London: Having gone from bumper cash inflows to redemptions in just two years, many sovereign wealth funds have been forced to shake up their investment strategies to embrace both super-liquid safe assets with more esoteric illiquid plays to bolster returns.
If the price of retaining easy-to-sell assets to meet sudden government cash calls is near-zero yields in cash deposits or Western government debt, then the $6.5 trillion sovereign fund sector will have to claw back returns by simultaneously moving deeper into riskier, less-liquid territory.
Changes run from radical rethinks about the purpose of such funds such as Saudi Arabia’s $3.5 billion (Dh12.90 billion)investment in ride service Uber to more nuanced shifts such as Qatar’s decision to use more external managers to run its money.
With oil crashing to under $30 a barrel in early 2016 and still down by more than half since 2014, states such as Saudi Arabia have been forced to raid their coffers to cover day-to-day spending.
And that shift — from managing inflows to managing withdrawals — can present significant portfolio rebalancing and risk management challenges, says Michel Meert, a director at PWC, which advises sovereign wealth funds (SWFs).
For instance, selling stocks and bonds to meet governments’ urgent cash needs can lead to unintended overweight positions in other areas, such as more illiquid assets, which cannot be disposed of as quickly.
“If you have an external element disrupting portfolios, most of the time it has a negative impact on performance. It incurs costs and you are not necessarily selling at the right time,” Meert said.
Similar unintended overweights can occur in the event of a stock market crash. Recognising this, Norway now allows real estate allocations in its $868 billion sovereign wealth fund (SWF) to go as high as 7 per cent, up from its previous 5 per cent ceiling.
This means it won’t be forced to sell property if a fall in the value of stocks pushes up real estate’s share in the portfolio.
Also, some of the more sophisticated sovereigns now split their portfolios into tranches of short-term, medium-term and long-term assets, said Alex Millar, head of EMEA sovereigns, Middle East and Africa institutional sales at Invesco.
“This recognises that at any time they could get a request from the government for some of their funds. So they need to keep a certain percentage of their portfolio liquid and secure for that. Above that threshold, they can park assets for longer.”
Volatile markets, lower returns
These changes are taking place alongside a broader shift out of publicly listed stocks and bonds.
Last year, SWFs pulled $46 billion from external managers, according to eVestment data.
This came amid rollercoaster equity moves and mounting frustration with low or negative interest rates in many Western bond markets.
They are turning instead to unlisted but higher-yielding assets, with some 55 per cent now investing in private equity, up from 47 per cent in 2015, according to research from Preqin.
Start-ups, particularly those that exploit disruptive technologies, are also attracting bigger slabs of SWF capital, including recent investments in GrabTaxi and Chinese internet company Meituan-Dianping.
And private debt vehicles that provide loans for everything from aircraft leasing to infrastructure now attract 35 per cent of SWFs, Preqin says.
“There is a need for yield,” said Declan Canavan, head of alternative strategies at JP Morgan Asset Management.
Oil addiction
For some oil-backed funds the changes are more fundamental, with Saudi Arabia revamping its 45-year-old, domestically focused Public Investment Fund (PIF) to create a $2 trillion SWF that will be the world’s biggest.
Traditionally, the central bank has served as Saudi Arabia’s sovereign fund, but the rate at which the country is burning through its savings has strengthened the hand of reformers who want to diversify the economy and reduce the economy’s dependence on oil.
“When the oil price is going up for many years in a row, states get addicted to the higher income and start spending more,” said PWC’s Meert. “What is happening now is forcing the different (fund) stakeholders to review what a clear mission is and how it will work.” The Uber deal confirms that Saudi Arabia is breaking from its past emphasis on low-risk investments such as Treasury bonds and emulating peers that favour big, direct stakes in companies.
However, the Qatar Investment Authority has decided to put less emphasis on direct deals and give more money to external managers to diversify its Europe-heavy portfolio.
The decision follows sharp falls in the value of its big holdings in carmaker Volkswagen and commodity trader Glencore.
But SWFs with big direct investment teams will have to make a tricky transition from sourcing and making deals to managing existing assets, said Ashby Monk, research director of Stanford University’s Global Projects Center and an expert on SWFs.
This may bring more changes to management teams, and funds such as Singapore’s Temasek and GIC are already beefing up risk management and investment functions.
“It’s a very different skill,” Monk said. “The risk management tools, the governance tools, the oversight tools are simply just not there.”