Strategies For Investing In Sovereign Wealth Funds

Sovereign Wealth Funds (SWF) are state-owned investment funds that invest in real and financial assets, including stocks, bonds, real estate, precious metals, and alternative asset classes. They are established by countries with excess capital to invest in various markets and assets, with the primary functions of stabilising the country's economy and generating wealth for future generations. As of 2023, there were 176 SWFs with combined assets of more than $11 trillion.

SWFs can be categorised as either commodity or non-commodity funds, depending on their source of financing. They are usually established using balance of payments surpluses, official foreign currency reserves, privatisation proceeds, government transfer payments, fiscal surpluses, and/or receipts from commodity exports.

The emergence of SWFs has sparked curiosity and trepidation, with some critics worrying about their lack of transparency and potential influence on the global economy. Despite these concerns, SWFs continue to grow in size and number, playing an increasingly influential role in international investing.

How to identify a sovereign wealth fund

Sovereign Wealth Funds (SWFs) are state-owned investment funds that invest in both real and financial assets, including stocks, bonds, real estate, precious metals, and alternative asset classes. They are established using balance of payments surpluses, official foreign currency reserves, proceeds of privatizations, government transfer payments, fiscal surpluses, and/or receipts from commodity exports. SWFs are usually large, with the top 10 controlling 80% of total SWF assets under management (AUM) globally.

There are five broad classifications of SWFs: stabilization funds, savings and future generations funds, pension reserve and future liabilities funds, reserve investment funds, and the most prevalent, strategic development sovereign wealth funds (SDSWFs).

• Ownership: SWFs are owned by the general government, including both central and sub-national governments. They are distinct from public pension funds, which are ultimately owned by the underlying policyholders, and central bank reserve assets, which are not invested.
• Investment Focus: SWFs invest in foreign financial assets to achieve financial objectives. They seek to maximize long-term returns and are often focused on strategic, economic, or social priorities that benefit their home country.
• Sources of Funding: SWFs are typically funded by revenues from commodity exports, such as oil, gas, or precious metals, or from foreign exchange reserves held by the central bank. They can also be funded by surplus reserves from state-owned natural resource revenues, trade surpluses, bank reserves, privatization proceeds, and governmental transfer payments.
• Investment Strategies: SWFs allocate their assets across various investment classes, including cash and equivalents, fixed-income securities, global public equities, and alternative investments such as private equity, venture capital, real estate, and infrastructure.
• Risk Tolerance: SWFs have varying risk tolerances, with some prioritizing returns over liquidity and vice versa. Their investment behaviour is driven by the underlying economic and strategic priorities of their host governments.
• Size and Influence: SWFs can have a significant impact on the global economy due to their large size and growing influence. They have attracted attention and scrutiny from investors and regulators due to their lack of transparency and potential influence on international trade and domestic financial institutions.

In summary, Sovereign Wealth Funds are state-owned investment vehicles that invest in a diverse range of assets to achieve financial objectives and benefit their home country. They are typically funded by commodity exports or foreign exchange reserves and have varying investment strategies and risk tolerances. SWFs have become prominent players in the global investment landscape, influencing markets and attracting scrutiny from regulators.

The different types of sovereign wealth funds

Sovereign Wealth Funds (SWF) can be classified into five broad categories:

Stabilization Funds

Also known as "rainy day funds", these are counter-cyclical fiscal tools that aim to protect a country's economy from internal and external economic shocks. Examples include fluctuations in commodity prices, economic boom-and-bust cycles, unexpected tax changes, financial crises, rapid increases in unemployment, technological breakthroughs, and sharp rises in natural resource prices. Russia's stabilization fund, for instance, aims to mitigate the impact of low oil and gas prices on its economy and domestic budgets.

Savings and Future Generations Funds

These funds focus on intergenerational equity, converting non-renewable natural resources into more sustainable and long-term financial assets. Examples include the Alaska Permanent Fund in the United States and Canada's Alberta Heritage Savings Trust Fund.

Pension Reserve and Future Liabilities Funds

Pension reserve funds support the monetary needs of social welfare and public pension systems, particularly in countries with ageing populations and low birth rates. Japan's Government Pension Investment Fund (GPIF) is one of the largest and most effective funds in this category, with $1.1 trillion in assets.

Reserve Investment Funds

These funds are unique in that they manage a portion or all of a nation's foreign reserves. Their investment strategies involve investing in higher-yielding, long-term assets, while also reducing the negative carry costs associated with holding reserves. The China Investment Corporation and the Government of Singapore Investment Corporation (GIC) are two prominent examples, with $813 billion and $360 billion in managed assets, respectively.

Strategic Development Sovereign Wealth Funds (SDSWFs)

SDSWFs are used to advance strategic, economic, and national development priorities while generating positive risk-adjusted returns. This may include developing infrastructure, pursuing economic diversification, or acquiring direct stakes in global firms to guarantee the offtake of strategic domestic resources.

How sovereign wealth funds invest

Sovereign Wealth Funds (SWFs) are state-owned investment funds that invest in a variety of assets, including stocks, bonds, real estate, precious metals, and alternative investments such as private equity and hedge funds. They are typically funded by a nation's budgetary surplus, commodity exports, or foreign exchange reserves held by the central bank.

SWFs can be classified into two main categories: commodity and non-commodity funds. Commodity funds are financed by exporting commodities such as oil, gas, and precious metals, while non-commodity funds are typically financed by foreign currency reserves or current account surpluses.

There are also five broad classifications of SWFs based on their purpose:

• Stabilization funds: These funds are established to insulate a country's economy from internal and external shocks, such as commodity price fluctuations or economic boom-and-bust cycles.
• Savings and future generations funds: These funds focus on creating intergenerational equity by converting non-renewable natural resources into more sustainable, long-term financial assets.
• Pension reserve and future liabilities funds: These funds support social welfare and public pension systems, especially in countries with ageing populations and low birth rates.
• Reserve investment funds: These funds explicitly manage a portion of a nation's foreign reserves, investing in higher-yielding, long-term assets while reducing negative carry costs.
• Strategic development sovereign wealth funds (SDSWFs): These funds aim to further economic and national development priorities, such as infrastructure development or economic diversification, while generating positive risk-adjusted returns.

In terms of investment strategies, SWFs typically allocate their assets across four main classes:

• Cash and equivalents
• Fixed-income securities
• Global, public equities
• Alternative investments, including private equity, venture capital, hedge funds, real estate, and infrastructure

The portfolio mixes of SWFs are driven by the underlying economic and strategic priorities of their host governments, which can include stabilization, capital maximization, and strategic economic development.

While SWFs have traditionally been passive, long-term investors, there is a growing trend towards alternative investments and a shift from fixed-income safe havens towards riskier but higher-returning equities and illiquid alternatives.

The history of sovereign wealth funds

Sovereign Wealth Funds (SWFs) have existed for more than a century, but their number has increased dramatically since 2000. The first SWFs were non-federal US state funds established in the mid-19th century to fund specific public services. The US state of Texas was the first to establish such a scheme, creating the Permanent School Fund in 1854 to benefit primary and secondary schools. The first SWF established for a sovereign state, however, was the Kuwait Investment Authority, created in 1953 to invest excess oil revenues before Kuwait gained independence from the United Kingdom. Two years later, in 1955, the Republic of Kiribati, a sovereign state in the central Pacific Ocean, created the world's second SWF—the Revenue Equalization Reserve Fund—to hold and grow its foreign currency reserves.

Little new activity took place until the late 1970s and early 1980s, when three major funds were created: Abu Dhabi's Investment Authority (1976), Singapore's Government Investment Corporation (1981), and Norway's Government Pension Fund (1990). Since then, the size and number of sovereign wealth funds have increased dramatically. According to the SWF Institute, there were 176 sovereign wealth funds with cumulated assets amounting to more than $11 trillion in August 2023.

SWFs are typically created when governments have budgetary surpluses and little or no international debt. They are particularly common in countries that depend on raw material exports like oil, copper, or diamonds, as the volatility of resource prices, the unpredictability of extraction, and the exhaustibility of resources can cause economic instability.

SWFs are primarily commodity-based and many have been established by oil-rich states. However, the SWFs of China are a notable exception to this model.

The pros and cons of sovereign wealth funds

Sovereign Wealth Funds (SWFs) have been viewed with curiosity and apprehension since their emergence in the early 2000s. This is because they exist in a grey area between return-maximising asset managers and clandestine government agencies.

The Pros of Sovereign Wealth Funds

SWFs can be a way for countries to invest excess capital into markets or other investments. They can accrue profit for the benefit of a nation's economy and its citizens, and stabilise the country's economy through diversification.

The primary functions of a sovereign wealth fund are to:

• Stabilise the country's economy through diversification.
• Generate wealth for future generations.
• Deploy dedicated, state-owned pools of capital across global markets and asset classes in furtherance of a country's strategic, economic, or social priorities.

The Cons of Sovereign Wealth Funds

SWFs have attracted significant attention as more countries open funds and invest in big-name companies and assets. This has led to widespread concern over the influence these funds have on the global economy. There is also concern that SWFs have a political influence, and that they lack transparency.

In the United States and Europe, many financial and political leaders have stressed the importance of monitoring and possibly regulating sovereign wealth funds. Many political leaders assert that sovereign wealth funds pose a threat to national security.

Frequently asked questions