Sovereign wealth funds set to boost investment in alternatives

And the trend towards greater transparency continues, with the release of the first annual report from Abu Dhabi Investment Authority.

Many sovereign wealth funds (SWFs) that had delayed moves into new asset classes and strategies are starting to look at diversifying their portfolios once more, according to US research house Preqin. In a report released earlier this month, the firm seeks to shed light on the investment activities of these institutions.

Soon after the report came out, Abu Dhabi Investment Authority (Adia) -- thought to be the biggest SWF by assets -- shed some light of its own by publishing its first annual review. While much of the document is fairly vague and short on detail, it does contain some interesting snippets, and at least shows some willingness to open up to public scrutiny. (Singapore's Goverment Investment Corporation released a similar document late last year.)

Adia has a significant permitted allocation to hedge and managed funds (5-10%), private equity (2-8%), real estate (5-10%) and infrastructure (1-5%). Moreover, the fund says it outsources 80% of its portfolio management and has 60% of its assets invested in index-replicating strategies.

Like all institutional investors, SWFs suffered during the crisis, due both to declines in asset values and withdrawals by governments to fund budget deficits, says Preqin. But the start of a global economic recovery has helped the aggregate assets of all SWFs to reach $3.59 trillion, an 11% increase from last year. They clearly remain a very important source of capital, adds the report.

At a time when fundraising for many alternative investments, such as private equity, continues to be very slow, SWFs represent a vital source of potential funding. (PE funds raised just $35 billion in the fourth quarter of last year compared to $53 billion in the quarter before and $158 billion in Q4 2008.)

In 2010, some SWFs that had put plans to expand diversification in their portfolios on hold due to the economic downturn are likely to begin resuming these programmes again, says Preqin. "We could see an even greater proportion of these funds investing in alternatives as they expand beyond the traditional asset classes," adds the report.

In terms of asset size, it is generally agreed that Adia is probably the biggest SWF. The next two largest SWFs are Norway's Government Pension Fund (GPF) and China's Safe Investment Company. These three together are estimated to manage well over $1 trillion in assets, according to Preqin. At the other end of the size scale, 12% of SWFs have less than $1 billion in total assets.

Asia and Mena are home to the largest number of SWFs, and account for 57% of all such funds. Funds based in the two regions make up three-quarters of the aggregate value of all SWFs worldwide.

With regard to specific asset classes, some 79% of SWFs are known to invest in public equities, while 12% are known not to, according to Preqin. And nearly 60% of SWFs that invest in public equities do so on a global basis.

Of the funds that invest in the asset class, around half invest in stocks almost exclusively in their own country or region. For example, the majority of investments made by Khazanah Nasional, one of Malaysia's SWFs, are in Malaysia itself or neighbouring Indonesia.

Asia is the most popular target region for equity investment, with 80% of SWFs active in equities willing to invest in the asset class there. Meanwhile, 70% of funds invest in equities in Europe, 67% in Mena and 61% in North America. Most of Asia's SWFs have an allocation to equities in their local region.

The recovery in the public equity markets during 2009 has encouraged funds that were planning to invest in the asset class but had put their plans on hold, to resume allocating to public equities for the first time. China's National Social Security Fund, for example, plans to increase its exposure to public equities.

On the fixed-income side, 79% of SWFs are known to allocate to this asset class. The ones that do not do so tend to focus on equities for various purposes, such as developing specific sectors of their domestic economies, investing to protect domestic industries and supporting domestic stock exchanges and financial markets.

Looking regionally at the asset class, 41% of SWFs that invest in fixed income do so on a global basis, one example being Norway's GPF.

North America is the most popular region for fixed-income investments made by SWFs, with 73% of funds that invest in the asset class known to invest in such instruments there. Many SWFs hold US government bonds, although holdings of these are generally falling.

The next most popular region for fixed-income investment is Asia, with 61% of funds known to have an interest in investing in the region, followed by Europe (57%) and Mena (40%).

SWFs are also big investors in the less liquid asset classes. They represent some of the largest investors in private equity in the world, and 55% of them are known to allocate to it, up from 49% last year, while 31% do not any such investments. Moreover, another 5% are considering making their first allocation to private equity, such as Emirates Investment Authority, set up in late 2007.

A number of SWFs have used the recent economic turmoil in their favour, such as Korea Investment Corporation (KIC), which plans to double its exposure to private equity in 2010 with a particular focus on distressed private equity and secondaries funds.

The vast majority (92%) of SWFs investing in private equity prefer buyout funds. This is understandable, given the large AUM of many SWFs and the fact that buyout funds tend to be larger and receive larger commitments than other types of private equity funds. KIC, for example, typically commits $100 million to each private equity fund.

Only 12% of SWFs look to invest in PE funds of funds, while 20% have a preference for mezzanine vehicles.

On a regional basis, of the SWFs known to invest in private equity, the largest proportion (42%) are based in the Mena region; in second place is Asia (home to 36%); and Europe houses the fewest SWF private equity investors (3%).

As with private equity, SWFs are among the largest investors in real estate, and half (51%) are known to allocate to it. The larger, more sophisticated and well-established SWFs are the most likely to invest in real estate, says Preqin.

The biggest property investors are SWFs in North America (100% of funds in that region hold the asset class), Mena (85%) and Australasia (67%). Less than half (44%) of SWFs in Asia are known to invest in property.

As for target regions, 66% of SWFs that invest in real estate allocate to North America, 59% to Asia and 55% Europe. The Mena region attracts investments from 41% of SWFs, although Mena-based SWFs account for 92% of this group.

A predominantly domestic investor base can also be seen in Asia: 88% of those with a preference for Asian real estate are from Asia or Mena.

As for infrastructure, nearly half (47%) of all SWFs are known to invest in the asset class, while 39% do not. And, as with property, the larger funds are more likely to invest in infrastructure than the smaller ones.

The most popular target region for infrastructure investment by SWFs is Asia, with 62% of funds that invest in infrastructure stating a preference for making investments focused on this region. Half of funds will make infrastructure investments in North America, while 35% consider investments in Europe and the same proportion in Mena. Most of the SWFs that are known to invest in infrastructure in Mena are local to the region.

Finally, nearly 40% of SWFs are known to be investing in hedge funds, with the highest proportion of them based in the Mena region (38%) and Asia (29%). Around half of funds that allocate to hedge funds made their first investments in the asset class in the past five years and a quarter did so after the start of 2007.

A high proportion of SWFs that invest in hedge funds have a preference for funds with a global mandate. North American hedge funds are also attractive, with just over three-quarters of those investing in hedge funds interested in North American-formed funds.

Looking at a couple of SWFs specifically, China Investment Corporation made its first hedge-fund investments in June 2009 and has since announced plans to continue making additional investments in hedge funds. It intends to build a hedge-fund portfolio worth up to $6 billion and has expressed a preference for Asia-based hedge funds.

Meanwhile, KIC expects to double its exposure to alternative investments over 2010 and has already begun allocating to additional hedge funds.

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