LONDON Sovereign wealth funds are looking less keen to live up to their recent reputation as investors of last resort given huge investments they made in failed Western banks are turning sour one year into the credit crunch.
State-owned wealth funds, which manage almost $3 trillion (1.5 trillion pounds) in assets, have grabbed global financial markets' attention since last year, when they replaced hedge funds and private equity as the main driver of corporate takeover activity.
Since 2007, these sovereign funds -- mainly from emerging economies with excess reserves -- have spent nearly $80 billion to buy stakes in major banks desperately needing cash to repair balance sheets damaged by losses on U.S. subprime mortgages.
It was a match made in heaven -- except that the arrival of the sovereign funds does not seem to have been enough to stop the rot. Banking stocks have continued to tumble and some shares have become diluted as a result of rights issues.
Most sovereign wealth funds (SWFs) do not have to report mark-to-market losses in public and some argue they can ride out temporary losses and cycle downturns to seek long-term returns.
But while they are unlikely to unwind investments they have already made, their appetite for jumping into risky deals again may be dulled.
"The opportunity of making large scale investments in Western investment banks doesn't come along very often. They have made these investments because it was a rare opportunity and one they could not turn down," said Ben Faulks, associate director at Standard & Poor's.
"(But) wealth funds have a mandate to make money, not to plough money into ventures destined for collapse. They are not charities. They won't make investments unless they think they can make money."
In a sign that SWFs might be worried about their loss-making investments, South Korea's state-owned fund said it had posted about $800 million in valuation losses before it converted preferred shares of Merrill Lynch MER.N into common stocks last week, more than two years ahead of schedule.
Under the original agreement, Korean Investment Corporation was to swap the shares into common stocks in mid-October 2010, but the fund had faced heavy criticism after Merrill's share price tumbled more than 50 percent this year.
"We learned a lot of good lessons from the investment in Merrill Lynch," said Chin Youngwook, KIC's chief executive."
"I think we may have to approach cautiously."
Another official at KIC said a share purchase in other U.S. financial firms could skew its portfolios and the fund was not seriously considering raising exposure to them at the moment.
Also facing huge paper losses on its Merrill investment, Singapore's wealth fund Temasek negotiated a rebate of $2.5 billion on its original $4.4 billion stock purchase after the U.S. investment bank raised fresh funds in July.
"SWFs have emerged as significant global investors," said Gay Huey Evans, who as vice chairman of investment banking and investment management at Barclays is responsible for coordinating the financial group's sovereign wealth business.
"If you are significant investors like SWFs, your management of risks has become even more important. There has been huge focus and improvement in risk management. Risk awareness is greater now than a year ago."
The move away from the United States and other developed countries into emerging economies -- "south-south trade" -- has also become a major theme for wealth funds, and not just because emerging markets are faring better than the slowing developed world.
Since SWFs get their start-up capital largely from trade surpluses with advanced economies, recycling these funds back in the West defeats the purpose of creating a diversified income stream for future generations.
A recent European Central Bank analysis shows that if emerging economies with excess surplus -- which make up the vast majority of SWFs -- opted for a more return-oriented portfolio allocation, it would trigger net capital flow out of U.S. assets of around $530 billion.
The euro zone could see a net outflow of $230 billion.
"Aggregating net capital flows of developed countries shows that capital would flow from developed to 'other', ie emerging and developing, countries," the ECB said in its July report.
"Oil-exporting countries may want to use their SWF assets to hedge against oil price fluctuations. In this case, standard portfolio theory would suggest that the SWFs should underweight assets that are strongly correlated with oil prices."
Britain and the United States have the highest share of oil company stocks in total market capitalisation.
Temasek already has a clear bias towards emerging economies. It raised exposure to the rest of Asia, excluding Japan and Singapore, to 40 percent last year from 34 percent previously.
It invests 38 percent in Singapore and 20 percent in OECD economies excluding Korea.
"Every last investor is cautious about U.S. risk more than they were before the credit crunch," said Jerome Booth, head of research at Ashmore Investment Management and member of its investing committee.
About 13 percent of Ashmore's assets worth $37.5 billion under management are allocated by its government clients, including sovereign wealth funds.
"The logic of central banks in emerging markets investing more in other emerging markets is very strong. All we're talking about is going to a more neutral position from a highly concentrated position in the G7."