Sovereign wealth funds are expected to take up index investing in order to achieve broad diversification in equities, with direct or strategic investments becoming relatively fewer as a proportion of rapidly growing assets under management.

So concludes State Street Global Advisors, which is a leading provider of index funds to institutional investors. SSgA currently manages $250 billion of assets sourced from æofficial institutionsÆ, which account for about 13% of the $1.9 trillion it manages in total.

SWFs û a term coined by SSgA û now manage $3 trillion worldwide and are the fastest-growing type of institutional investor, says Singapore-based Hon Cheung, Asia regional director for SSgAÆs official institutions group.

Unlike the regionÆs central banks, which manage AsiaÆs vast pools of foreign reserves, most official institutions are intended to invest for the purpose of building wealth, not to preserve capital. That means they are primarily focused on equities or asset classes other than cash or G3 sovereign bonds. But the rapid growth of their assets means active or strategic equity investments will hit capacity constraints.

This is leading many SWFs to seek asset-class diversification and to adopt the same kind of thinking about risk and return as one finds with traditional institutional investors, such as pension funds, insurance companies or endowments, says Cheung. ôThis implies a move to broad indexing.ö

While pension funds, for example, have specific, calculable liabilities to meet, SWFs usually do not. But they want a real rate of return against domestic inflation, or are looking to build funds for future generations. Cheung says they will adopt, therefore, the same tools of risk measurement and budgeting as orthodox investors. But they have the luxury of taking a very long view û hence the headline-grabbing, once-in-a-generation strategic stakes in the likes of Merrill Lynch and Morgan Stanley in late 2007.

One concern about SWFs is their lack of clearly defined liabilities. Whereas market practitioners and regulators can be fairly certain of how a central bank will manage its reserves, the same is not true of SWFs. But Cheung argues such concerns are overblown; the strategic stakes taken in Western financial institutions are examples of very long-term thinking, he says.

Another concern about SWFs is the market impact they can have as more of them invest in equities. Today, if that $3 trillionÆs worth of SWF assets was to be fully invested in global equity markets, these groups would collectively own 5% of the worldÆs market cap. ôIf they all become active equity managers, it would be disruptive,ö Cheung says.

Therefore, he concludes, as these groups build assets and seek risk assets, they will have no choice but to seek diverse, passive strategies. Indexing also suits younger SWFs that may not have a lot of experience in international investing.

When asked, however, about the amounts of SWF assets now going into passive equity strategies, Cheung declines to give an answer. He acknowledges that the same cultural barriers that have made other institutions in Asia ex-Japan suspicious of active investment (perhaps because they come from emerging markets, where volatile markets make for plenty of trading opportunities) apply to SWFs. ôMany official institutions are still developing their asset-allocation profile,ö he says.

Part of the mystery is due to lack of disclosure among most SWFs. No one knows how much of that $3 trillion is actually invested in equities. Flows from relevant countries can be hard to discern because central banks have added trillions of dollars to their reserves as well. ôSovereign wealth funds are not replicating the role of central banks, but does that mean they put 10% into equities, or 90%?ö Cheung wonders.

For the purveyors of index investments, the higher that portion into equities, the more likely SWFs will adopt passive strategies.