Sovereign Wealth Funds Venture into New Territory

Low yield on government bonds has pushed countries’ rainy-day funds toward alternative investments; foreign offices are opening to handle them.

Temasek Holdings Pte Headquarters Ahead Of Annual Review

Signage for Temasek Holdings Pte is displayed in the lobby at the company’s headquarters as an employee passes through an electronic gate in Singapore, on Monday, July 7, 2014. Temasek’s assets probably grew at a slower pace in the year to March because the value of some of its biggest financial assets declined. Photographer: Bryan van der Beek/Bloomberg

Bryan van der Beek/Bloomberg

Historically, government bonds have been an asset allocation staple of sovereign wealth funds. Central bank monetary policy is making a significant impact on sovereign debt markets. In the euro zone alone, 26 percent of European government bonds and 54 percent of German Bunds are trading on a negative yield. These unprecedented low yields have pushed SWFs to reassess their weightings and readjust their portfolios.

There has been a global proliferation of SWFs. Roughly half of the funds came into being during the past eight years; three quarters have been in existence since 2000. A further 22 jurisdictions are considering launching their own SWFs. Additionally, since 2002 assets under management of this group of institutional investors have been growing at an unprecedented rate — more than 15 percent a year — and this upward trend doesn’t look set to end, with assets forecast to grow from $7.1 trillion to $10 trillion by 2020.

Thanks to their massive wealth, SWFs can access a range of asset classes, factors and strategies that short-term investors cannot. This combination can lead to greater diversification potential and has prompted an expansion into alternative investments, such as real estate, infrastructure and the private markets, as SWFs harness the premium associated with more illiquid assets and with being a countercyclical investor.

In the traditional fixed-income markets, SWFs have shown interest in the broader credit markets — especially in the area of loans and mezzanine finance — as well as high-yield and emerging-markets debt. There has also been a noticeable increase in allocations to equities, both public and private, especially in markets that have improving fundamentals, such as the U.S. and Western Europe.

Long popular among SWFs, real estate offers excess spreads, inflation protection and stable yields. To access such assets cost-effectively, SWFs continue to leverage their relationships with asset managers to source investments. Direct transactions topped $50 billion during the first half of 2014, up 23 percent from a year prior. Competition continues to build within this sector, however, and bids for high-quality, core real estate assets are hotly contested, most notably in London and New York. Consequently, SWFs are considering more opportunistic real estate segments, such as shopping malls and development projects. Interest in investing in international infrastructure continues to grow very noticeably, especially given the growing demand for patient capital to finance these long-term projects, as evidenced by a significant increase in both direct- and co-investment transactions.

One other feature worth noting is the rapid growth in SWFs’ foreign office outposts to handle their growing bevy of international investments. Take two sovereign funds from Southeast Asia: Singapore’s Temasek Holdings and Malaysia’s Khazanah Nasional, which have 11 and four offices abroad, respectively. As SWFs continue their migration to proactive investment management around the world, asset managers who wish to partner with them will need to evolve and understand the need for global solutions combined with clear thought leadership to serve this fast-growing segment of investors.

Patrick Thomson is global head of sovereigns and head of institutional business in Asia (ex-Japan), Australia, the Middle East and Africa, at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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