Sovereign wealth funds* are continuing to grow due to both investment returns and being given government money to run, say market participants, but the latter trend may be set to slow. 

The government debate around SWFs is fiercer than it used to be, says Victoria Barbary, director at the Sovereign Wealth Center, a London-based research organisation.

Central banks are becoming even less keen to give up their money, she explains. Since they have a better understanding of investments than in the past, they feel they can do more in-house rather than set up a separate entity. This is a trend that has been steadily on the rise for some time.

“Clearly this [tension between central banks and SWFs] will be a difficult issue to resolve,” says Garry Hawker, director of consulting for growth markets at Mercer in Singapore.

“The main thing is you don’t want [a country’s central bank and SWF] competing against each other in a way that’s detrimental – for example, chasing the same deal and pushing prices up.” He points to the fact that Singapore’s GIC and Temasek, for instance, have different mandates.

The tension between central banks and sovereign wealth funds continues to be an issue, agrees Andrew Economos, Asia head of sovereign and institutional strategy at JP Morgan Asset Management. But if an SWF performs well, he argues, it will continue to cede more traditional asset classes to the central bank as it looks to stay at the cutting edge of more sophisticated investing.

“The good news is that there are plenty of reserves to go around in Asia,” he notes, “so you will continue to see flows into sovereign wealth funds.”

That seems to be backed up by the continued rapid growth of such wealth funds as China Investment Corporation and Korea Investment Corporation. CIC had $575 billion in assets under management as of late August, up from around $400 billion in September 2011, according to the Sovereign Wealth Funds Institute.

And KIC currently runs $65 billion up from $47 billion in August last year, with the fund expecting the figure to rise to $100 billion in the next few years due to government contributions.

Then there are the more recently established SWFs, with more in the pipeline. Barbary points to several SWFs set up relatively recently, such as the State Oil Fund of Azerbaijan and the Petroleum Fund of Timor-Leste.

Such entities are far less sophisticated in their investments than the more well established state entities, she notes: they have come out of central banks and lack the expertise to invest in stocks, so initially just want passive management of developed-market equities. Plus they are growing quickly, and more are likely to appear, making this a major opportunity set for fund house, she adds.

A trend Barbary believes may emerge is that finance ministries – such as Indonesia’s – will start out by investing only domestically before branching out into offshore investments to fund their activities at home. She cites Malaysia’s Khazanah Nasional and Abu Dhabi’s Mubadala Development Company as two that have followed this route.

That said, tension between central banks and SWFs is probably limited to a very small number of countries, argues David Smart, London-based head of sovereign relationships at Franklin Templeton Investments.

“That’s because with the older ones, delineations tend to have been fairly well established over time,” he notes. “But some of the central banks with a significant amount of excess reserves are definitely moving into a number of what are perceived to be riskier assets.”

The Bank of Israel, for instance, has been very open about its views on the importance of having 10% of reserves in equities as a diversifier from debt, says Smart. “Many central banks have seen the writing on the wall with regard to US bond yields and have viewed that equity shift as a very good diversifier on a risk-adjusted basis."

South Korea’s central bank, too, has been widening its asset-class composition, diversifying out of government bonds and into corporate fixed income and equities. Choo Heung-Sik, Bank of Korea’s head of reserve management, told AsianInvestor earlier this year that he is keeping an open mind to investing in alternative assets in future.

He also points to the growing importance of emerging markets exposure, both from a currency diversification perspective and in terms of returns relative to embedded risks.

*The cover story in the November issue of AsianInvestor magazine takes an in-depth look at trends among sovereign wealth funds.