Sovereign wealth funds (SWFs) should better orientate their portfolios towards fast-growth markets, reduce exposure to aging industries and embrace mega trends if they are to improve long-term returns, according to a senior strategist at UBS Asset Management.

"SWFs need to analyse their current portfolios and see how best they can take into account the individual mega trends like climate change," said Massimiliano Castelli, head of strategy for global sovereign markets at the Swiss fund manager. 

The asset manager hosted the second sovereign investment circle, a SWF-focused forum, from 25 to 29 March in Singapore. Overall, 40 senior executives from more than 30 sovereign institutions in 15 countries participated. 

Castelli told AsianInvestor that there is no one-size-fits-all framework for SWFs to incorporate mega-trends into their investment allocations. Instead, the asset owners have to consider the peculiarities of their existing portfolios, and then focus on building exposure to promising countries and sectors, as well as add more alternatives. 

PORTFOLIO FUTURE-PROOFING

Currently, most SWFs rely heavily on traditional global benchmarks for their existing allocation models, noted Castelli. These benchmarks may be diversified in terms of asset class, but they are typically heavily geographically skewed towards the developed world markets and have heavy weightings in certain sectors. 

This means the funds risk failing to benefit from exposure to fast-growing regions such as emerging markets, while they are also at risk of being heavily invested in industries that could face more tougher circumstances in the future.

One such example is fossil fuels. With climate changing and public pressure increasing, investors should reduce their allocations to fossil fuels when considering the mega trend that calls for more environmental-friendly sources of energy. However, index providers are yet to lower their weightings towards such industries in many of their more popular benchmarks even as some investors begin to do so, he said.

SWFs should look to reduce such exposures to reduce long-term risks. Plus they should consider  narrowing in on countries and new sectors that are driving growth, particularly emerging markets, he suggested, without offering specific examples. 

The traditional investment model approach favoured by SWFs also often fails to take into account mega trends, such as the slow-down in globalisation and likelihood of worsening climate change. These trends are progressing and new investment frameworks need to acknowledge these developments, said Castelli.

CHANGES HAPPENING

While many SWFs are proving slow to adapt their asset allocation approaches, some have been more willing to change. 

A few of Asia's SWFs have started diversifying towards higher growth regions like emerging markets and begun incorporating mega trends in their investment framework, Benno Klingenberg-Timm, head of sovereign clients at UBS Asset Management, told AsianInvestor.

A few, such as New Zealand Superannuation Fund, have been cutting their exposure to carbon-heavy investments. Similarly, some SWFs have caught on the digitalisation trend and are investors in some of these tech giants, Klingenberg-Timm said. Castelli added that Temasek is a good example.

The Singapore-based SWF was ranked the most active sovereign wealth fund investor between 2017 and 2018, according to a report by the investment arm of the Spanish Institute for Foreign Trade and the IE Business School. It has been active regionally, and took part in the $14 billion global fundraising by Ant Financial, the operator of China’s largest payment platform. A consortium of SWFs and private equity firms, which also included GIC and Khazanah, took part.

Klingenberg-Timm said SWFs have also recognised that climate change will impact businesses and investment returns if not addressed. Malaysian sovereign wealth fund Khazanah and NZ Super are two of the most responsible investors globally, according to a study by Scott Kalb, founder of advocacy group Responsible Asset Allocation Initiative at New America, in association with Tufts University in Boston.

CHALLENGES AND CONCERNS

A key challenge for SWFs to navigate is the varying pace of growth and sophistication in different regions and sectors.

For example, emerging markets typically enjoy faster economic growth than their developed market peers, but the latter often demonstrate strong innovative power in the technology and services sectors, Castelli said. In the event of a slowdown in globalisation, companies at the lower end of the manufacturing chain in emerging markets will be affected.

Another challenge for SWFs to allocate to alternatives stems from their very demand for it. A growing number of investors have crowded into the space, making it harder to find projects that deliver the level of investment returns targeted by Asian SWFs, which range from low to mid-teens at a minimum, said Terry Pan, chief executive for greater China, Southeast Asia and Korea for Invesco.

Sovereign wealth and state pension fund allocations to alternatives have doubled since 2013, an industry report by Invesco showed last year.