Managing Sovereigns

U.S. mutual funds are targeting sovereign wealth funds as a potential growth area.

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U.S. mutual fund companies don’t have much to get excited about these days, given the brutal beating stock markets took in 2008 and the investor panic rattling the global financial system. But there’s one bright spot for these asset managers: the promise of new business from sovereign wealth funds that are increasingly turning to outside asset managers to tap fresh talent, boost returns and diversify their holdings — mainly into U.S. value and growth equities and emerging markets.

“Let’s face it, they just can’t find a mattress big enough for their cash,” says John Casey, chairman of research firm Casey, Quirk & Associates. Despite getting hammered by recent investments in ailing U.S. financials — for example, China Investment Corp. paid $31 a share for a 10 percent stake in the Blackstone Group in June 2007; on February 25, Blackstone was trading at $4.12 a share — these funds still want exposure to U.S. equities through U.S. asset managers, says David Smart, global head of sovereign funds and supranationals at Franklin Templeton Investments. The firm has $400 billion under management, of which just over $10 billion is from sovereign funds and central banks. Smart says about $1 trillion of the $3.5 trillion to $4 trillion held in sovereign wealth funds around the world is currently with outside managers. “Despite the price of oil dropping, there remains a very large and still growing pile of money to be invested.”

It’s already happening. Carol Geremia, president of Boston’s MFS Institutional Advisors, notes that $10 billion of the firm’s $134 billion under management is sovereign wealth money, and that segment boasts a compound annual growth rate of 36 percent for the eight years ended in 2008. For the same period, MFS’s total institutional assets have grown at a rate of 13 percent. Sovereign wealth funds accounted for 15 percent of MFS’s total institutional assets at the end of last year, up from just 3 percent at the end of 2000, and Geremia expects that share to rise to 25 percent in five years’ time.

She won’t disclose the names of any sovereign clients, but Geremia says the firm has won mandates from them in such strategies as emerging-markets debt and equities and in such regional products as Asia ex-Japan funds.

Sovereign wealth fund managers have been ramping up their due diligence efforts, says Geremia. U.S. mutual fund managers who can bolster that process stand to cash in. “The stakes are high with SWFs,” she explains. “They’ve got the ability to think long-term, but they are under heavy scrutiny” from within their own borders.

In particular, sovereign wealth funds are making sure that the managers they are considering working with have stuck with their strategies during the crisis, done a good job of managing risk compared to their peers and communicated their risk management strategies clearly to investors. For U.S. mutual funds that want their business, these new requirements mean providing more-detailed reporting than what’s required by pension funds and other institutional investors. For example, sovereign funds want in-depth explanations of how managers are handling risk, including reports on counterparty risk, a subject rarely raised before the credit crisis.

“If you play in this space, you need to make the investments in technology, systems and process that allow you to be flexible in reporting formats,” says Hazel McNeilage, global head of institutional advisory services for Principal Global Investors, which has $248 billion in assets. “And you need to be able to provide a high level of information to clients within short time frames.”

McNeilage agrees that sovereign funds will continue to look to third-party investors but adds that U.S. managers will have to cater to the demands of these higher-maintenance clients if they want to win the business. For instance, managers who in the past may have taken risks that weren’t clearly articulated to investors, or those who violated investment guidelines, won’t likely make the cut going forward. “Mandates may not go to incumbents,” she notes. “If the sovereign funds are uncomfortable with the transparency of the investment process or the risk controls,” they will be let go.

U.S. mutual funds that can help sovereigns boost their due diligence won’t be the only winners. Managers of index funds also stand to gain, asserts Franklin’s Smart. These funds have always had a leg up with investors who doubt that active managers will outperform passive funds over the long term.

But there’s another factor: Active managers who invest in small companies can’t sink huge amounts of cash into this market, owing to the cost of researching hundreds of companies, and sovereign wealth funds typically have large buckets of cash to invest. Active managers may also be reluctant to put too much strain on their small-cap strategies. “We don’t want to be completely swamped by new inflows,” says Smart. Small-cap index funds, by contrast, invest in a list of companies contained in the benchmark and can better handle large amounts of cash.

Phil Maisano, vice chairman and chief investment officer at Dreyfus Corp. and chief investment strategist at BNY Mellon Asset Management, which owns Dreyfus, adds that most sovereign funds would have to use dozens of managers if they wanted to put 20 percent of their funds to work in small-cap, which is a standard allocation. Each fund manager might be able to handle $500,000. “They’d need 5,000 managers to invest in small companies,” he quips. The very real potential downside for U.S. managers, however, is that some sovereign wealth funds will use in-house resources to invest in indexes, as the strategy doesn’t require labor-intensive fundamental research.

Ultimately, in the current environment sovereign wealth funds are watching the bottom line, and this should translate into new opportunities for passive managers, says Jeff Molitor, a principal in Vanguard Group’s international business. The position was created in 2008 to help the low-cost money manager, with $40 billion in sovereign wealth fund money, grow that share. Molitor says some active managers have avoided going after sovereign wealth funds because of the costs of servicing these investors and the cut-rate fees they demand. Geremia concurs, noting that sovereign funds have been demanding that their managers run training programs for the funds’ in-house investing staff in areas including best practices, investment approaches, compliance, technology and compensation. In meeting their clients’ demands, however, these U.S. fund managers risk sharing so much inside knowledge that sovereign funds will opt to manage the money themselves.

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