Sovereign wealth funds have evolved over the last two years and are now applying their lessons learned. Changes to asset allocations, investment decision processes and market volatility are front and center.
State Street Global Advisors (‘SSgA’) recently came out with a white paper describing how major sovereign wealth funds (‘SWFs’) reacted during the 2007 – 2009 financial turmoil as well as changes they are now making. This article highlights the key points of that white paper and what it means for Investment Managers who work with SWFs.
There are two types of Sovereign Funds and a single Investment Philosophy:
Sovereign funds fall into one of either “Traditional” policy funds or “Wealth and Growth” funds.
Managing the assets of sovereign wealth funds has typically entailed an unwavering dedication to the principles of long-term investing. The investment horizon for many sovereign funds either has an indeterminate life or an infinite life and as a result, many SWFs and their investment managers have used a long-term, patient investment style.
SSgA points out that SWFs did not escape the challenges from the difficult and volatile markets of the last 3 years. However, most have made it through the trials and tribulations and are now re-examining, amongst other things, their investment style.
1st Change: Introduction of new limitations:
While most SWFs operate with an indeterminate life or an infinite life, many have now discovered that they could be subjected to unexpected withdrawals on their assets. For such funds, they are faced with known and unknown limitations:
- Known limitations: Formal obligations needed for policy purposes, such as monetary/currency stabilization.
- Unknown limitations: No formal obligations or fixed expiration date. Assets within the sovereign fund can be withdrawn at any time for purposes such as economic stabilization or budgetary shortfall. This causes unplanned liabilities that increase the need for liquidity and capital preservation over growth.
Funds that face the possibility of unknown withdrawals have been forced to reassess their investment style since they have to serve the dual mandate of long-term savings and contingency funding.
2nd Change: Modified investment styles and asset classes
SSgA pointed out that a heightened focus on portfolio risk has caused SWFs to reevaluate the use of active vs. passive investment managers. In fact, the one of the most insightful quotes to explain the pressure that active investment managers are facing comes from a major Middle East sovereign fund who SSgA quoted as saying:
“whereas in the past we used to assume that assets should be actively managed unless it was clear that a certain asset class or market did not offer opportunities for active managers or reward active management, now we tend to see it the other way around. We conclude that assets should, as the default, be managed passively…”
This is a reversal in approach that has not been lost on the investment management industry and in particular, active managers.
Another change to investment style is the global search for yield. Just like individual investors, SWFs are disappointed with the historically low yield on the government bonds in G7 countries and have begun to look for alternative sources. SSgA notes that the corporate bond market as well as emerging markets sovereign bonds could be the target of potential future investments.
In summary, investment managers who work with sovereign funds likely face two main impacts:
#1) SWFs are now a much more demanding clientele.
SWFs now demand a greater emphasis on risk management, correlation of investment returns and portfolio attribution. These demands are likely to stretch the capabilities of investment managers while at the same time, the switch to passive management is lowering the revenue base and profitability from with an investment manager operates.
#2) Investment managers will need enhanced product offerings.
Products are needed to deal with fixed/known portfolio liabilities, much like a pension plan, as well as provide a core base of liquidity in the portfolio should the sovereign fund face unexpected withdrawals. This need for liquidity, while still searching for investment return, could impact the potential asset flows to investments such as private equity which have long time frames and limited liquidity.
You can access the full SSgA report at the following link: “Current Issues in Official Sector Asset Management“.
How do you feel investment managers will react to their sovereign wealth clients? 
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