Sovereign Wealth Funds (SWFs) are becoming increasingly important in the institutional investor landscape thanks to advanced investment strategies and a solid growth in assets under management (AuM). Traditionally, SWFs followed a strategy that combined fixed-income products and equities. However, the introduction of monetary policies, such as quantitative easing and low interest rates following the global financial crisis, has led fixed-income products to become progressively less attractive. To diversify and generate superior returns, SWFs are turning to alternative asset classes such as private equity, real estate, infrastructure, gold, commodities, and hedge funds. What impact do alternative investments have on SWFs’ portfolios and what are the benefits of including them? Find out below.
SWFs: A unique investor
SWFs play an essential role for their home countries. Through their accumulation of wealth, they provide governments with an important instrument to stabilise the economy and exchange rates. With flexible goals, they are able to react to economic or political changes dynamically. SWFs are also playing a larger role in the institutional investor landscape, with their share of assets having more than doubled since 2004.
SWFs’ AuM are also growing, rising from just below US$2 trillion in 2004 to US$7.4 trillion in 2016 largely due to high and increasing commodity prices before 2014.
Why SWFs adapt their investment strategies and diversify their portfolios?
Recently, somewhat adverse conditions have affected SWFs. Since 2014, falling oil prices and the end of a commodities supercycle led many SWFs to search for new sources of yield. Attempting to broaden their investment horizons some turned to non-fossil sources and to alternatives. SWFs are including private equity, hedge funds, real estate, infrastructure, and commodities assets to enhance returns and diversify their portfolios.
Since 2010, the share of SWFs’ AuM allocated to alternatives has grown from 19% to stand at 23% at the end of 2016. They are doing so largely because of the current low interest rate environment. Recent research (1) shows that alternatives not only drive diversification, but also provide enhance returns compared to traditional asset classes over the long term.
Why bet on alternatives?
The introduction of alternatives into a portfolio offer a number of benefits. Increased diversification, principle protection, a hedge against inflation, and an increase in portfolio performance.
Diving into specifics, PwC’s new report, titled The rising attractiveness of alternative assets for Sovereign Wealth Funds, found that private equity had the strongest returns across all asset classes over five, ten, and twenty year periods, even outperforming equities in the short-term.
The report also shows strong growth in infrastructure and real estate after the global financial crisis, rising 16.5% and 11.1% respectively between 2010 and 2016. Investments in real estate have the added benefit of providing a hedge against inflation. In the coming years, these asset classes could become even more fundamental to SWFs’ investment strategies. This will be especially evident in emerging markets considering mass urbanisation and its associated economic growth.
Performance of real estate and infrastructure compared to bonds and equity (annualised returns)
Commodities, unlike private equity, real estate, or infrastructure, underperformed over all considered time-periods as the graphic above shows. Despite this, the end of the supercycle[i] in 2014 led to sharp drops in the prices of commodities, significantly increasing the number of SWFs allocating to the asset class. Diversified investments in commodities give SWFs the ability to influence directly their economy, which partially explains their popularity.
Commodities returns and equities are fairly correlated. Due to growing interest in socially responsible investments and Environmental, Social and Governance (ESG) strategies, certain SWFs are not including oil and gas investments in their portfolios. SWFs need to consider reputational risks when adding non-renewable energy sources to the portfolio.
Given the record high of capital markets at the moment, there is an increasing expectation of a market correction. Gold can play a truly strong role in this context, due to its low correlation to equities and its ability to act as a crisis hedge. Generally, we see the price of gold rises as investors’ perceived uncertainty in the stock markets and decrease as markets normalise. Unlike other alternatives, gold is also highly liquid.
What we think
SWFs are likely to continue to turn to alternatives as a new source of income for the future. Finding the right allocation strategy for these asset classes is crucial. In addition, SWFs should keep in mind the need for continuous monitoring of their portfolios and their investments and reallocate their capital to reflect economic developments.
[i] A Grand Supercycle is the longest period, or wave, in the growth of a financial market