Cheap money transforming SWF investment strategy

Sovereign funds tasked with managing national wealth may be forced to drastically alter their investment strategy in the coming years as the latest US liquidity spree fuels cash inflows but depresses asset returns.

While their assets are set to hit as much as $10 trillion in the coming decade, a low-returns climate makes orthodox portfolio management more unattractive, pushing these funds further into private equity-style or deal-based investment.

The Federal Reserve's $600bn bond buying plan announced last week and liquidity injected by other leading central banks are a double-edged sword for sovereign wealth funds (SWFs), which currently manage $3 trillion of assets.

Cheap money fuels yield-seeking capital to fast-growing emerging economies, and their measures such as currency intervention to counter inflows boost FX reserves, generating more risk capital to be managed by sovereign wealth funds.

The low interest rate environment underpins demand for commodities or exports from developed economies, boosting windfall revenues, part of which will end up in SWF coffers.

But returns tend to diminish in the low yield environment. A weak dollar and upward pressure on local currencies also erode valuations, squeezing their returns further.

"Sovereign wealth funds had hoped for a transition from the crisis situation to a more benign global economic environment, but considerable risks remain in their business," said Steffen Kern, economist at Deutsche Bank and an expert on SWFs.

"Low interest rates plus [US] quantitative easing impact the monetary and interest rate environment in which SWFs operate. Monetary policies naturally influence the valuation of existing bond portfolios and new investments. This should not be underestimated."

Kern estimates that 40-60 percent of SWF portfolios is still invested in interest-based securities, making them vulnerable to low returns stemming from near-zero interest rates.

The growing pile of cash which sovereign funds manage may make it harder for them to invest flexibly. Kern has upgraded his well-cited projection for total assets under management by SWFs to $10 trillion by 2020, from $7 trillion by 2018.