The Growth Of Sovereign Wealth Funds

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By Greg Peel

According to BCA research, assets currently under management by sovereign wealth funds total US$3 trillion. The analysts estimate that within a decade that figure will be US$13 trillion. To put that into perspective, that’s about what the S&P 500 is currently worth and about 2.5 times the size of US Treasury markets.

A sovereign wealth fund (SWF) is a fund set up out of government reserves. Typically a central bank will divide its reserves into a “liquidity” tranche and an “investment” tranche. The liquidity tranche is what the central bank considers necessary to hold as a back-up should there be a run on the currency. This was a stark lesson learnt by, for example, Asian countries in 1997. Asia allowed its currencies to run amok as the “little tigers” emerged into the global economy. They had little to no reserves in place when the whole thing came crashing down during the Asian currency crisis.

The investment tranche is typically that left over when a central bank is happy it has enough liquidity reserves in place. The liquidity tranche is not invested for a return, simply for rapid access. By contrast, the investment tranche seeks to gain at least some reasonable return for its trouble. US Treasuries are a popular parking area, particularly considering those currencies that are pegged to the US dollar.

But Asia had learnt its lesson too well from 1997, and currency pegs have only served to send official reserves skyrocketing. Similarly there are oil-producing nations in the same boat, given the rise of the US dollar oil price. Such governments are now seeing simple investments in US bonds as underproductive, and lacking in diversification of risk. Hence there is a strong move to set up SWFs and actually make some of those excess reserves really work for their keep.

Australia has its own SWF in the form of the Future Fund. In Australia the central bank is largely independent from the government, but other countries have different policies. The Future Fund is a government, not an RBA initiative, but its intention is simple: invest now for the future, particularly for the demands of an ageing population. To do so by simply investing in low-risk, low-return government paper would be to squander opportunities and probably fall short. It’s also a case of “make hay while the sun shines”, as the government has been able to run significant fiscal surpluses ever since the commodity boom began.

And other countries, too, have a similar idea – to invest some of the money back into infrastructure of education projects, for example, all of which is an investment in the country’s future. But rather than just spending the money straight up, it can be invested in more risky and diversified assets that can provide returns to finance fiscal projects into time. This is the plan of the Future Fund, and so too of other nations. Oil countries, for example, would do well to invest in anything other than oil, given that market can supply around 70% of the nation’s revenues. China clearly is smart to invest in mining companies given the amount of the world’s resources it is consuming.

It is no surprise that countries flush with petrodollars feature heavily in the top ten of SWF asset totals. The United Arab Emirates has some US$600-900 billion under management, well ahead of number two Singapore at US$200-350 billion. This list then contracts through Norway, Saudi Arabia, Kuwait, Hong Kong, Russia, Singapore (another fund), China, and Qatar (with US$45 billion). Australia comes in a eleventh, with US$42 billion*. All up BCA has 29 countries on the list, including East Timor but not including the US. The states of Wyoming and Alaska each have their own funds, however.

BCA suggests SWFs have been structured to be less bureaucratic than central banks themselves. Their risk/reward tolerance falls somewhere between pension funds (low) and hedge funds (high). They are less transparent than pension funds, but less opaque than many hedge funds. They do not play too much with leverage and shy away from illiquid investments.

Assets under management by SWFs now well exceeds that of aggregate global hedge funds, and is about one eighth of global pension funds. Their importance is only likely to grow from here, notes BCA. Those countries with excess savings, such as China, already have plenty of money in their liquidity tranches, so their investment tranches can only get much larger. BCA suggests there is little chance of China and others selling any meaningful amounts of US Treasuries, as is the worry, given currency pegs and US dollar-denominated commodities. They will, however, look to diversify government paper holding as well as move into commercial paper and the stock market. At the current rate of global economic growth, Treasury markets should remain “well bid”, suggests BCA.

But the real winner will likely be equity markets, as investment from SWFs closes the equity/bond valuation gap.

The increase of SWF investment has sparked fear from some governments, most notably the US. The US is already talking protection against Chinese imports, and has in the past resisted Chinese investment in oil. There has also been controversy about Dubai trying to invest in ports. Imagine Muslim companies investing in US infrastructure or resources.

BCA’s response is to suggest that those countries which do not attempt to protect heavily against SWF investment will be those who benefit more from the sheer weight of money looking for a home. Australia has been fairly open to date.

* JP Morgan this morning noted Australia’s Future Fund has now grown to A$60 billion under management. To date that consists of about $10 billion in escrowed Telstra ((TLS)) shares, $2 billion in other Australian equities, $2 billion in international equities and the rest in cash.

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