More reserves should flow into SWFs, says State Street

Sovereign wealth funds shifted towards more passive strategies and increased equity exposures last year, according to a recent survey. But there is potentially a lot more for them to invest.

In line with what one might expect, sovereign wealth funds (SWFs) saw substantial asset growth during 2009, according to a non-scientific poll by US asset manager State Street Global Advisors (SSgA).

The survey polled 12 sovereign wealth funds -- six in Asia-Pacific and six in the Europe, Middle East and Africa (EMEA) region. The Asia-Pacific entities' assets under management had risen 40% by September 2009, from $10.6 billion to $14.9 billion, while the EMEA funds' AUM had grown by 16.5% from $103.9 billion to $121.6 billion.

"The higher growth in the Asia-Pacific assets partly reflects their better performance over the period, probably resulting from their higher cash balances going into 2009 and their greater exposure to equities during the market rally," says the report.

Other findings include a noticeable shift towards more passive strategies, in line with the strategies many had set out and also with the general trend among asset managers and owners. In December 2008, the 12 SWFs polled were invested in 15 active mandates, four enhanced (a combination of active and passive), 10 passive mandates and two alternative mandates. By September 2009, the number of active mandates had dropped to 11, while the number of enhanced and passive mandates had risen by one apiece.

Another shift is that of a substantial increase in equity assets, with the value of the 12 SWFs' equity portfolios rising by 64% from $32.4 billion to $53.1 billion in the same period. The value of their alternatives portfolios also grew by a substantial 22% from $14.2 billion to $17.3 billion, a trend that may be set to continue.

These increases will have been due to both valuation increases and inflows, says Hon Cheung, regional director for the official institutions group at SSgA in Singapore. Further analysis showed a tendency for the SWFs from EMEA to reduce their exposure to equities over the period, and a smaller tendency for the Asia-Pacific ones to increase their equity exposure.

In many ways, SWFs are doing the same as other asset managers and owners in shifting back to pre-crisis allocations, since many had moved strongly into bonds and cash in the past couple of years. "[Many firms] need to do an awful lot of buying of equities to get back to pre-crisis positions," says Cheung, "as many had moved strongly into bonds and cash."

On the currency side, there's been a big shift that is of major relevance to sovereign wealth funds, specifically entities such as central banks. That is the huge growth in Asian foreign reserves, which have increased to $5.1 trillion now from $4.3 trillion a year ago.

"We believe these reserves are being managed too conservatively," says Cheung. "Looking forward, we estimate that around $2.3 trillion could be used for SWF purposes. The capacity for future SWF growth in Asia is, therefore, significant."

Another point he makes is that there seems to be a gradual, and understandable trend towards large regional institutions -- such as central banks -- buying Asian local-currency bonds.

There are two reasons central banks hold bonds, says Cheung. One, they want to have liquid assets to reduce volatility in their currency; assets called 'transitory capital reserves'. Another is to offset liability the local-currency bonds they have issued. These reserves -- 'sterilisation reserves' -- are being held also to try to ensure the entity can match its currency policy as closely as possible, he says.

Given that in the past the main trading partner for Asian countries had been the US, it made a lot of sense for Asian countries to have their sterilisation reserves in dollars. "But now over 50% of Asian trade is intra-regional, so if you're trying to match policy against your trade-weighted partners," says Cheung, "your portfolio should contain a lot more Asian-currency bonds than it did historically."

According to the International Monetary Fund, 65% of the currency holdings of central banks around world was in dollars, he adds. "That's been a tradition of central bank reserve management -- you were supposed to hold a large amount in liquid reserves like dollars, yen, JGBs [Japan government bonds], a bit of sterling," says Cheung. "But we're seeing evidence of this changing as we win more bond mandates from central banks in the region."

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