Sovereign wealth funds have attracted a lot of attention in recent years as more countries open funds and invest in big-name companies and assets. Some experts estimate that all sovereign wealth funds combined to hold more than $5 trillion in assets in 2012, a number that is expected to grow relatively quickly. This has given way to a widespread concern over the influence these funds have on the global economy. As such, it is important to understand exactly what sovereign wealth funds are and how they first came about.
Sovereign Wealth Fund
A sovereign wealth fund is a state-owned pool of money that is invested in various financial assets. The money typically comes from a nation's budgetary surplus. When a nation has excess money, it uses a sovereign wealth fund as a way to funnel it into investments rather than simply keeping it in the central bank or channeling it back into the economy.
The motives for establishing a sovereign wealth fund vary by country. For example, the United Arab Emirates generates a large portion of its revenue from exporting oil and needs a way to protect the surplus reserves from oil-based risk, thus it places a portion of that money in a sovereign wealth fund. Many nations use sovereign wealth funds as a way to accrue profit for the benefit of the nation's economy and its citizens.
The primary functions of a sovereign wealth fund are to stabilize the country's economy through diversification and to generate wealth for future generations.
The first funds originated in the 1950s. Sovereign wealth funds came about as a solution for a country with a budgetary surplus. The first sovereign wealth fund was the Kuwait Investment Authority, established in 1953 to invest excess oil revenues. Only two years later, Kiribati created a fund to hold its revenue reserves. Little new activity occurred until three major funds were created:
- Abu Dhabi's Investment Authority (1976)
- Singapore's Government Investment Corporation (1981)
- Norway's Government Pension Fund (1990)
Over the last few decades, the size and number of sovereign wealth funds have increased dramatically. In 2012, there are more than 50 sovereign wealth funds, and according to the SWF Institute, has exceeding north of $5 trillion.
Commodity Versus Non-Commodity Sovereign Wealth Funds
Sovereign wealth funds can fall into two categories, commodity or non-commodity. The difference between the two categories is how the fund is financed.
Commodity sovereign wealth funds are financed by exporting commodities. When the price of a commodity rises, nations that export that commodity will see greater surpluses. Conversely, when an export-driven economy experiences a fall in the price of that commodity, a deficit is created that could hurt the economy. A sovereign wealth fund acts as a stabilizer to diversify the country's money by investing in other areas.
Commodity sovereign wealth funds have seen huge growth as oil and gas prices increased between 2000 and 2012. In 2012, commodity financed funds totaled more than $2.5 trillion.
Non-commodity funds are typically financed by an excess of foreign currency reserves from current account surpluses. Non-commodity funds totaled $2 trillion in 2012, which is three times the total three years earlier.
Currently, the majority of funds are financed by commodities, but non-commodity funds may reach beyond 50% of the total by 2015.
What Do Sovereign Wealth Funds Invest In?
Sovereign wealth funds are traditionally passive, long-term investors. Few sovereign wealth funds reveal their full portfolios, but sovereign wealth funds invest in a wide range of asset classes including:
- Government bonds
- Foreign direct investment
However, a growing number of funds are turning to alternative investments, such as hedge funds or private equity, which are not accessible to most retail investors. The International Monetary Fund reports that sovereign wealth funds have a higher degree of risk than traditional investment portfolios, holding large stakes in the often-volatile emerging markets.
Sovereign wealth funds use a variety of investment strategies:
- Some funds invest exclusively in publicly listed financial assets.
- Others invest in all of the major asset classes.
Funds also differ in the level of control they assume when investing in companies:
- There are sovereign wealth funds that place a limit on the number of shares bought in a company and will enforce restrictions either to diversify their portfolios or to adhere to their own ethical standards.
- Other sovereign wealth funds take on a more active approach by buying larger stakes in companies.
Sovereign wealth funds represent a large and growing portion of the global economy. The size and potential impact that these funds could have on international trade have led to considerable opposition, and the criticism has mounted after controversial investments in the United States and Europe. Following the mortgage crisis of 2006-2008, sovereign wealth funds helped rescue struggling Western banks CitiGroup, Merrill Lynch, UBS, and Morgan Stanley. This led critics to worry that foreign nations were gaining too much control over domestic financial institutions and that these nations could use that control for political reasons. This fear could also lead to investment protectionism, potentially damaging the global economy by restricting valuable investment dollars.
In the United States and Europe, many financial and political leaders have stressed the importance of monitoring and possibly regulating sovereign wealth funds. Many political leaders assert that sovereign wealth funds pose a threat to national security and their lack of transparency has fueled this controversy. The United States addressed this concern by passing the Foreign Investment and National Security Act of 2007, which established greater scrutiny when a foreign government or government-owned entity attempts to purchase a U.S. asset.
Western powers have been guarded about allowing sovereign wealth funds to invest and have asked for improved transparency. However, as there is no substantive evidence that funds are operating under political or strategic motives, most countries have softened their position and even welcomed the investors.
The Bottom Line
The size and number of sovereign wealth funds continue to grow, assuring that these funds will remain a crucial part of the global economy in the future. One report projects that if sovereign wealth funds continue to grow at their current pace, they will exceed the annual economic output of the U.S. by 2015 and that of the European Union by 2016. The emergence of sovereign wealth funds is an important development for international investing, and as regulation and transparency issues are resolved in the coming years, these funds are likely to take on a major role in shaping the global economy.
As an expert in finance and global economic trends, I can provide a comprehensive understanding of sovereign wealth funds and their impact on the global economy. My expertise is grounded in a thorough knowledge of financial markets, investment strategies, and the historical development of sovereign wealth funds.
Sovereign Wealth Funds: A Brief Overview
Sovereign wealth funds (SWFs) have become a focal point in recent years, with an estimated combined holding of over $5 trillion in assets in 2012, a figure expected to grow rapidly. These funds, state-owned pools of money, are crucial in diversifying a nation's surplus budget rather than keeping it within the central bank or channeling it back into the domestic economy.
Historical Development: Origins and Growth
The concept of sovereign wealth funds emerged in the 1950s as a solution for countries with budgetary surpluses. The Kuwait Investment Authority, established in 1953, was the pioneer SWF, followed by others like Abu Dhabi's Investment Authority (1976), Singapore's Government Investment Corporation (1981), and Norway's Government Pension Fund (1990). Over the decades, the number and size of sovereign wealth funds have grown significantly.
Commodity vs. Non-Commodity SWFs
Sovereign wealth funds can be categorized into two types: commodity and non-commodity. Commodity SWFs, often fueled by exporting commodities like oil, act as stabilizers for export-driven economies. Non-commodity funds, on the other hand, are financed by foreign currency reserves from current account surpluses. In 2012, commodity funds totaled over $2.5 trillion, while non-commodity funds reached $2 trillion.
Investment Portfolio and Strategies
Traditionally, sovereign wealth funds are passive, long-term investors. They invest in various asset classes, including government bonds, equities, and foreign direct investment. Some funds, however, venture into alternative investments like hedge funds and private equity. The International Monetary Fund notes a higher risk profile for sovereign wealth funds, particularly due to their significant stakes in emerging markets.
International Debate and Regulation
The size and potential impact of sovereign wealth funds on international trade have sparked opposition and criticism. Controversial investments in the U.S. and Europe, particularly during the mortgage crisis of 2006-2008, raised concerns about foreign nations gaining too much control over domestic financial institutions. This led to calls for increased transparency and regulation. The United States, for instance, passed the Foreign Investment and National Security Act of 2007 to scrutinize foreign government-owned entities attempting to acquire U.S. assets.
The Future Outlook
Sovereign wealth funds continue to grow in size and number, projecting to play a crucial role in the global economy. If current growth rates persist, these funds could surpass the annual economic output of the U.S. and the European Union by 2015 and 2016, respectively. As regulatory and transparency issues are addressed, sovereign wealth funds are poised to shape the international investing landscape in the years to come.
In conclusion, the emergence of sovereign wealth funds represents a significant development in international finance, and understanding their dynamics is essential for anyone navigating the complexities of the global economy.