Sovereign wealth funds may be net sellers of world

LONDON (Reuters) - Sovereign wealth funds could soon turn into net sellers of world assets as diminishing return profiles prompt them to liquidate foreign assets accumulated in boom times and invest instead locally.

Such a shift is likely to come increasingly from those that have aggressively diversified away from liquid government bonds and have actively managed portfolios -- a prerequisite for higher returns before the credit crisis.

Beyond the short term, owners of sovereign wealth funds (SWFs), mainly from oil-rich emerging nations, are likely to reassess the importance of liquidity and uninspiring but safe assets and channel more funds into domestic markets.

After helping to swell what became a $3 trillion industry, the fortunes of many SWFs have turned sour along with those of other risk-seeking investors as the credit crisis dragged into its second year. Oil, a key source of revenues for many SWF owners in emerging economies, has plunged $100 a barrel since July.

In places such as the Gulf, some estimate that the current oil price below $50 a barrel is simply not enough to cover fiscal needs of their increasingly wealthy economies, let alone transfer excess surplus to these funds.

"SWFs are experiencing significant losses and they now have far less in their coffers. Their assets were geared toward global growth and they ignored the stabilization function of liquid assets," said Brad Setser, fellow for geoeconomics at the U.S. think tank Council of Foreign Relations.

"They are drawing heavily on foreign assets to cover domestic needs and support local equity markets. (The model) is moving from one where the Gulf buys the rest of the world into one where Gulf is net sellers ... They will sell illiquid foreign assets."

He estimates the breakeven oil price for the Gulf -- the level needed to cover domestic budget needs -- has shot up to levels above $50 a barrel from around $20 in 2000-2002.

Setser reckons SWFs are suffering a double-digit loss after the crisis, having enjoyed a return on portfolio of around 10 percent before the crisis, assuming a 60-20-20 asset split for equities, government bonds and alternatives.

Morgan Stanley estimates that some SWFs may have seen up to 25 percent of paper losses so far this year.

The fund that is likely to have the most diversified its assets is the Abu Dhabi Investment Authority (ADIA), considered the biggest and the most aggressive among its peers.

Setser estimates that the ADIA could have lost up to $150 billion -- or a third of its estimated $500 billion in assets.

DOMESTIC FOCUS

As the focus shifts to liquidity and away from juicy returns, SWFs are looking into supporting struggling domestic economies.

Gulf and Asian wealth funds are no stranger to this as they have been supporting domestic industries with the aim of developing a sustainable economic and financial system.

This is in contrast to a model adopted by countries like Norway and Russia which have focused on building offshore portfolios that would yield returns in the long term.

Analysts say Russia and others that had adopted this model could move increasingly toward the Gulf style, but not Norway which already has a developed banking and financial system.

Some have argued that SWFs should avoid investing at home as it creates inflationary pressure and could also lead to inefficiency and poor productivity given the resulting large public sector involvement in private firms.

Andrew Rozanov, head of sovereign advisory at State Street Global Markets, says it is a choice between leaving future generations a diversified financial portfolio invested overseas that yields a dividend on which they can live, or letting them inherit a productive and thriving local economy, which creates jobs and opportunities in industries and sectors beyond oil.

"For SWFs in many emerging market economies the whole set of sovereign liabilities must be considered -- not just financial wealth maximization, but also various public policy objectives," he said.

"Whatever taboos may have existed in developing countries around investing a portion of sovereign wealth domestically have certainly gone out of the window."

THE NEED TO INVEST

Even if they may turn into sellers of the world, pressuring the already battered global markets, many say wealth funds must invest to make decent returns for their descendants.

"If your objective is to grow your assets to meet certain future liabilities, then the worst thing you could do is put them all in Treasuries, because inflation will most likely eat them away over the long-term," Rozanov said.

A study of world markets over 108 years by ABN AMRO shows real equity returns beat real bond returns by 5.8 percent to 1.7 percent since 1900.

And the trend of "south-south" investments -- where SWFs invest in developing nations -- is also likely to accelerate once emerging markets recover from the crisis.

The Organization for Economic Cooperation and Development estimates the cost of SWFs not diversifying their portfolio away from U.S. Treasuries or stocks could reach more than $100 billion -- 1 percent of the GDP of developing nations.

"They will be net buyers of the world," said Hendrik du Toit, chief executive officer at Investec Asset Management.

"They have to take risks. They cannot make profit for future generations by sitting on cash."

(Editing by Stephen Nisbet)