Sovereign wealth management funds are a way of investing foreign exchange reserves of a country.
Sovereign wealth funds offer longer-term investment horizon compared with traditional reserve portfolios, assuming higher tolerance for short-term risk. Therefore, a more diversified and less conservative asset allocation is possible – constructing a more efficient portfolio that could include illiquid asset classes. Illiquid assets should offer meaningful premium over more liquid asset classes, as have been demonstrated by some notable U.S. college endowments. What’s more, compared with traditional reserves management, sovereign wealth funds can be
more active in moving into high-growth markets. This increased level of access into high-growth economies should make noticeable differences in terms of returns over the years. Hence some countries have started sovereign wealth funds.
The opportunity for expansion of sovereign wealth funds is big. By the end of 2040, according to Goldman Sachs research, the combined GDP of BRIC countries and Mexico will be bigger in dollar terms than that of the G7 economies.
Sovereign wealth fund may pursue additional objectives apart of return. Sovereign wealth funds may pursue to diversify the sources of long-term wealth. They may try to optimize their portfolios with respect to characteristics of their national economies, such as seeking strategic ownership positions in important foreign enterprises. For example, one could choose to invest in strategic resources which the country lacks. And for countries with abundant human capital and manufacturing capabilities but with little resources, it may make sense for them to invest in natural resources to diversify their national portfolios.
Challenges in sovereign Wealth Management
Risk management challenge: Sovereign wealth funds need to have a
different approach to risk from that of traditional reserves management as the fund moves into non-traditional asset classes.
And yet, it is often difficult to find good data with sufficient history for certain asset classes. And analyzing the market behavior of expanded set of asset classes and finding correlations among them are much more difficult. Moreover, the characteristics of the market indices used to represent alternative asset classes change rapidly, further compromising the usefulness of the historical asset class record. Therefore, sovereign wealth funds need to develop a new modeling approach to confidently monitor and control the market risk of their portfolio assets
A well defined mandate: A well-defined mandate is crucial to successful management of funds. Problems arise when mandates are poorly defined – leading to bitter arguments about its proper uses. And this problem is acute especially in developing countries, where it is tempting to fund government expenditures. In addition, agreement on the risk/return profile of a fund can sometimes be very difficult if there are differences in views on the characteristics of the fund’s future liability.
Financial protectionism: The relationship with recipient countries could get more complicated when sovereign wealth funds show particular interest in other countries’ highly strategic industries. How they might react is unclear.
Possible expansion of financial protectionism could bring about adverse effects on the still on-going globalization process – one of major factors bringing global prosperity.
The total size of sovereign wealth funds could now be as large as USD 2.5 trillion, according to a recent research by Morgan Stanley. The funds derived from oil and gas export proceeds account for some two thirds of the total, with the rest consisting of funds mainly controlled by the Asian exporters. The sovereign wealth funds are expected to double in size before 2010 and reach USD 10 trillion mark before 2014. It could well surpass the size of the world’s total official reserves in the not-too-distant future, and will have powerful implications on the global financial markets.
One of implications is apparent portfolio shifts from the sovereign bond markets to more risky asset markets in coming years. Global currency, commodity and debt market may experience huge changes in terms of demand and supply scenarios.
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