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.
Indeed, many sovereign funds hit the headlines this year with various private equity-style investments. In the first half of 2010, 16 of 33 funds tracked by advisory group Monitor conducted 92 publicly reported investments with a value of $22.2bn - double the number and value of the first half of 2009.
In the first half of this year, sovereign wealth funds made 15 deals valued at $6.9bn in the energy and power sector, while these funds invested over $1.6bn in mining firms.
Even Abu Dhabi Investment Authority, the world's largest and traditionally a portfolio investor, has increased exposure to infrastructure by buying a stake in Britain's Gatwick Airport in February for around £125m ($202m).
ADIA also raised its stake in Australian toll-road operator Intoll to 9.9 percent in May.
"Over the last year, SWFs have begun to find their feet in the current uncertain investment climate," said Victoria Barbary, senior analyst at Monitor.
"ADIA sees infrastructure/real estate as pretty solid and giving them long-term returns. We will see more of that as ADIA looks to bring in infrastructure investment inhouse. They want to maximise their returns."
Last year ADIA said it still had around 60 percent of its assets invested passively in index-replicating strategies and allocates up to 30 percent in government bonds and credit.
China tops a league in SWF investing in natural resources, whose six deals worth nearly $2.4bn in energy and mining assets made up over half of total SWF investment in this sector.
Beijing may restructure its $300bn China Investment Corp, a move that could result in a sharper focus on its overseas portfolio.
Surging capital inflows and upward pressure on the yuan in a low yield environment are certainly making CIC's life difficult.
Back in 2007, Chairman Lou Jiwei said CIC needs to earn at least 300 million yuan ($45m) a day just to pay the interest on bonds and operation costs - which translates to around 5.5 percent on their current total capital.
Other estimates show CIC must return 10 percent in dollar terms on its overseas investment given the special government bond yield of around 4.5 percent and the yuan's appreciation.
CIC also faces a peer pressure from the State Administration of Foreign Exchange which also manages sovereign wealth.
Sarah Eaton of the University of Toronto and Zhang Ming from the Chinese Academy of Social Sciences said in a paper Beijing is using this implicit tournament between CIC and SAFE as carrot and stick mechanisms with which to discipline SWF managers.
"Because they all make overseas investments of China's sovereign wealth, their relative performance will be a key criterion in the government's future decisions about how to divvy up surplus foreign exchange," they wrote.
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