Insourcing Rises as SWFs Grapple With Oil Drop, Forex Swings

June 09, 2015 by Loch Adamson

SWF continue to insource amid falling #oil prices and #currency volatility @InvescoUK
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Nick Tolchard Invesco 650
Invesco's Sovereign Wealth Group Chairman, Nick Tolchard

A survey of sovereign wealth funds shows insourcing of portfolio management continues to rise even as some are challenged by falling oil prices and currency volatility.

For sovereign wealth funds, the trend is do-it-yourself. State-owned investors are increasingly managing their portfolios on their own, relying on internal expertise as they shun outside managers across a range of global assets. Indeed, a new survey shows that in five out of six asset classes — equity, bonds, private equity, real estate and cash — sovereign wealth funds have on average increased their internal management allocation since 2013. Only infrastructure experienced a rise in outside hired hands.

The development is one of several highlighted by Invesco, the Atlanta-based money management firm, in its annual survey of sovereign wealth funds: Invesco Global Sovereign Asset Management Study 2015. Researchers interviewed 59 state-owned investors, including central banks and public pension funds, of various sizes from around the world with different objectives. 

Cost is a driving factor in the move toward insourcing, according to Nick Tolchard, chair of Invesco’s sovereign wealth group in London. “There is a focus on management fees,” he says. “Sovereign investors are looking to use managers where there is a demonstrable added value, along with a more passive stance for much of the core portfolio.” That means the industry may have to up its game in a changing environment. “There’s a feeling to go for passive for the core and develop the talent for alpha generation,” Tolchard says.

For global equity, the proportion of internally managed assets grew to 34 percent in 2015 from 26 percent in 2013, according to the survey. In bonds, the increase was to 57 percent from 52 percent and for real estate it jumped to 42 percent of assets from 31 percent. Internally managed cash rose to to 86 percent of the total allocated from 80 percent in 2013. State-owned investors also grew their principal investment capability, increasing their direct private equity investments slightly to 28 percent of their allocation from 26 percent.

On the other hand, internal management of global infrastructure allocations dropped sharply to 16 percent from 26 percent, the survey showed. That is likely due to increasing competition for high-quality assets, which encourages state-owned investors to seek specialist assistance.

“Value Proposition”

One recent example of the survey’s findings — the Abu Dhabi Investment Authority (ADIA), which earlier this month released its annual report. Among its disclosures was that allocations to external managers fell by 10 percentage points to 65 percent of its total portfolio. Given the Sovereign Wealth Center conservatively estimates that ADIA has about $620 billion under management, that’s roughly $62 billion of assets that external managers won’t be handling. The fund also said it was implementing a so-called high-conviction strategy of best ideas from internal managers as a way to generate alpha, or returns above those of a market benchmark.

Invesco’s wide-ranging survey reported that sovereign wealth funds put a high degree of importance on internal management, 8.9 ranked on a scale of 1 to 10, versus somewhat less, just 8 on the same scale, for external active management. External indexing was of far less importance, only 6.1 on the scale. 

At first blush, the trends look worrisome for investment firms. “The implication is asset managers need to focus on their value proposition,” Tolchard says. But the findings might reflect a shift toward internal management of indexed portfolios, particularly among large sovereign wealth funds. Asset managers typically charge mere basis points for such management. There is also this worry for state investors: The survey reports that sovereign wealth funds have faced sharply increased difficulty in recruiting asset managers in 2015 compared to 2014. 

Sovereign wealth funds, though, seem to be satisfied with their external managers’ performance. Overall, state-owned investors ranked their own performance of their investment strategy a 7 out of a possible 10 in 2015, up modestly from 5.9 two years ago. This, despite returns that can hardly be described as shooting the lights out. “Established sovereigns now have a track record of internal performance and few cited internal teams in the top quartile,” the study says.

Increasing Demand

One challenge for some state-owned investors has been the roughly 50 percent drop in oil prices over the past 12 months. Here, a pronounced divergence appeared between oil dependent North American sovereign wealth funds that Invesco surveyed and their hydrocarbon fueled counterparts in the rest of the world. Fully 80 percent of North American sovereign vehicles — four out of the five funds surveyed — reported that they expect new inflows to slow as a result of falling crude prices. However, just 42 percent of their oil-dependent peers in the rest of the world expect funding to decrease, while 25 percent expect it to remain the same and even more, 33 percent, actually expect it to increase.

“We hadn’t necessarily expected a variation in attitude between resource derived funds,” says Tolchard. “It’s worth mentioning that the Middle East sovereign investors are more confident of funding than the North American funds.”

These attitudes also highlighted differences in governance models between North American sovereign funds and those elsewhere. Just 20 percent of North American funds said they expected to the government to tap them in the future. By contrast, 67 percent of highly oil-dependent sovereign wealth funds in the rest of the world expected funding withdrawals due to cratering crude — which is undoubtedly partly a function of their mandates. The governments of the Middle East, for example, have a greater need to tap their oil revenues for socio-economic programs than the U.S. and Canada, for example. That, naturally, would increase the pressure for Middle Eastern government to pull out money from funds as overall oil revenue declines.

State-owned investors’ demand for various asset classes is changing too. The survey looked at the difference between positive and negative responses by sovereign wealth funds when they were asked about their demand for different asset classes. The state-owned investors envisioned increased demand for higher-risk, growth assets such as private equity, especially in their domestic markets, as well as infrastructure, real estate, equities and hedge funds. Sovereign wealth funds surveyed expected decreasing or underweighting exposures to bonds, both global and domestic, as well as cash and so-called direct strategic investments in companies in their home markets.

Unloved Russia

Overall, Tolchard thinks the results point to a strong desire by sovereign wealth funds to generate above market returns by shifting toward alternatives going forward, a logical assumption given the high valuations of some equity markets and rock bottom yields of much government debt. “There are more targeted opportunities for alpha,” he says. “It could be real estate or infrastructure.” Indeed, the survey showed that while just 9 percent of total sovereign wealth fund portfolios was allocated to emerging markets, 17 percent of their exposure to infrastructure was in the emerging markets. That might reflect worries concerning listed equities in such markets. Infrastructure, despite its lack of liquidity, is sometimes perceived as a safer asset class in developing nations.

State-owned investors see the U.S. as being the most attractive of any other country cited, and by formidable margins. Specifically, on a scale of 1 to 10, the U.S. scored 8.2 for expected economic performance, 7.7 for private sector performance, and 8.0 for sovereign investor attractiveness. Last year, the U.S. ranked 6.8, 7.0 and 6.6 respectively by those measures, the survey shows. 

The shift pushes expectations for the U.S. well ahead of those for the U.K. and Germany, nations of which sovereign wealth funds had high expectations last year, and whose scores are more or less the same for 2015. “The U.K. was perceived as being more hospitable toward sovereign investors,” says Tolchard. “It may be the U.S. is now perceived as being more welcoming.”

The big loser this year in terms of expected performance is Russia. In 2014, it scored a mediocre 4.8, 4.7 and 4.7 for expected economic performance, private sector and sovereign investor attractiveness, respectively. This year, those figures plunged to 4.2, 3.9 and 3.9. Despite slowing economic growth, state-owned investors’ expectations for China this year are quite similar to last year’s scores: 6.9 for economic performance, 5.9 for private sector opportunity and 5.8 for sovereign investor attractiveness.

Volatile Environment

In addition to heightened geopolitical risk, the past 12 months have been punctuated by volatile currency swings, most notably the rise of the U.S. dollar, the fall of the ruble and the unpegging of the Swiss franc from the euro. Invesco took the opportunity to drill down into the status of foreign exchange programs at sovereign wealth funds. “Currency strategies have indeed become a greater area of focus with no approach being the norm,” says Tolchard.

The largest proportion of funds surveyed — 43 percent — were entirely exposed to currency volatility with no hedging performed, Invesco found. These sovereign wealth funds tended to be smaller organizations. Twenty-one percent of state-owned investors reported that they hedge some or all of their portfolio. Thirty-six percent of surveyed sovereign investors took an active approach to currencies, using sophisticated forex programs to manage their exposure as a way to generate a profit.

Not surprisingly, sovereign wealth funds with the active currency management programs tended to be those with the most assets. Fully 27 percent of funds with more than $100 billion in assets under management had so-called active forex programs. Of those with $10 billion to $100 billion in assets, 24 percent described themselves as active currency managers. Among sovereign wealth funds with under $10 billion in assets, just 7 percent ran active forex management. 

This year’s annual survey is the third by Invesco. One thing remains nearly certain — surprises lie ahead, whether in asset performance, commodity prices, forex gyrations or political upheaval. “The environment for sovereign investors continues to be volatile,” Tolchard writes in his introduction. That, at least, is one notion you can bank on.

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