Secretive state funds have markets anxious

By Steven C. Johnson

NEW YORK (Reuters) - With more money on hand than the entire hedge fund industry, investment funds controlled by governments in Asia, the Middle East and elsewhere are fast becoming the 800-pound gorillas of global markets.

But their super-secretive style -- the majority keep their portfolio allocations under wraps and several are still setting up shop -- makes investors nervous.

"The issue is they are largely unregulated, and nobody is aware of what risks they're taking," Brian Garvey, senior currency strategist with State Street Global Markets, said at the Reuters Investment Outlook Summit this week.

Sovereign wealth funds, as these state-owned investment vehicles are known, are not new. Kuwait, the United Arab Emirates and even Alaska got into the game more than 30 years ago, setting up rainy day funds for times of low oil prices.

But huge export revenues and lofty energy prices have since swelled official savings to unprecedented levels.

China alone is sitting on more than $1 trillion in foreign exchange reserves, the result of a large trade surplus and central bank intervention to keep the Chinese yuan weak.

In the past, countries parked most of their savings in safe, highly liquid government bonds.

But with more money on hand today than they would ever need to pay for imports or defend their currencies in a crisis, countries are being forced to put the money to better use.

Analysts expect Russia, for instance, to boost equity purchases once its wealth fund is fully operational in 2008.

Morgan Stanley predicts such strategies will reduce the appeal of government bonds and push up yields by an additional 30 to 40 basis points over the next decade.

Beyond these basics, nobody has much inkling of what such funds' portfolios will look like, and given the size of the flows involved that makes investors anxious.

Morgan Stanley estimates the 12 largest funds will have nearly $2.5 trillion in assets by year end. That's more than the global hedge fund industry, thought to control about $1.6 trillion. The investment bank says the total will swell to $12 trillion by 2015, nearly the size of the U.S. economy.

"Unfortunately," said Mike Moran, FX strategist at Standard Chartered in New York, "(wealth funds) are perhaps the least transparent of all global investors."

HIGH DEGREE OF CONCERN

That's important when trillions of dollars are at stake. A sudden unwinding of a state fund's loss-making equities trade, for instance, could spark a rout that would wipe out smaller investors.