Introduction to Sovereign Wealth Funds

As more and more countries open funds and invest in big-name companies and assets, sovereign wealth funds have received a lot of attention-some countries are more transparent than others. This has given way to widespread concerns about the impact of these funds on the global economy. Therefore, it is important to understand exactly what sovereign wealth funds are and how they are created.

Key points

  • Sovereign wealth funds are a way for countries to put surplus capital into the market or other investments.
  • Many countries use sovereign wealth funds as a way to accumulate profits for the benefit of the national economy and citizens.
  • The main function of sovereign wealth funds is to stabilize the national economy through diversification and to create wealth for future generations.
  • The emergence of sovereign wealth funds is an important development in international investment.

Sovereign wealth fund

Sovereign wealth funds are state-owned capital pools that invest in various financial assets. This money usually comes from a country’s budget surplus. When a country has excess money, it will use sovereign wealth funds to invest it instead of simply depositing it in the central bank or directing it back to the economy.

The motivation for establishing sovereign wealth funds varies from country to country. For example, a large part of the United Arab Emirates’ income comes from oil exports and it needs a way to protect its surplus reserves from oil risks; therefore, it deposits part of its funds in sovereign wealth funds.

Watch now: What is a sovereign wealth fund?

history

The first batch of funds originated in the 1950s. The emergence of sovereign wealth funds is to solve the problem of countries with budget surpluses. The first sovereign wealth fund was the Kuwait Investment Authority, which was established in 1953 to invest in excess oil revenue.Just two years later, Kiribati established a fund to hold its income reserves.Before the creation of the three main funds, almost no new activities took place:

  • Abu Dhabi Investment Authority (1976)
  • Singapore Government Investment Corporation (1981)
  • Norwegian Government Pension Fund (1990)

In the past few decades, the size and number of sovereign wealth funds have increased dramatically. According to data from the SWF Institute, there will be more than 91 sovereign wealth funds with accumulated assets close to US$8.2 trillion in 2020.

Commodity and non-commodity sovereign wealth funds

Sovereign wealth funds can be divided into two categories, commodity or non-commodity. The difference between the two categories lies in the way the fund is financed.

Commodity sovereign wealth funds finance through export commodities. When the price of a commodity rises, the country that exports that commodity will see a larger surplus. Conversely, when commodity prices in export-driven economies fall, deficits that can hurt the economy are created. Sovereign wealth funds act as stabilizers and diversify national funds by investing in other areas.

Non-commodity funds usually come from excess foreign exchange reserves from current account surpluses.

What do sovereign wealth funds invest in?

Sovereign wealth funds have traditionally been passive long-term investors. Few sovereign wealth funds disclose their entire portfolio, but sovereign wealth funds invest in a wide range of asset classes, including:

However, more and more funds are turning to alternative investments, such as hedge funds or private equity, and most retail investors do not have access to these investments. The International Monetary Fund reported that sovereign wealth funds are riskier than traditional investment portfolios and hold large numbers of shares in frequently volatile emerging markets.

Sovereign wealth funds use a variety of investment strategies:

  • Some funds specialize in investing in publicly listed financial assets.
  • Others invest in all major asset classes.

The level of control that the fund assumes when investing in a company is also different:

  • Some sovereign wealth funds set limits on the number of shares they can buy in a company and will implement restrictions to diversify their investment portfolios or to comply with their own ethical standards.
  • Other sovereign wealth funds have taken a more active approach, buying more company shares.

International debate

Sovereign wealth funds occupy a large and growing part of the global economy. These funds may have caused considerable opposition to the scale and potential impact of international trade, and there has been increasing criticism after controversial investments in the United States and Europe. After the mortgage crisis of 2006-2008, sovereign wealth funds helped rescue the troubled Western banks Citi, Merrill Lynch, UBS and Morgan Stanley.This leads critics to worry that foreign countries have too much control over domestic financial institutions, and these countries may use this control for political reasons. Such concerns may also lead to investment protectionism, which could harm the global economy by restricting valuable investment dollars.

In the United States and Europe, many financial and political leaders have emphasized the importance of monitoring and possibly supervising sovereign wealth funds. Many political leaders assert that sovereign wealth funds pose a threat to national security, and their lack of transparency has contributed to this controversy. The United States passed the 2007 Foreign Investment and National Security Act to solve this problem, which established a stricter review system when foreign governments or government-owned entities attempt to purchase US assets.

Western powers have always been cautious about allowing sovereign wealth funds to invest and demand greater transparency. However, since there is no substantive evidence that the fund is operated for political or strategic motives, most countries have softened their positions and even welcomed investors.

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