Sovereign wealth funds (SWFs) have come to the end of their rapid growth, and many are approaching the limit of how much they can invest in illiquid assets such as private equity and property, says a new report that State Street Global Advisors (SSGA) will release today.

The US fund house argues that this change in landscape has big implications for global asset allocation and could mean a shift back into fixed income at the expense of alternatives, reversing a trend of recent years. 

SWFs held roughly $6 trillion in assets under management at the end of 2016*, of which more than a quarter (27.3%) was invested in alternative assets (anything not publicly traded), according to the research. That means they account for a startling 15% ($1.6 trillion) of alternative assets globally (see figure 1 below).

FIGURE 1: SOVEREIGN WEALTH FUND ASSET ALLOCATION ($ BN)
(click for full view)

Yet SWFs in Asia* (excluding central Asia and the Middle East) have 37.9% of their overall AUM in alternatives, having moved sooner and more decisively into those investments (see figure 2 below). And it’s likely that SWFs’ $1.6 trillion alternatives exposure will be even higher today, as institutional investors’ shift into private markets continued last year.

FIGURE 2: GLOBAL AND ASIAN SWF ALTERNATIVES ALLOCATIONS

  2002 2007 2012 2014 2016
Asia only* 17.4% 24.7% 30.1% 36.8% 37.9%
World 7.7% 11.5% 23.8% 26.2% 27.3%

*Excluding central Asia and the Middle East. Source: SSGA research

Elliot Hentov, global head of policy and research in the official institutions group at SSGA and co-author of the report, told AsianInvestor: “Asian sovereign wealth funds are, by and large, approaching the limits of their internal capabilities and the level of illiquidity they can handle in terms of their private market allocations [in line with the trend globally].”

Generally, the “disproportionately large role of SWFs in private markets is an indicator of limits to future growth”, noted the report. “It also explains why vendors of private asset classes have particularly targeted sovereign investors as potential buyers.”

Private market peak?

For several reasons SSGA believes SWFs are close to the peak of their private market allocations as a further increase could hit institutional constraints.

First, while many SWFs were early investors into assets like private equity, the space is more crowded now and there are questions as to whether investors receive an adequate illiquidity premium.

While the supply of private assets is theoretically almost limitless, noted the report, the asset management industry sometimes struggles to produce institutionalised vehicles for such investments; infrastructure is a notable example.

In the absence of such market vehicles, funds would need to invest directly or alongside other asset owners. This would require a corresponding expansion of internal capabilities, including governance and expertise, said the SSGA paper, and many funds may be approaching their institutional limits in this regard.

Second, as inflows have slowed, each fund is facing a higher probability of net outflows in any given year, and liquidity management is difficult to conduct with a high share of illiquid investments.

“Private markets are not a panacea to a low-yield environment and over-allocation to it can lead to portfolio inefficiencies,” said the report.

Bonds set for new flows

Third, a rising-interest-rate environment will make higher-risk assets less appealing for many funds. And since most SWFs are anchored in dollars, noted SSGA, the US interest rate cycle is central to their fixed income decisions.

Markets expect at least a 100-basis-point rise in the federal funds rate over the next 12 to 18 months, which should boost the attractiveness of bonds for long-term buyers such as SWFs, said the report. Even a modest rebound in the appeal of fixed income assets would likely occur at the expense of higher allocations to alternatives, it added.

Of course, some SWFs still have plenty of scope to raise their alternatives exposure. Norges Bank Investment Management, which manages the $1 trillion portfolio of Norway’s state oil fund, has no allocation to private equity or infrastructure. But that’s set to change; last month it asked the finance ministry to allow it to invest 4% of its portfolio (some $40 billion) into private equity over time.

And some newer, smaller and less advanced SWFs, such as Timor Leste Petroleum Fund, have little or no allocations to private markets.

Ultimately the purpose of each fund dictates the level of liquidity it needs to maintain. “You can comfortably have a SWF that focuses mainly on alternatives,” said Hentov, but there are not many of them.

An SWF can only put most of its assets in private markets if it is an inter-generational investment fund, for which liquidity is a minor, secondary concern, he noted. That will only be the case if it has a long-term mission and knows the government will not draw down capital from it in the coming five or 10 years to support the fiscal balance sheet.

There are a few fitting that description, noted Hentov: CIC and Singapore’s Temasek can both afford high exposure to private markets. The governments of both China and Singapore have other investment institutions—Safe Investment Company and GIC, respectively— that maintain a relatively bigger allocation to more liquid assets.

Slow growth here to stay

Another rising issue in the SWF segment is its slowing growth. Between 2014 and 2016 SWF assets grew by 3% annualised, compared to 15% between 2012 to 2014 (see figure 3 below), noted SSGA. They stood at $790 billion across 21 funds in 2002, compared to $6 trillion across 37 funds** today.

FIGURE 3: SOVEREIGN WEALTH FUND GROWTH SLOWING (%)
(click for full view)

Structural indicators suggest the era of rapid SWF growth is drawing to a close, said the report. Firstly, the oil market, which accounts for at least half of all SWF wealth, as the market appears to have been reshaped with new spare capacity that could cap a rise in commodity prices.

The other large source of sovereign wealth accumulation, and the most prevalent in east Asia—growth in foreign exchange reserves—also appears to be slowing. This is because many emerging markets are moving from export-driven towards consumption-based economic growth and aging populations increase fiscal pressures on governments. China being perhaps the most notable example.

*Of that $6 trillion, funds in east Asia accounts for 42% (excluding central Asia and the Middle East, but including Australia and New Zealand). The figure rises to 82% if the scope expands to include central Asia and the Middle East.

**Includes SWFs with AUM of at least $2 billion and not those that SSGA considers to be sovereign holding companies.