Size, investment horizons, and few liabilities make sovereign wealth funds a unique investor class. In a low-yielding environment, such characteristics mean those funds have discrete advantages, says Michel Meert, Director, Investment Advisory at PwC.
Institutional investors face a new landscape — one shaped by zero-interest-rate policies of many central banks, quantitative easing and low growth. Sovereign wealth funds face the same issues as many other asset owners as they struggle to generate meaningful returns under such conditions.
Sovereign wealth funds differ from other kinds of institutions. State-owned funds typically have a multi-generational investment horizon and do not require an immediate yield as they tend to have strong cash inflows in normal economic circumstances.
As a result, these funds can exploit long-term, illiquid asset classes and strategies to help them meet their investment objectives, while other investors can’t.
Most market participants focus on the short- and medium-term. But the intergenerational mission of most sovereign wealth funds allows them to access arguably superior investment opportunities in illiquid assets from a greater variety of sources than other institutions.
That said, simply investing in illiquid and alternative investments is not the same as a free lunch. Such allocations are exceedingly complex.
Investing in asset classes that are not easily tradeable, like real estate, private equity and infrastructure, requires different skillsets to those required for allocating money to bonds or publicly listed stocks. To be successful, sovereign wealth funds need to build internal private market specialist teams or hire external managers and skilled strategists, and ensure their investment committee is developing effective strategies and allocation policies.
Allocating to these more complex types of investments also means crafting an informed philosophical approach and building an organizational structure with effective governance oversight. A clear set of beliefs should drive the allocation of money to private markets, with a specific strategy developed for each asset class. These should be aligned with the overall mission of the fund.
Private and alternative markets are less transparent than public ones, generate a far wider variety of results — from stellar to disastrous — and are often linked to high costs. Sovereign wealth funds have the scale and experience to demand access to such asset classes on more favorable terms than they have been able to negotiate in the past.
And this shift in the balance of power is becoming more evident as even some big pension funds, including the California Public Employees’ Retirement System, with more than $300 billion in assets under management, are demanding more. In the past year, the fund announced it was rationalizing its private equity portfolio by reducing its number of general partner relationships and divesting from hedge funds.
Sovereign wealth funds’ size can limit their ability to act quickly. Norway’s decision to allow Norges Bank Investment Management to invest in real estate is certainly logical from a diversification perspective. But it means the $861 billion Government Pension Fund Global is trying to rapidly deploy large amounts of capital in markets where demand for prime real estate is already high. This illustrates the first mover advantage in the investment world: Being a follower with significant amounts of capital may ultimately impede returns.
Sovereign wealth funds’ long-term perspective could help them avoid the herd mentalities common among institutional investors. Without fixed liabilities, state-owned investors have the luxury of considering contrarian or counter-cyclical positions. Not every investor can do that.
In the past, insurers and pensions often took contrarian positions, in particular during extreme events. But acting in this way has become harder for them as the burden of recent regulation has forced a greater focus on liability matching. Without this requirement, sovereign investors have the freedom to act differently, and benefit their stakeholders over the long term. Investments by various funds in the banking sector during the 2008–’09 financial crisis just may be examples of such contrarianism.
State-owned investors have a slightly different take on the subject. In a press release following the last annual meeting of the International Forum of Sovereign Wealth Funds in Doha, last November they declared their role in “contributing to maintain a stable global financial system, through championing long-term investment”. To foster global economic stability, sovereign wealth funds are increasingly proactive and take leadership positions as asset owners.
Long-term investors like sovereign wealth funds can be patient and wait for opportunities at lower prices — and hopefully garner higher returns. However, being contrarian means resisting peer comparisons. Governance bodies and stakeholders need to focus on appropriate long-term goals in addition to short-term benchmarking and accept that investing requires conviction.
Moving away from the crowd will generate criticism when performance lags that of peers. So sovereign wealth funds must have a defined mandate, a clear investment philosophy as well as a well-functioning and transparent investment decision-making process.
While some investors are focusing on smart beta in a shift away from higher-cost active management, sovereign asset owners can differentiate themselves as long-term investors by constructing a portfolio based on major secular trends.
If a sovereign wealth fund is investing for future generations, surely it is beneficial to think about the megatrends that will drive the world economy, along with financial markets, over such a timeframe. This will help to increase the likelihood that the fund will generate sustainable returns over time, rather than chanced to the vagaries of cyclical market movements.
State-owned investors can benefit from extended and ongoing changes in local and international economies by maintaining robust processes to identify long-term trends. Sovereign funds should then choose which ones best suit their strategy and investment horizon, and implement those decisions across asset classes.
A Neglected Tool
Backing secular economic trends dovetails with the long-term outlook of many sovereign wealth funds, but in fact is currently embodied in only a limited number of them. The $177 billion Temasek Holdings is one of the best examples, where thematic long-term thinking is embedded in the portfolio construction process and clearly communicated.
Focusing on less liquid asset classes, contrarian moves and identifying long-term investment themes are all valuable and viable strategies for sovereign wealth funds. Yet they underuse one far more simple performance enhancing tactic: rebalancing. While asset allocation rebalancing is widely used by liability-driven investors, and smart individuals, it is not given sufficient emphasis by some other institutions, such as state-owned investors.
Whatever the frequency or nuances of a particular rebalancing regimen, it forces an investor to follow its strategic allocation and direct assets into a default approach of selling high and buying low. It also makes it easier to achieve a consensus on market actions, especially during times of stress. A rebalancing policy not only imposes discipline, but it also helps an organization limit the risk of overconfidence in forecasting future market direction.
Depending on a sovereign wealth fund’s goals and the economic and fiscal situation of its sponsoring jurisdiction, asset allocation can and should vary. For instance, the decision to start using France’s Fonds de Reserve Pour Les Retraites, or Pension Reserve Fund, to help meet a pension gap some years ago started a change in investment direction and asset allocation.
More recently, plummeting commodity prices, and in particular the sharp selloff in crude, represent game changers for a host of sovereign wealth funds. Swinging from a long period of substantial cash inflows to, in some cases, a reduction in assets, should prompt alterations in asset allocations and perhaps even objectives for state-owned investors.
Divergences in global economic and monetary policies, geopolitical issues, contingent liabilities, and the exhaustion of natural resource revenues will also affect how sovereign wealth funds invest.
Low interest rates have prompted sovereign wealth funds to increase their allocation to illiquid assets. This is likely the right move as the state-owned investors focus on long-term growth and preservation of capital. Other large investors face short- and medium-term liabilities.
However, we are likely to see more sovereign wealth funds incorporating long-term trends into their investment perspective, adopting a more contrarian approach and paying greater attention to rebalancing. This might be beneficial not only for the funds themselves, but also for the stability of global financial markets.