Sovereign Wealth Funds: Is Bigger Always Better?

On February 23rd, 1953, the government of Kuwait founded the Kuwait Investment Authority (KIA). The mandate of the KIA was to invest the country’s surplus revenue from oil production to create a pool of wealth that could be used to support future generations. This represented the first instance of a sovereign wealth fund (SWF). Broadly, sovereign wealth funds are state-owned investment funds that invest money from the government. Sovereign wealth funds can get money from a variety of sources, including state-owned natural resource revenue, trade surpluses, budgeting surpluses, proceeds from buying or selling foreign exchange, and direct transfer payments from the government. SWFs can also have a variety of different purposes. A very common goal is for a SWF to help stabilize a country’s economy during fluctuations in the business cycle. When a country generates a surplus, that money can grow in the SWF and eventually be drawn on in an economic downturn to meet the country’s needs. This can be especially important for countries with commodity-based economies, as their economic performance is subject to volatile resource prices. For countries with large stores of non-renewable resources, sovereign wealth funds can be used as a tool for ensuring intergenerational equity. By investing the money a country gets from oil extraction, a SWF allows future generations to share in the benefits of depletable resources even if they run out soon. Finally, some countries use these funds to meet long-term pension fund liabilities.

Over the past couple decades, sovereign wealth funds have grown tremendously. Currently, SWFs have over 10 trillion dollars in assets under management collectively. For reference, the total industry AUM of hedge funds is around 5 trillion dollars. The two largest funds, the China Investment Corporation and Norway’s Government Pension Fund Global each have over 1.2 trillion dollars in AUM. They are both around the same size as Vanguard Total Stock Market Index Fund, the world’s largest mutual fund. In 2022, it was estimated that SWFs held a 5.4% share in global public equities. This article will attempt to examine how the investment strategies of SWFs have changed over time and point out potential downsides that the continuous growth of funds poses.

Historically, sovereign wealth funds have invested in four main asset classes: cash, fixed-income securities, public equities, and alternative assets (private equity, real estate, infrastructure, etc.). The specific risk tolerance and asset allocation of each fund will vary depending on the purpose of the fund and the specific economic context of the country it’s controlled by. Funds that are more focused on acting as a stabilizer for a country’s economy usually take on less risk and are more invested in cash so that they can provide liquidity to a country on short notice. Funds that are more focused on saving for future generations and maximizing capital tend to take on more risk and are heavily weighted towards public-equity and alternative assets. One noticeable trend over time for many of these funds is a shift away from safer fixed-income assets, towards riskier alternative assets. For example, in a survey done by the International Forum of Sovereign Wealth Funds (IFSWF) it was found that in the past 3-5 years, 50% of surveyed funds increased their allocations for both public equities and private equity in foreign markets. These increases were mainly funded by withdrawals from government and corporate bond portfolios. Funds have also increased the percentage of assets that are actively managed. According to the IFSWF, 54% of their members’ assets are actively managed. One fifth of members also report that they’ve increased the percentage of actively managed assets over the past three to five years. Although funds have performed well in recent years, active management can be risky because of the high management fees involved and the possibility of underperforming the market.

Looking specifically at Norway’s SWF, we can see a huge change in its asset allocation since inception. In 1998, when the fund was worth around 22 billion dollars, it was invested around 60% in fixed-income and 40% in equities. In 2009 when the fund was worth around 468 billion dollars, the equity portfolio represented around 60% and the fixed-income 40%. The allocation towards equities and other risky assets has continued to grow to date. In 2022, the fund was worth around 1.3 trillion dollars with around 70% invested in equities, 27% in fixed-income, and 3% in real-estate and infrastructure. Looking at the returns data, it seems that this strategy of riskier investing has paid off. In 2022, the fund enjoyed a relative return of 0.9 percentage points compared to a benchmark index. When looking at the last five years this figure drops to 0.5 percentage points. Looking at the fund since 1998, the relative return is 0.32 percentage points. The same trend of improvement over time can be seen when looking at the fund’s Sharpe ratio relative to a benchmark. The fund’s ratio was 0.14 above the benchmark in the last 12 months, 0.04 in the last ten years, and 0.02 since 1998. Finally, just looking at gross returns, in the last ten years the fund earned an average of 7.51 percent, compared to returns of 5.81 percent since 1998.

While a shift in investment strategy has allowed rapid growth of these funds, this may not strictly be a good thing. There are many who point out that having such massive institutional investors can pose major risks. One example is that the investments of sovereign wealth funds can undermine public accountability of government spending. In many countries, the process for approving budgets and large spending projects involves some form of legislative oversight where spending must be approved by a parliament or similar governing body. When a government doesn’t get all its desired spending approved, they can bypass this budget approval system by pressuring SWFs to invest in the projects they wish to fund. The risk of politically motivated investing is especially high in countries where SWF activities are not publicly disclosed, which is the case for more than 50% of funds according to the Natural Resource Governance Institue. There have been instances of countries like Iran and Azerbaijan using their funds to support politically motivated projects. Another potential risk is that getting too large may cause diseconomies of scale within funds which can reduce the quality of investing. When an institutional investor gets large, it must be split into many different teams who often don’t communicate with each other. Having complex hierarchies and organizational structures can slow down the decision-making process and make an organization less efficient. Additionally, having too much capital may lead to an increase in poor investments given that the number of high-quality investment opportunities are finite. A final problem is that SWFs may increasingly be exposed to currency risk as a result of foreign investment. Given that a country’s economy is finite in size, as a fund grows It must increasingly look abroad to invest the large amounts of capital it possesses. For instance, Norway’s public equity portfolio includes investments in companies from 63 different countries. Having massive exposure to foreign markets inherently increases exposure to fluctuations in exchange rates, which may cause undesirable volatility in the returns of a fund. Completely hedging currency risk may be difficult for the largest funds to do properly given that currency swap markets have a limited trading volume, so funds may not be able to access enough of the right swaps to adequately insulate their portfolios. Furthermore, while the strategy of equity investing has been very successful in the past decade, this trend may not continue. Stock returns have been historically high due in part to persistently low interest rates since the financial crisis. From 2012 to 2021, the average annual return of the S&P 500 was 14.8%. Additionally, fiscal stimulus policies during the covid-19 pandemic caused a large spike in company valuations. In 2021, the S&P 500 had a return of 26.89%. The combination of high valuations and central banks unwinding asset-inflating monetary policy is leading experts to predict lower equity returns in the coming decade. For example, Blackrock predicts that the average return on US equities in the coming decade will be 7.9%

To conclude, while sovereign wealth funds have clear potential benefits to a country, with some funds enjoying tremendous success in recent years, it's important for countries to carefully consider the challenges that may arise as they continue to grow.