A fertile landscape

Sovereign wealth funds are providing the fuel that's enabling many global managers, particularly those in active strategies, to recover from the financial crisis.

Among the fastest growing group of institutional investors, with assets estimated to reach about $5.5 trillion by 2012 from the current $3.8 trillion, SWFs generally held their nerve through the financial crisis, according to consultants, managers and academics who work with the funds. As the pool of assets expands at a breakneck pace, the capital available for externally managed passive and active strategies is set to increase, even when assuming that the actual percentage of the assets outsourced would remain steady or decline, sources said.

“In some cases, (SWFs) were just about the only part of the institutional business that has been growing” in the past two years, said Michael McCormack, executive director of consultant Z-Ben Advisors Ltd., Shanghai, referring to large global money managers. “It is not possible to overstate their position at the center of institutional growth strategies.”

John Nugee, London-based managing director and head of the official institutions group at State Street Global Advisors, said: “These funds are growing in size and need to deploy capital, so there's no doubt that (fund officials) will continue to allocate new cash reserves to active strategies.” SSgA is one of the largest managers of SWF assets with a total of 67 clients with $447.4 billion in passive and active assets under management as of year-end 2009 from SWFs, supranational agencies and central banks. That's nearly double the amount of assets managed at the year-end 2008, when SSgA had $234.7 billion sourced from the same group of clients. In 2009 alone, SWFs and other government-owned investment funds accounted for 77% of SSgA's institutions group's assets under management.

Like other institutional investors, SWFs — loosely defined as government-owned investment funds — are reconsidering the active risk budget within their investment portfolios. While officials from some funds, including the 2.76 trillion Norwegian kroner ($465 billion) Government Pension Fund-Global, Oslo, were shifting more assets into passive, many others were adding rather than abandoning externally managed active portfolios in the past year, sources said. Liquidity risks, particularly in relation to actively-managed alternative strategies, also have figured more prominently in the debate over active vs. passive management.

While most SWFs do not have to meet certain liabilities or cash flow demands the way pension funds and endowments might, they do need liquidity to maneuver the investment portfolio, Mr. Nugee said. “Liquidity is also the ability to exit investments if you think they're going to fall,” he added.

Scott E. Kalb, chief investment officer of the $30 billion Korea Investment Corp., Seoul, said the fund has been scrutinizing both beta and alpha return factors within its portfolio. The resulting adjustments have included a shift into passive strategies managed internally. Fund officials also increased the allocation to equities, which include alternatives, to about 50% of total assets from 40%. The KIC made its first alternative investment in July 2009 and now has an allocation of about 2%-3%, which could double this year, depending on the active opportunities available. The KIC will receive an estimated $5 billion in cash inflows this year.

“Passive is another way of talking about beta. When you look at a portfolio, beta is doing most of the work in driving the returns, like the horse that pulls the cart. But what you're putting in that cart — and the reason for the journey — is the alpha,” Mr. Kalb said. “In general, we would rather have active than passive where we think managers can significantly add value over time. Passive, to us, is alpha-negative. We try and manage beta so that it's not a drag on alpha.”

Sovereign wealth funds' pursuit of active strategies is threefold, sources said.

First, government-owned investment funds are in the midst of diversifying into riskier assets from their traditional holdings of government bonds, as opposed to maturing pension funds that need to stabilize their portfolios with less risk. Second, the types of assets that attract SWFs — alternatives, real assets and emerging market or global equities and credit — have been those that are more conducive to active management. Third, the heft of their wallets and the severity of the financial crisis have resulted in “some of the lowest fees ever offered by (active) managers anywhere,” according to one former money manager who worked with SWFs.

In addition to SSgA, global multiasset managers such as UBS Global Asset Management, BlackRock Inc., Pacific Investment Management Co., Goldman Sachs Asset Management, Morgan Stanley Investment Management, Credit Suisse Asset Management and BNY Mellon Asset Management have won recent active mandates from SWFs, according to consultants and academics familiar with the funds.

Other active managers appointed by SWFs over the past year include T. Rowe Price Group Inc., Franklin Templeton Investments, Schroder Investment Management, Martin Currie Investment Management, Rogge Global Partners, Ashmore Investment Management Ltd. and Mondrian Investment Partners, according to sources.

Alternatives have been among one of the most active areas of investments for SWFs in the past year and, as a result, private equity, hedge fund and real estate managers have gained significant asset inflows or commitments from this group of clients. For example, some of the top private equity managers to have won recent SWF commitments include Carlyle Group, 3i Group, Madison Dearborn Partners, TA Associates, Advent International, Apax Partners, Blackstone Group and TPG Partners, according to London-based alternative investment research firm Preqin. Among this group, Carlyle tops the list with known commitments from eight SWFs based in the U.S., Middle East and Asia, according to Preqin.

“Sovereign wealth funds, for the most part, stuck to their guns and kept an eye on their investment strategy through the crisis,” said John A. Fraser, global chairman and CEO of UBS Global Asset Management based in London.

Mr. Fraser declined to specify how much UBS has in assets under management for SWFs, but said actively managed asset inflows from such clients have been growing and helped the institutional asset management division to turn a corner in 2010.

“It's definitely an important growth area for us,” said Mr. Fraser, whose firm launched a separate business development group dedicated to sovereign wealth funds in 2004 that now has eight people based in New York, London, Zurich and Singapore.

Hani Kablawi, managing director and head of client management for Europe, Middle East and Africa at BNY Mellon based in London said: “The fact that we have six of our most senior people on the sovereign advisory board is a strong statement that from a (corporate) governance standpoint, we're doing everything we can to make sure that we're heading in the right direction.”

Mr. Kablawi, who is also co-chair of the bank's sovereign advisory board, which focuses on SWF business development, said new inflows from SWFs in the past year have included inflation-linked bonds, emerging market local currency debt and active global equity strategies. The mandates have ranged from about $100 million to $750 million each.

Sovereign wealth fund officials are “venturing further out in the efficient frontier to seek higher returns. They're accepting higher levels of risk, giving up some liquidity in order to gain returns,” said Mr. Kablawi, who declined to say how much the firm manages for SWFs.

David Smart, global head of sovereign funds and supranationals at Franklin Templeton, said the firm's SWF assets under management represented about $42 billion of the firm's total AUM of roughly $553 billion at year-end 2009, compared with $34 billion the previous year. The 2009 figure doesn't include a mandate won earlier this year to manage the entire Fondul Proprietatea, Bucharest, Romania, which has about $5 billion in assets.

“No doubt if you look at what's going on among defined benefit (pension) plans, there has been a marked shift away from active long-only equity toward liability-driven investment strategies,” Mr. Smart said, “leaving sovereign wealth funds as one of the dwindling group of ultra-long-term investors.”

Sam Meakin, senior analyst at London-based Preqin and author of its 2010 Sovereign Wealth Fund Review, said the desire of SWFs to diversify into riskier asset classes temporarily halted during the financial crisis but is “very much picking up again.”

“It's not possible to quantify (the total number of new mandates) in terms of absolute figures” because many of these funds are notoriously protective of any information about their investment portfolios, Mr. Meakin said. Some, including what is believed to be the world's largest fund — the Abu Dhabi Investment Authority — have never publicly revealed their assets. Estimates of ADIA's total assets have ranged anywhere from $325 billion to $625 billion.

In China, the National Social Security Fund, Beijing, announced in March the selection of 12 managers — including 10 new ones — to run active equity strategies in global, European, emerging markets, Asia-Pacific ex-Japan and Chinese equities listed overseas. Officials did not reveal how large each mandate would be, but sources familiar with the fund estimated an average of at least $100 million to $200 million per manager. Furthermore the mandates are expected to grow as the fund, which has about $140 billion in assets, is expected to gradually shift overseas equity exposure to about 20% from the current 7%.

Michael Burns, president and CEO of the $36.2 billion Alaska Permanent Fund Corp., a sovereign wealth fund based in Juneau, said fund officials there implemented an innovative portfolio restructuring earlier this year that carved out five actively managed external “mini funds” targeting an inflation-adjusted return rate of 5% net of fees. The “external CIOs” appointed to run the portfolios include AQR Capital Management LLC, Bridgewater Associates Inc., Goldman Sachs Asset Management and PIMCO, each managing about $500 million. In addition, Grantham, Mayo van Otterloo & Co. LLC was appointed to manage $250 million.

The fund receives 25% of the state's oil revenues, mineral bonuses, royalties and related income.

“We wanted to see what each of the managers would do if they were unfettered by our mandates,” Mr. Burns said. “We see this as a learning opportunity ... to improve our own internal capabilities.”

The Wyoming state treasurer's office manages about $11.7 billion in assets sourced from the state's mineral rights. About $3.5 billion is allocated to the state's operating account, but the remainder is invested in various funds and includes the Permanent Wyoming Mineral Trust Fund.

Michael Walden-Newman, CIO of the treasurer's office, said fund officials increased the allocation to hedge funds last year because “we realized that absolute-return strategies are well positioned to take advantage of the market dislocation.”

In 2009, fund officials increased the hedge fund allocation to 7.5% from 5%, adding to existing allocations to Pacific Alternative Asset Management Co. and Aurora Investment Management LLC. Earlier this year, officials also committed $75 million to the WestRiver Real Estate Finance Fund launched by Alexander Zabik, former managing director at BlackRock. Authorities are searching for real estate opportunities to meet an increased allocation to 7.5% from 5% of the portfolio.

“We're in it for the long haul as the state of Wyoming isn't going anywhere,” Mr. Walden-Newman said. “I used to go deep-sea fishing with my dad and he would say to me that if you don't want to throw up when the waters get choppy, keep your eyes on the far horizon. Those words came back to me in the fall of 2008.”