Sovereign Wealth Funds Growing in Popularity

By Elizabeth Harrin (London)

The global economy has taken a battering recently – but not everywhere has been equally affected. Ernst & Young’s ITEM Club, one of the UK’s best-known independent economic forecasting groups, is predicting that the emerging markets will grow about 1% this year. Admittedly, growth up until recently had been around 6%, but at least those economies are not contracting. This has put the spotlight on to sovereign wealth funds (SWFs), which have helped keep the economies buoyant.

SWFs are like other investment funds, but they are owned and managed by the state. Depending on where the funds are based they might get some special tax perks for being a state-owned venture. For some countries, this state-run fund is managed by the central bank and is hugely important to the economy; for others it is just a slush fund without much of a role to play in balancing the books.

As you might expect, it is countries with state-owned commodities that tend to have this type of investment vehicle. Seventy-eight per cent of SWFs are in the Middle East and Asia and the largest SWFs are in the UAE. Even so, SWFs are not as big or as mature as corporate and institutional investments – but they haven’t fallen so hard as hedge funds or private equity either.

It is difficult to estimate exactly the total global size of SWFs but ITEM estimates that it’s around US$3.5 trillion. Things are looking up, and helped by increasing oil prices, the forecast is that growth could be around 15% over the next few years and that will take total assets under management to around US$8 trillion by 2015. $8 trillion may sound like a lot, but in reality the investment returns are not stellar – as you’d expect, governments tend to play it safe when it comes to managing national funds.

However, that looks like it is starting to change, as a direct result of the financial crisis that affected many ‘safe’ investments like assets in banks. The China Investment Corporation, for example, has recently been in talks with the World Bank’s private sector lending division International Finance Corporation about investing in their Debt and Asset Recovery Program – effectively buying up toxic debt.

Sovereign Wealth Funds in Canada

It’s not just emerging markets that have SWFs – and it doesn’t need to be an entire country, either. Alberta’s Heritage Savings Trust Fund in Canada was set up 32 years ago and has generated around CAN$30 billion in investment income which funds Government initiatives in the province. It has also seen an upturn recently with investment income above what was expected. “The Heritage Fund has continued to see some impressive results since the first quarter,” says Iris Evans, Finance and Enterprise Minister. “The markets are doing well, which benefits both the Heritage Fund and Albertans through the fund’s contributions to supporting priority programs.”

However, while increased oil, oilsands and tax revenue is up, all of which have helped prop up the Heritage Fund, the province can’t sit back just yet. “While it is heartening to see some improvement in the province’s finances, we’re still forecasting a significant deficit,” says Evans. “We can’t just cross our fingers and hope things will get better. We have to take action, and we are.” There are plans in place to take $2 billion in fiscal corrections to get back in the black by 2012-2013, and there’s a comprehensive spending review underway as well.

SWFs for Long Term Planning

The horizon of 2013 is pretty short term for a SWF. Another feature of these state-owned funds is their long term approach, and Kuwait is a good example. “Kuwait’s SWF – Kuwait Investment Authority – was established as the Kuwait Investment Office before the country gained its independence from the Great Britain [in 1961],” says Professor Ghiyath Nakshbendi, Executive-in-Residence at the Department of International Business at American University’s Kogod School of Business. “It shows the concern of the rulers to plan for the welfare of its citizen when oil is no longer a source of income. It reflects the level of sophistication in managing the wealth of the state.”

The long term approach is one of the reasons that SWFs have not been hit as badly by the economic downturn. “Knowing that they are long-term and mostly financed through equity, there is no pressure for them to divest,” says Nakshbendi. Funds that trade on their equity and borrow to finance their investment don’t have the luxury of being able to sit out a few bad years.

However, SWF managers haven’t just been sitting around basking in their relatively protected status. The International Forum of Sovereign Wealth Funds held its inaugural meeting in Azerbaijan in October – and learning the lessons from the global financial crisis was on the agenda. It’s difficult to say exactly what lessons translate to the SWF environment, but they would include having a full understanding of liquidity risks to protect the fund and the wider community. ITEM says that there are already reviews of strategy and organisation underway at many SWFs. The Qatar Investment Agency, for example, is recruiting sector experts for their specialist investment teams and the Abu Dhabi Investment Authority is doing the same.

All the trends point towards SWF growth in the coming years, as emerging economies continue to race ahead of developed economies. The predicted rise in oil and other commodities – good news for Albertans – will also help strengthen their position as a key part of the global financial system. “SWFs are here to stay,” says Nakshbendi. “The area requires more attention because SWFs are considered as investment players in the international arena.”