What lies beneath the growth
of sovereign wealth funds

Sovereign wealth funds have gained attention as governments increasingly rely on them to manage public assets. In the past decade, their total assets have doubled, growing from $6.7 trillion in 2014 to $12.7 trillion in 2023. If the combined sovereign wealth funds were a country, it would be the world’s third-largest economy, trailing only the United States and China.

Unlike traditional investment funds, sovereign wealth funds are government-owned and funded. Their strategies and management are directed by state bodies instead of banks or private financial companies. This structure enables them to prioritize national interests over purely profit-driven goals.

Why governments use sovereign wealth funds

In theory, the existence of sovereign wealth funds is supported by the idea that governments or central banks often hold substantial liquidity that they plan to invest with a long-term perspective. Rather than channeling these funds into conventional money markets, they establish sovereign wealth funds to actively manage diverse assets like stocks, bonds and commodities.

For example, Norway’s Government Pension Fund Global, one of the largest sovereign wealth funds, invests its profits from oil in global stocks and bonds, managing $1.74 trillion with an annualized return of 6.3 percent since 1998. Another example is the Kuwait Investment Authority, established in 1953. It is the oldest such fund in the world, created to manage the country’s growing oil wealth, and it currently has investments in assets like real estate and global equities.

Although governments can choose to invest through treasuries or collaborate with private firms, many prefer sovereign wealth funds because they allow for the appointment of expert managers and the adjustment of strategies without the lengthy negotiations typical of external partnerships. Moreover, by reporting directly to government leaders, these funds avoid the bureaucratic delays typical of standard departments. This approach is faster and more focused.

Sovereign wealth funds offer clear advantages. Professionals in these funds tend to have greater expertise than long-standing bureaucrats and are less swayed by political pressures than those in ministerial departments. Additionally, such funds are nimbler and better aligned with specific objectives. A country can establish multiple funds, each tailored to a particular goal. This allows for investment strategies that can be carefully crafted and adjusted according to the investor’s preferences.

Do sovereign wealth funds make sense for every government?

Whether sovereign wealth funds make sense for a government depends on its financial health and priorities, which may not always support ambitious initiatives. Even with a balanced budget, tax revenues and public spending rarely align, leaving treasuries flush with cash at times and strapped at others.

This explains why governments resort to money markets to bridge the gaps. In these cases, there is not much decision-making to do: Lending and borrowing are usually denominated in the same currency as revenues and expenditures. The counterpart is usually of the highest quality, meaning it is unlikely to default in the short term.

Central bankers and government officials, exercising caution, consider their options for surplus cash: buying long-term bonds, lowering short-term debt or acquiring liquid assets in the financial markets. Current and expected interest rates drive the decision, possibly together with advice from outside professionals, including investment bankers. In this cautious environment, a sovereign wealth fund may appear unnecessary.

Yet, the situation shifts when we consider the widespread budget deficits and increasing public debt faced by many countries. With cash reserves stretched thin, launching or maintaining a sovereign wealth fund becomes challenging, prompting a critical question: Should a government borrow more, deepening its deficit, to establish one?

Such a strategy could be reasonable if a government approaches its finances like a trader, borrowing at relatively low interest rates. The borrowed funds could be invested in a sovereign wealth fund to generate significant profits for the government, helping it manage debt while building a surplus. One might question whether governments should engage in financial market speculation, but that is a different story.

In addition to generating profits, these funds can effectively address specific financial goals, such as safeguarding state-funded pension systems. When lawmakers view retirement as a public responsibility, a sovereign wealth fund emerges as a key safeguard, at least partially shielding contributions from routine budget demands and preventing politicians from siphoning them into a pay-as-you-go framework.

The term “partially” is important, though. For a sovereign wealth fund to offer complete protection, it must avoid investing its funds in treasury bills issued by the government it belongs to. Its dividend payment policy should adhere to strict pre-established rules aligned with the fund’s objectives. Unfortunately, this level of security is not always guaranteed, especially when the funds are formed and managed by governments facing financial difficulties.

The wealth advantage

Sovereign wealth funds thrive under governments with strong public finances and diverse revenue streams beyond taxes. These streams often come from state-owned companies, lucrative natural resources or balance-of-payment surpluses.

In these cases, sovereign wealth funds become an appealing option, particularly if lawmakers believe these inflows should not be used to lessen the tax burden but instead set aside for specific purposes while free of rigorous parliamentary oversight. State-funded pension systems fall into this category, as do government-led domestic and foreign direct investments, such as acquiring companies or infrastructure, and potentially even defense spending.

This report was originally published here: https://www.gisreportsonline.com/r/sovereign-wealth-funds/