley in New York, has drawn up five criteria that he thinks define sovereign wealth funds: one, they are state-owned; two, they have high foreign currency exposure; three, they have no explicit liabilities; four, they have high risk tolerance; and five, they have long investment horizons.

Where sovereign wealth funds invest

Varying investment objectives and risk profiles of SWFs

Source: Citi

The lack of fixed liabilities and the long-term investment outlook mean that sovereign wealth funds can, and often do, invest across asset classes and styles: from fixed income to forestry; from passive government bond funds managed internally to alpha-seeking mandates outsourced to third-party hedge funds.

"For sovereign wealth funds, the aim is typically to seek long-term capital growth coupled with a degree of capital preservation," says Mark Austin, head of multi-client relationships for EMEA at Northern Trust in London. "So it makes sense to diversify their portfolios both globally and across asset classes."

Some funds have more diversified portfolios than others. Adia, the world’s biggest sovereign wealth fund, with about $625 billion of assets under management, according to Standard Chartered, invests in equities, fixed income, real estate, hedge funds, private equity and commodity trading advisers. These asset classes are then broken down further to allow for greater specialization. So within equities, for example, Adia invests in European, US, Japanese and Australian stocks, regional small caps and emerging markets equities. In fixed income, the specific asset classes include global government bonds, global investment-grade credit, emerging markets and global inflation-indexed bonds. Overall, Adia’s asset allocation is roughly 50% to 60% in equities, 20% to 25% in fixed income, 5% to 8% in real estate, 5% to 10% in private equity and 5% to 10% in hedge funds and CTAs.

The Alberta Heritage Savings Trust Fund is another sovereign fund with a diverse portfolio, with 45% invested in equities, 30% in fixed income, 15% in alternative assets and 10% in real estate. Norway’s fund, on the other hand, has so far invested solely in public equities and fixed income. At the end of 2006 the split was 40:60.

However, this year the allocation has begun to change, with a greater bias towards equities. The plan, based on a parliamentary decision, is to eventually turn around the split to 60% equities, 40% fixed income. Knut Kjær, chief executive at Norges Bank Investment Management, which oversees Norway’s $360 billion state vehicle, says the move to increase the fund’s equity holdings is a reflection of the fund’s ultimate owner – Norway’s government and parliament – becoming comfortable in taking on more risk. This is all part of the fund’s evolutionary process, says Kjær. "Our advice on increasing the equity exposure is much about understanding the risk tolerance of the asset owner," he says. "The positive experience from 2001 and 2002 when the fund rebalanced during a declining equity market, instead of selling like many investors, has been an important one."

Emerging markets

What has become apparent over the past year to 18 months is that many funds, both old and new, are moving towards riskier assets to help provide high returns. One trend that some investment bankers are seeing is bigger allocations to emerging markets.

Stephen Jen, Morgan Stanley

"To the extent that sovereign wealth funds improve market liquidity, particularly in a way that is not herdish like other types of short-term capital flows, they should be a positive factor for markets in general"
Stephen Jen, Morgan Stanley

"For all of the headlines being generated by the investments in the US and Europe, it’s a fraction of the money that’s going to the emerging markets," says Michael Philipp, chairman of Europe, Middle East and Africa at Credit Suisse in London, who estimates that as much as 80% to 90% of sovereign wealth money is being invested in emerging markets. "They are investing where the growth is."

Whether the level of flows moving into emerging markets is as high as Philipp reckons is impossible to verify. However, there’s little doubt that these regions are attracting greater attention. Adia is a big believer in the emerging markets growth story and is making significant investments, especially in Asia. "What we have invested in emerging markets equities is far greater than what the biggest US pension funds would have – many times more," said Jean-Paul Villain, head of investment strategy at Adia, in an interview with Euromoney last year.

QIA is another sovereign fund planning to increase its exposure to Asia. "Because of some of the attractive risk/return profiles we see there, as well as because of our current weighting towards North America and Europe, we are looking to increase our exposure to Asia," says Kenneth Shen, head of strategic and private equity at the fund.

Not surprisingly, many of the funds are attracted to China. Take Industrial and Commercial Bank of China’s record-breaking $19.1 billion IPO last year, for example. Several sovereign funds participated in the deal, particularly funds from the Middle East, including Kuwait Investment Authority, Adia and QIA. Indeed, more than half of the top 15 allocations for the IPO went to Middle East investors.

"Demand from Middle East investors for US or European IPOs has been fairly limited historically, whereas in Asia they make up fairly significant proportions," says Richard Gibb, head of the Asia Pacific financial institutions group at Merrill Lynch.

Asian funds are big supporters of their own region, largely because of its growth prospects. Temasek, for example, has significant stakes in companies in Thailand, China, Indonesia and Korea as well as at home in Singapore. One of its most recent transactions was the acquisition of a 10% share in Minh Phu Seafood, Vietnam’s largest shrimp processor and exporter.

"Increasingly, sovereign wealth funds are evaluating investments in a manner similar to other major asset managers by choosing to invest primarily on the basis of economic opportunity, irrespective of the sector or geography," says the Citi report.

Alternatives focus

Another area where sovereign funds are allocating their capital is in alternative investments – real estate, private equity, hedge funds, and commodities. Other institutional investors have long seen the potential of these asset classes. "The model for the large sovereign funds is similar to that of the leading US university endowment funds, such as Yale, Harvard and Princeton," says Richard Kushel, a managing director at Blackrock in New York. "They were early adopters of absolute return strategies and placed much greater emphasis on alternatives and less on short-dated liquid instruments."

The financial clout of sovereign wealth funds

Comparing SWFs with other investors and markets ($trillion)

Sources: Citi; Cerulli Associates; EIU; BIS; EVCA; Bloomberg;

Now sovereign funds are following suit. "Clearly, if a fund is investing for 50, 100, 200 years down the road, then having a percentage of sovereign wealth invested in relatively illiquid assets can make sense," says HSBC’s Sweeney Barnes.

She adds that the level of sovereign funds’ interest in alternatives investments can be gauged by a week-long seminar that HSBC holds for them and central banks every year. "At last year’s event one of the very best attended sessions was the hedge fund one," she says.

"There was quite a lot of debate when we were determining the programme about the role that hedge funds had in a traditional central bank forum." The experience, she says, suggests that as these funds accumulate more assets they are increasingly looking for alternative investment ideas.

Some sovereign funds have already built a strong track record in these asset classes. Adia, for example, has been investing in them for several years. It was an early investor in hedge funds, back in the mid-1980s, and made its first foray into private equity in 1992, initially in Europe, and then globally later in the decade. Today it is one of the world’s biggest investors, possibly the biggest according to some observers, in global hedge funds and private equity. Adia, moreover, does not invest solely in third-party managed funds; it invests in the companies themselves. In July, for example, Adia purchased a 10% stake in Apollo Management, a US private equity firm.

Norway’s fund, conversely, has yet to invest in private equity or real estate, although next year parliament is expected to pave the way for holdings of the latter.

As more sovereign funds seek to make investments in illiquid assets, however, they need to be wary of capacity constraints. Quite simply, there are not enough hedge funds and private equity firms in the world to take on these funds’ potential demands. "It may come to a point when they become too big and it becomes too expensive to invest in alternatives to the same extent as before," says Morgan Stanley’s Kos. "They may have to confront a choice of how much alpha and how much beta. One outcome could be that overall returns become driven more by beta. It depends on the individual fund."

Strategic considerations

What further sets sovereign funds apart from other institutional investors is that investments are often made for strategic as well as financial reasons. In May, for example, China Investment Corporation bought a 10% stake in Blackstone for $3 billion in advance of the US private equity firm’s IPO. Remarkably, the decision to invest was made even before CIC was properly set up. Clearly, the Chinese authorities were eager to make a mark with its new fund. Unfortunately for them, the move has backfired, with CIC losing $840 million on its investment in the first three months. The Chinese state media have been particularly critical.

On paper, the Chinese bet seemed sound. At the time, Blackstone was riding the crest of a wave and all indications were that its IPO would prove a resounding success. As it was, the deal came out just as the world was beginning to learn about the credit crunch, and Blackstone’s share price, in line with several other financial institutions, got hammered.

From a strategic point of view the investment made sense, enabling the Chinese to gain potentially preferential treatment for future private equity transactions. The investment also gives CIC access to some of the world’s best-connected and most experienced dealmakers. That the transaction no longer looks as smart as it did at the time of execution is unlikely to deter CIC from making other direct investments. Bankers fully expect the fund to buy significant stakes in foreign companies, especially in Africa, where the Chinese state is already heavily involved as an investor. Other parts of the globe will not be ignored either, with Europe, Latin America and southeast Asia likely to be on the fund’s radar.

Targets will probably include energy, resources and technology – areas where China’s economy is weak and heavily dependent on foreign expertise. To that end, CIC will not only make direct investments but will also finance local companies in these sectors in their efforts to buy strategic assets overseas.

CIC is not alone is making strategic investments. Many of the Gulf funds are buying assets in healthcare, education and financial services as part of a strategy to diversify their economies. One reason why QIA bought a 20.8% stake in the London Stock Exchange and a 9.98% stake in Nordic exchange OMX is because the transactions will give a boost to Qatar’s nascent local capital markets – a critical development if the country is to build a sustainable economy that is not dependent on gas. OMX especially is renowned for its state-of-the-art technology.

Qatar’s finance minister, Yousef Hussein Kamal, says that QIA is now in the middle of negotiations with an education institution in the US. One of the conditions of a potential deal is that the target institution would have to establish a facility in Qatar.

Trophy assets

Sometimes there is nothing strategic about investments. They are pursued for branding reasons or because the sovereign fund sees its target as a trophy asset.

One observer claims that the attempt of QIA to buy the UK retailer J Sainsbury had no clear strategic rationale but was undertaken because "the fund’s advisers in London thought it was a great play". That the bid failed because QIA was unwilling to stump up an extra £500 million ($1.03 million) of equity and that the whole saga destroyed millions of pounds-worth of shareholder value provided the critics of sovereign funds with plenty of ammunition.

The rise of sovereign wealth funds
Estimated size of the 10 biggest sovereign wealth funds
CountryFundLaunch yearSize ($bln)Growth rate (%) estimated p.a.
UAEAbu Dhabi Investment Authority197662510
NorwayGovernment Pension Fund – Global199036028
KuwaitKuwait Investment Authority195321330
ChinaChina Investment Corporation2007200N/A
RussiaStabilization Fund2004127.596
QatarQatar Investment Authority200560N/A
USPermanent Reserve Fund (Alaska)197640.218
Sources: Standard Chartered, Oxford Analytica, Norges Bank

The case for the QIA defence, however, would argue that the fund pulled out because the transaction no longer made economic sense. "The fact that QIA did not complete the deal could be viewed in some ways as a positive," says Cyrus Ardalan, vice-chairman at Barclays Capital in London. "One of the criticisms of sovereign wealth funds is that they don’t act commercially. But in this case QIA did. It could have paid the extra money but didn’t want to."

The critics

That, though, is unlikely to assuage the critics. In recent months, western politicians including German chancellor Angela Merkel, EU economic and monetary affairs commissioner Joaquin Almunia and US treasury official Clay Lowery, have all made statements warning of the dangers of sovereign wealth funds.

Their comments encompass a number of fears: strategic assets falling into foreign state hands, a realization that the world economic order is changing in favour of emerging markets, and, as far as the US is concerned, a worry that if sovereign funds diversify out of treasuries, its debt-fuelled economy will be put at risk.

Germany has even put forward a plan to create an investment fund aimed at protecting local companies from foreign sovereign predators. The fund would buy blocking minority stakes in companies deemed vulnerable to a foreign takeover. The problem for German officials is that they are not getting any support from local banks and insurance companies. Critics of the idea point out that many German companies themselves have direct investments overseas. More significantly, it would be foolish of the German government to bite the hand that might feed its companies.

One banker says he has received visits from five German companies in recent months desperate to get introductions to sovereign wealth funds in the hope that they will take significant minority stakes.

These companies would rather have sovereign funds invest in them than private equity firms, says the banker, alluding to the fact that sovereign funds tend to be much more compliant investors (although of course sovereign funds adopt an activist stance if necessary, as Australia’s Future Fund is doing with Telstra). Moreover, at a time when private equity firms are limited in their capacity to take on deals, the best hope that many companies in need of large injections of capital have is sovereign funds.

And it’s not just in the M&A market that sovereign funds are making a difference. Their longer-term horizon and limited use of leverage means that they can also be a source of stability to the capital markets. "Sovereign wealth funds have a strong risk-bearing capacity and ability to accommodate short-term and medium-term volatility," says Norges Bank’s Kjær.

Morgan Stanley’s Jen adds: "Having such a different temperament from private funds, sovereign wealth funds should reduce the risk of herd behaviour."

These characteristics mean that sovereign wealth funds can enhance market liquidity and, consequently, market efficiency. "To the extent that sovereign wealth funds improve market liquidity, particularly in a way that is not herdish like other types of short-term capital flows, they should be a positive factor for markets in general," says Jen.

Perhaps if sovereign wealth funds were less secretive these characteristics would be more obvious. Equally, if senior western politicians were less confrontational they might come to realize that their economies need sovereign wealth funds. For one thing seems clear: these funds are the new rulers of finance.