Pauline E. Ranger Since the early 2000s, Sovereign Wealth Funds have been met both with curiosity and trepidation. They are somewhere between a return-maximizing asset management company and a covert government agency.
This article will take us on a journey into the $7,4 trillion SWF world, providing insight into its objectives, mandates, and ambitions. It also explains the allocation strategies.
This is chess, not checkers
Since their official arrival on the investment market in the 2000s, sovereign funds have been met with a healthy mixture of curiosity and trepidation. It’s a fair question. They exist between the murky gray of mega-cap asset management and clandestine governments that are used to advance sovereign agendas. Is their rescue of West’s banks, Citi, Merrill Lynch UBS, and Morgan Stanley, during the 2008 financial crises a collective investment to find alpha or a geopolitical exercise? Are China Investment Corporation’s African Infrastructure-for-Resources deals about nonrenewable resource security or about geopolitical influence?
SWFs have become a mainstay of global investments despite conspiracy theories and geopolitical games. They have become a major asset class as their AUM has risen to $7.4 billion, and their scope, scale, and sophistication of deals have increased. SWFs, when viewed as pure-play asset management, have a wide range of investment objectives. This, in turn, drives the investment behavior, portfolio mix, and success metrics.
This article provides an overview of sovereign wealth funds, their “categories,” and investment strategies. It also discusses the ever-changing allocation strategies.
Sovereign Wealth Funds
A Sovereign Wealth Fund is a State-owned Investment Vehicle established to channel surpluses in balance of payments, foreign exchange operations, privatization proceeds, transfer payments from the government, fiscal surpluses, and revenue from resource exports into global investments for sovereigns.
SWFs are able to invest in both real and financial assets. They can be found investing in stocks, bonds, and real estate, as well as alternative investments like hedge funds and venture funds. Although SWFs have a global outlook, they invest in the domestic market, particularly when it comes to strategic developments in sovereign wealth funds. In 2017, SWFs held over $7.4 trillion AUM. This represents approximately 6% of global assets managed by institutions.
Most sovereign wealth funds have their headquarters in either oil-exporting countries or East Asia. From a capital-sourcing perspective, SWFs can be divided into two categories : (1) commodity funds and (2) other non-commodity funds. Commodity SWFs receive their funding from nonrenewable commodities (oil and gas) that can be exported. These exports increase the AUM in high-price periods, but they also destabilize the economies of the source countries. Currency reserves or surpluses typically finance non-commodity SWFs in the current account, which is driven by corporate and household savings rates.
In economic theory, it’s important to know that SWFs are part of the total capital base of their respective countries. Total capital includes all net financial assets (e.g., real estate, machines, and infrastructure), as well as unexploited human capital, unexploited resources, unexploited environmental conditions, and unexploited natural capital. As an oil-producing nation, if we use Hartwick’s Rule to determine zero-sum equity between generations, selling and extracting nonrenewables will deplete one’s wealth unless all the money is reinvested in one of these factors: financial, physical, or environmental capital. The net savings for oil-rich nations would be negative if they did not fully reinvest their exhausted resources. This logic was the basis for the first SWFs, which were created by oil-rich countries around the world.
The Origins of Sovereign Wealth
In 1953, the first SWF was created as an investment vehicle for countries that had surplus export revenues and budgetary surpluses. Kuwait Investment Authority was the first SWF, established in 1953, to invest in Kuwait’s excess crude oil income and diversify its nation away from its dependence on a single resource. The Republic of Kiribati in the central Pacific Ocean created the Revenue Equalization Reserve Fund two years later to hold and grow their foreign currency reserves.
There was little new activity until 1976, 1981, and 1990, respectively, when the Abu Dhabi Investment Authority, Singapore Government Investment Corporation, and Norway Government Pension Fund were founded. The size and number have exploded since then to over 120 sovereign wealth funds, with heavy asset consolidation. The top ten SWFs account for 80% of SWF AUM worldwide, while the top twenty SWFs are responsible for 90%. China and Singapore control five of the top ten sovereign wealth funds.
Sovereign Wealth Funds: Types
SWFs may be similar in form and source, but they are different in their purpose. This is often due to the differences in circumstances, policies, and liability structures of each country. The three broad priority categories that are most commonly pushed onto sovereign wealth funds by sovereigns include (1) economic stability, (2) capital maximization, and (3) strategic developments.
Five broad SWF classes are available to achieve these goals: (1) stabilization funds, (2) future generation funds and pensions reserves (capitalization priority), (3) reserve investment funds and other future liabilities (capitalization priority), and (5) strategic development sovereign funds.
In this article, I will elaborate on the “three broad categories of SWFs” as well as the “five broad classes” of SWFs.
The five classes of Sovereign Wealth Funds
Funds for stabilization Also known as “rainy-day funds,” stabilization funds were created to protect/smooth out economies against internal and external shocks. These shocks can include commodity peaks (which are most acute in petroleum countries) and global or domestic boom-bust cycles. Russia is an oil and gas-exporting nation with a fund that effectively stabilizes oil prices. Its mission is to reduce the impact of downswings in domestic budgets and currency rates caused by low oil and natural gas prices.
Future generation and savings funds: They are funds created to promote intergenerational equity and saving, and wealth transfer by converting nonrenewable resources into sustainable financial assets with “longer duration.” Two examples of savings and future-generation funds that generate returns are the Alaska Permanent Fund in the United States and the Alberta Heritage Savings Trust Fund in Canada.
Funds for pension reserves and future liabilities: The purpose of the Pension Reserve Funds is to provide monetary help that can be used by a country’s public pension and social welfare systems. This is especially true in countries with aging populations and declining labor force. Japan’s Government Pension Investment Fund is one of these funds, with assets of $1.1 trillion.
