September 28, 2011 / 5:25 PM / 6 years ago

Analysis: Equity rout may force shift in SWF strategy

LONDON (Reuters) - Sovereign wealth funds may be shifting toward alternative investments such as infrastructure and property as they reconsider their investment strategies after a decade of equity underperformance against low-yielding fixed income.

That means the $4 trillion sector is unlikely to play white knight to hobbled euro zone banks as it did in 2008, when state-owned investment vehicles plowed $80 billion into troubled Western lenders.

Sovereign wealth funds, which manage windfall national revenues from oil, commodities or trade surpluses, typically take part of a bond-heavy portfolio from their central bank and buy stocks and alternatives to generate higher returns for future generations.

Their investment style varies widely depending on their objectives -- some are portfolio investors like pension or endowment funds while others behave like private equity funds.

JP Morgan’s analysis of some SWFs shows more than half their assets are typically invested in publicly-listed equity, 31 percent in bonds and cash, and the rest in alternatives -- investments outside of mainstream asset classes that include hedge funds, commodities, property or infrastructure.

But their asset mix may change gradually, especially given the disappointing relative performance of stocks over the past decade. Reuters data shows fixed income gave a total return of 89 percent on a rolling basis in the past 10 years, compared with 59 percent for global equities.

“Normal distribution of returns that was underpinning a lot of past ways of looking at things is not as relevant as it used to be. It’s time to reconsider that,” said Patrick Thomson, global head of sovereigns at JP Morgan.

“Sovereign clients are well aware of this ... We’re observing a fairly significant trend into different sources of returns, such as infrastructure, real estate, and large deals in the private equity space.”

Measuring returns on direct infrastructure investments can be tricky given many involve direct or partnership deals. Still, global infrastructure companies have given a total return of nearly 100 percent on a dollar basis since 2001, according to Goldman Sachs’ Infrastructure Index .INFRAXDT.

According to Investment Property Databank, global property delivered a total return of 87.2 percent between 2000 and 2010.

In August, Qatar Diar, an arm of Qatar Investment Authority,

bought London’s Olympic Village for 557 million pounds jointly with developer Delancey. A source said the QIA is also close to buying London’s W Hotel for 200 million pounds.

Abu Dhabi Investment Authority is ramping up its private equity activities and is also looking to significantly boost its infrastructure investments, sources said.

The real estate sector made up more than 12 percent of total acquisitions made by SWFs in the past 12 months, coming behind financials, energy and power and industrials, according to Thomson Reuters data.


The poor performance of equities in recent years means that SWFs cannot just shift their capital between a traditional mix of equities, bonds and cash. Instead, they are likely to allocate part of their assets to super-liquid bonds, then invest another part in riskier assets, such as property.

Only in the very long term do equities beat fixed income, as shown in research headed by London Business School Professor Elroy Dimson.

U.S. stocks gave an annualized return over 111 years of 6.3 percent in real terms, against a 1.8 percent gain on government bonds. However, between 1980 and end-2010, the annualized real return on government bonds was 6 percent, broadly matching the 6.3 percent for equities.

On average, the realized equity risk premium versus bonds over 2000-2010 was -3.2 percent per year. This means equities underperformed risk-free investment by that amount each year.

“We all know that over the long run, equities can be expected to return more than bonds, but -- as a look at Japanese equities since 1990 will show -- we need to realize that the long-term may be very long,” said John Nugee, head of official institutions at State Street Global Advisors.

“Like for other investors, it is the preservation of capital that ranks higher for sovereign funds.”

Many experts say even SWFs, which do not have liabilities and can invest for the long term, can’t afford to wait so long.

After posting double-digit losses during the credit crisis, some funds were forced to shrink their investment horizon, to deliver visible returns on an annual basis for example.

“Like many private investors, SWFs’ severe losses in the crisis have likely made them more aware of, and perhaps more averse to, various types of risk,” the International Monetary Fund said in its report released earlier this month.

“In addition, changing mandates that could now include fiscal, economic, and financial stabilization objectives may require assets to be safer or more liquid.”


SWFs emerged as saviors of global finance during the 2007-2009 financial crisis with their massive investments in the financial sector, and some euro zone politicians may be hoping that they will again ride to the rescue.

But so far surplus-rich nations that own SWFs have been non-committal, instead preferring to stay on the sidelines to see how events play out.

Australia’s $76-billion SWF said last week it has increased its allocation to cash due to the market turmoil and will wait to see how events play out before putting the money back to work.

“SWFs have gone back to being ordinary investors. It seemed for a period that an injection of funds from large investors such as SWFs might solve the financial crisis, but in retrospect, the problem was larger than anyone thought,” Nugee said.

Asked if SWFs may be interested in investing in French banks, he added: “I think they would like to leave it to governments this time. Actions by third party investors such as SWFs are not the solution to this problem.”

Graphic by Scott Barber and Vincent Flasseur; Editing by Catherine Evans

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