Sovereign Wealth Fund

Sovereign Wealth Funds (SWFs) have recently emerged as one of the most controversial issues and topics for many studies especially with its effects and movements in correspondence with recent financial developments in the global market. Hence, in this report, an overview of key issues regarding SWFs is presented in depth together with a summary of future trends and recommendations towards the development of SWFs. A Sovereign Wealth Fund is a state-owned investment vehicle which can also be structured as a reserve investment corporation (SWF institute, 2008).

The funding of SWFs comes from central bank's reserves as the result of budget and trade surpluses including the net exports of natural resources. The basic purpose of a SWF is to boost growth of local enterprises and hedge against the risk of key commodity price swings. However, when the size of a SWF grows bigger, the resources are usually allocated to invest into overseas projects to generate extra returns for the state.

The first SWF was established by the Kuwait Investment Authority (KIA) in 1953 with the funding derived from the country's oil revenues to generate more returns for future generations and reduce the independence on non-renewable resources. Since the inception of the first SWF, they have undergone rapid growth with an increasingly significant role among other financial institutions. At present, SWFs are located almost all over the world while the funds of larger size (over US$100 billion) are centralized in Middle East, US and Asia Pacific1 Currently, SWF assets are estimated to total US$3.

3 trillion, up from US$ 500 million in 1990, which is still a small figure compared to assets from other types of financial institutions2. However, it is expected that the size will grow up to 10 trillion by 2010 and 12 trillion by 2012, which shows the potential of growth and the increasing role in financial market of SWFs. The 10 largest SWFs are managed by the governments of UAE, Norway, Singapore, China, Russia, Qatar and US3.

Due to the fact that SWFs are funded by national foreign exchange reserves and invest rigorously into overseas projects, they own high foreign currency content (SWF Institute, 2008). However, it is not necessary for a SWF to hold its entire portfolio in foreign currency, therefore, the exposure to foreign currency is still less than the one of official reserves4. Besides, while private pension funds and sovereign pension funds bear the national pension liabilities, SWFs bear no explicit liabilities but only serve as an investment tool of the government to generate returns on excess reserves.

4 While central banks often invest their reserves in relatively risk-free assets such as US treasury bonds, it is shown that for the last few years SWFs have invested in large scale long-term projects related to large corporations, merge and acquisition activities as well as other risky alternative investments5. In general, SWFs invest for a longer time horizon and are more willing to take riskier projects when compared to sovereign and private pension funds. 

SWFs have a wide range of investment strategies and styles reflecting their different objectives. They can differ significantly in their asset allocation and risk management strategies due to their objectives and constrains. For example, SWFs usually adopt a long term approach although stabilization SWFs have shorter term investment horizons in order to take into account possible shorter term national liquidity and financing needs (1) .

In executing their asset allocation, SWFs can invest solely in publicly-listed financial assets, or across asset classes including M&A and alternative investment such as real estate, private equity, hedge funds, and commodities. Other SWFs that aim at maximizing absolute returns over longer time horizon may invest in riskier asset and acquire larger stakes in equities and a wider geographical dispersion. Naturally, SWFs are passive and long-term investors with no aim to affect company decisions since they usually vote by proxy or ask managers to vote on their behalf.

However, SWFs currently has tendency to use more aggressive investment strategy now, especially less transparent funds from non-democratic countries6. The active investment strategies involve taking active control of companies through mergers and acquisitions or acquiring minority stakes. Such investment totaled over US$ 100 billion since 2006 and grows significantly in 2007 due to capital injections into banks after credit crisis. Regarding management, Msome SWFs use independent external managers while some funds are run by government. Most SWFs use external managers in areas where their capacity is limited.

It has been observed that over the last decade there was a rapid accumulation in foreign exchange reserves by developing countries. IMF data shows that from December 2001 to October 2007, global reserves tripled from US$2. 1 trillion to US$6. 2 trillion, and more than 80% of this increase is from developing countries and their current reserves have reached US$5 trillion7 The foreign exchange reserves have been growing very fast in the last several years, remarkably with the growth from China, India, commodity-producing countries and oil-exporting countries based in Middle East.

Take the US$1. 6 trillion increase in Asian reserves as an example. Three-fourths of this huge increase actually come from China and India. For oil-producing countries, their reserves are no less than US$430 billion which is 2. 5 times more than the amount they had five years back. Grouping China, India and oil-exporting countries, we can see that this group actually accounted for more than half of the deviation in international reserves.

Another country who is also present in this trend is Latin America with its reserves almost doubled during this period. 8 The two main reasons behind this trend of increase in foreign assets were identified by Aizenman and Glick (2007) as recent boom in commodity prices, particularly oil and the accumulation of international assets by non-commodity exporting countries which are running persistent account surpluses. With the rapid accumulation in their foreign exchange reserves, SWFs in developing countries have been growing very fast.

The foreign exchange reserves of the Middle East, Russia and China have been increasing rapidly9. The total accumulation of current account surplus for oil producers is US$500 billion and US$325 billion solely for China. Because of this, oil producers' reserve surged to US$3. 5 trillion compared to China's US$1. 3 trillion and Russia's US$425. Out of the largest 20 SWFs, 14 have their main source of income derived from oil or other commodities, which mean 70% of total funds in SWFs are based on oil and gas.

And this money stream flowing into investments in developed economies is now a focus of attention from Western governments. 10 Apart from Middle Eastern funds and some more established investment vehicles in Asia such as Government Investment Corporation (GIC) and Temasek in Singapore, the Western attention focused on some newer funds, such as the $200 billion China Investment Corporation (CIC) set up earlier this year. In addition, accumulation of funds from Eastern Europe, Latin America and Africa has increased.

An example of this is Russia's plan to split its lower return Stabilization Fund into a Reserve Fund and a Fund for Future Generations. The Reserve Fund will accommodate an increase in revenue from oil and gas up to 10% of GDP, and the Fund for Future Generations will be used to invest in riskier assets. Brazil has also made a new move in establishing a state investment vehicle. Even Libya has just set up a fund of $40 billion.