Sovereign Wealth Management 2007

Sovereign wealth funds offer longer-term investment horizon compared with traditional reserve portfolios, assuming higher tolerance for short-term risk. Therefore, a more diversified and less conservative asset allocation is possible – constructing a more efficient portfolio that could include illiquid asset classes. Illiquid assets should offer meaningful premium over more liquid asset classes, as have been demonstrated by some notable U.S. college endowments. What’s more, compared with traditional reserves management, sovereign wealth funds can be
more active in moving into high-growth markets. This increased level of access into high-growth economies should make noticeable differences in terms of returns over the years.

And this new opportunity set is not small. By the end of 2040, according to Goldman Sachs research, the combined GDP of BRICs and Mexico will be bigger in dollar terms than that of the G7 economies. Sovereign wealth funds may also pursue to diversify the sources of long-term wealth. They may try to optimize their portfolios with respect to characteristics of their national economies, such as seeking strategic ownership positions in important foreign enterprises. For example, one could
choose to invest in strategic resources which the country lacks. And for countries with abundant human capital and manufacturing capabilities but with little resources, it may make sense for them to invest in natural resources to diversify their national portfolios.

Challenges in sovereign wealth management in 2007

First, global financial market conditions may have become less favorable to new investors. Valuations are at or near historic highs, and global liquidity has pushed up prices in all asset sectors, including equities and commodities. Bond yields are now higher after the lows seen in 2005. Credit spreads remain extremely tight.

Though the global economic environment is still benign and solid expansion of the global economy is most likely in coming years – as suggested by the IMF’s latest report, downside risks for financial markets may be increasing, as the cyclical factors contributing to the low volatility environment could reverse. The visibility of financial losses means that the public is more likely to focus on them should they occur, and this could pose serious reputation challenges to newly-established sovereign wealth funds.


Second, there are risk management challenges. Sovereign wealth funds need to have a
different approach to risk from that of traditional reserves management as the fund moves into non-traditional asset classes.

And yet, it is often difficult to find good data with sufficient history for certain asset classes. And analyzing the market behavior of expanded set of asset classes and finding correlations among them are much more difficult. Moreover, the characteristics of the market indices used to represent alternative asset classes change rapidly, further compromising the usefulness of the historical asset class record. Therefore, sovereign wealth funds need to develop a new modeling approach to confidently monitor and control the market risk of their portfolio assets

Third, a well-defined mandate is crucial to successful management of funds. Problems arise when mandates are poorly defined – leading to bitter arguments about its proper uses. And this problem is acute especially in developing countries, where it is tempting to fund government expenditures. In addition, agreement on the risk/return profile of a fund can sometimes be very difficult if there are differences in views on the characteristics of the fund’s future liability.
There is another issue – that is, the potential emergence of so-called ‘financial protectionism’. The relationship with recipient countries could get more complicated when sovereign wealth funds show particular interest in other countries’ highly strategic industries. How they might react is unclear.

Possible expansion of financial protectionism could bring about adverse effects on the still on-going globalization process – one of major factors bringing global prosperity.

Size

The total size of sovereign wealth funds could now be as large as USD 2.5 trillion, according to a recent research by Morgan Stanley. The funds derived from oil and gas export proceeds account for some two thirds of the total, with the rest consisting of funds mainly controlled by the Asian exporters. The sovereign wealth funds are expected to double in size before 2010 and reach USD 10 trillion mark before 2014. It could well surpass the size of the world’s total official reserves in the not-too-distant future, and will have powerful implications on the global financial markets.

One of implications is apparent portfolio shifts from the sovereign bond markets to more risky asset markets in coming years. Global currency, commodity and debt market may experience huge changes, and it could cause significant challenges to the global financial market conditions over the years.

Opportunity or challenge it may be, this is clearly an ongoing trend on the global scale, and we should be on the lookout for their broader implications as global investors.