Opportunities and Threats – the Role of Sovereign Wealth Funds in the Financial Markets
Over the last 20 years, sovereign wealth funds have performed remarkably well and are now more widely popular, according to the latest White Paper published by Deutsche Asset & Wealth Management (Deutsche AWM). The authors Valeria Miceli, Professor of Economics of Financial Markets at the Catholic University of Milan, and Asoka Wöhrmann, CIO at Deutsche Asset & Wealth Management (Deutsche AWM), regard them as the richest source of capital support for financial markets.
Thanks to their long-term investment horizon and higher risk exposure, sovereign wealth funds often behave as counter-cyclical investors. As such, they invest in falling markets and in illiquid assets to exploit future price recovery and liquidity premiums. “Consequently, sovereign wealth funds with their stabilizing investments have played an important role as long-term investors since the financial crisis”, according to Asoka Wöhrmann.
Prior to the onset of the financial crisis, financial markets regarded sovereign wealth funds with skepticism. According to the authors, this is because they offered little transparency and were poorly regulated. In addition, many of them are owned by undemocratic countries. Similarly, investments in sensitive sectors such as defense, infrastructure and energy supply are viewed critically. Misgivings ranged from industrial espionage through to potential favoring of domestic companies while hindering their foreign counterparts.
“In the scientific studies we analyzed, we found no indications of misuse of fund assets or destabilization of a financial system. Quite the opposite: a number of studies highlight the stabilizing effect of sovereign wealth fund investments, both in micro and macro-economic terms”, Miceli emphasized.
Over recent years, both assets under management and the actual number of sovereign wealth funds have increased substantially. At the end of 2013, the asset portfolio of the 69 existing sovereign wealth funds had grown to USD 6.3 trillion, compared with around USD 500 billion in 1995. Around one third of these funds were launched between 2000 and 2013. Commodity revenues, particularly oil exploration, accounted for 61 per cent of their assets, with the remainder generated from balance of payments surpluses.
Miceli and Wöhrmann believe sovereign wealth funds will continue to perform strongly, although not as dynamically as in recent years. “This is partly due to lower commodities prices and reduced export surpluses for countries such as China. Furthermore, currency appreciation and increasing wages have meant that countries have scaled back the amount of money made available”, according to Miceli. Estimates suggest that fund assets under management will increase to USD 10 trillion by the end of 2016.
In this environment sovereign wealth funds are reexamining their investment strategies and diversifying their portfolios. Until now, sovereign wealth funds have preferred to invest in advanced economies, with a disproportionately high equity allocation in highly-capitalized companies. The authors cite significant liquidity and higher institutional standards applicable in advanced markets as reasons for this. From 1995 to 2010, on average 40 per cent of sovereign wealth fund assets were invested in Europe – 34 per cent in the EU and 6 per cent in non-EU countries. A further 27 per cent was invested in Asia and 16 per cent in North America. Using this investment strategy sovereign wealth funds claim to have produced an average annual yield of 8 per cent from 2010 to 2013.
In future, the authors predict that sovereign wealth funds will invest more in emerging and frontier markets. They will also increasingly turn to alternative investments – especially real estate, infrastructure and private equity. Other types of fixed income such as high-yielding corporate bonds will also come to the fore.
“Sovereign wealth funds have definitely arrived in institutional investor circles” is Asoka Wöhrmann’s summary. “Thanks to their long-term investment horizon, their high tolerance of risk and limited regulation, they can buy or sell exactly when it is opportune rather than when they are compelled to, unlike their institutional competitors. That makes them a capital-rich support for financial markets”.
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