Where Asian sovereign wealth goes next

ARTICLE FOR FUND FORUM – delivered Doha, Qatar, October 2011

Asian sovereign wealth funds: where they’re going and what it means for the rest of the world

Just a few years ago, any article on Asia Pacific sovereign wealth funds would have struggled to get far out of Singapore. The city state’s two sovereign entities – Temasek and the Government of Singapore Investment Corporation (GIC) – have long been seen as elder statesmen of the sovereign wealth community, sophisticated and largely successful. But where else would you go after that? You could argue that the investment portfolio of the Hong Kong Monetary Authority’s Exchange Fund has sovereign wealth characteristics; beyond that, there was little to discuss.

Today, things are very different, for two reasons: firstly, the appearance of several new fund vehicles; and secondly, the fact that they have, to varying degrees, committed to at least some transparency, certainly far more than is commonplace in the Middle East. As newer funds in China, Korea, Australia and even Timor L’Este have moved past three year track records and started to reflect their likely long-term asset allocation, it is now possible to have an entirely different discussion about Asian sovereign wealth.

So what trends can we see? Let’s start with the obvious one: dramatically rising asset volumes.  Cerulli Associates calculates that volumes in Asian sovereign wealth funds have risen from $432 billion in 2006 to $1.268 trillion today. Definitions of sovereign wealth funds are fraught with difficulty, so let’s dissect that figure right away: we’re including the investment portfolio assets of the HKMA’s Exchange Fund (but not the chunk that is kept in backing to Hong Kong’s monetary base); we’re including Malaysia’s Khazanah; we haven’t added smaller or newer funds such as Brunei or Timor-L’Este, nor more distant Australia’s Future Fund; and we’ve made an educated guess at GIC’s total assets, which are not disclosed beyond being “over $100 billion” (we think they’re at least three times that).

Secondly, the diversity of sources of funds is growing. Whereas Singapore accounted for at least two thirds of regional sovereign wealth assets in 2006, they fell below half of the regional total by 2010 and will continue to drop. It would be no surprise to see the China Investment Corporation become the biggest fund in the region in coming years as the State Council entrusts more assets to it. Korea’s fund assets, from a low base, are becoming significant, and Australia’s too.

Moreover, sovereign funds are beginning to appear in progressively more obscure and frontier-spirited locations. It is a surprise to many to learn that one of the most transparent and conservative sovereign wealth funds in the world is located in the fledgling nation of Timor L’Este or East Timor, investing the wealth that comes from natural gas fields in the Timor Sea. It has become a role model for newly commodity-rich states: Papua New Guinea and Mongolia are also developing sovereign funds.

Sovereign funds do vary dramatically in their approach to asset allocation, either by asset or geography, but there are some general conclusions one can draw. One is that, gradually, sovereign funds are becoming more inward looking into Asia, at the expense of the developed world.

The gold standard in this respect is Temasek, which in 2002 launched a revamped 40-30-20-10 benchmark, with the 40 being Asia ex-Singapore, 30 Singapore, 20 OECD and 10 ‘other’, which in practice so far chiefly means Latin America. If Temasek’s conviction towards this was ever in doubt, any concerns were surely erased by the losses it made in its holdings in western banks during the financial crisis. Temasek knows it knows emerging markets best, and almost everything about its investment policy today relates to emerging market themes: transforming economies; growing middle income populations; deepening comparative advantages; and emerging champions.

Others simply express Asian convictions with overweights; CIC, for example, has a much bigger holding in Asia than any MSCI weighting would come up with, but it’s still less than its assets in North America. Singapore’s GIC has long talked about shifting towards emerging markets assets, and in the year to March 31 2011, finally appeared to do so: emerging market equities climbed from 10 to 15% of the portfolio during the year, while developed market equities dropped from 41 to 34%. Asia across the board now accounts for 27% of the portfolio, up from 24% last year – and remember GIC can’t invest in Singapore.

Another widespread trend is a move into alternative assets.  Singapore’s GIC is seen as a leader in this respect: it made its moves into alternatives early and by 2009 they accounted for 30% of the fund, if real estate is included (GIC being one of the world’s biggest real estate investors in its own right). The figure has actually dropped slightly to 26% in 2011, but still GIC is considered a regional expert in private equity, venture capital, infrastructure and hedge funds; it has worked with pretty much every major private equity player worldwide.

CIC’s 2010 report was particularly interesting, because it was the first time that the Chinese institution had invested enough of its assets to provide a meaningful representation of what its long-term allocations are likely to look like. 21% of the fund was in alternatives. In particular much of 2010 was spent investing in REITs, private equity and infrastructure, while new alternative strategies adopted during the year included a metals and energy indices swap, a gold equity fund, an active commodity index strategy, and futures or options around indices, bonds, commodities and FX forwards. Another important step came in May, when CIC reorganized its investment departments. There are now four, and three of them have alternative attributes: alongside the Department of Public Equity, which combines external fund managers and proprietary trading, there is the Department of Fixed Income and Absolute Return, which apart from bonds handles credit derivatives, hedge funds, multi-asset portfolios and commodities; the Department of Private Equity, which handles real estate, industry and technology, financial services, consumer goods and services, healthcare and biopharma investments; and the Department of Special Investments, which is more focused on energy, mining, precious metals, agriculture and infrastructure.

At KIC, an alternative investments program was launched in 2009. When last disclosed alternatives accounted for just 5.8% of the fund, not counting a special situations division, but CIO Scott Kalb has spoken of 20% being a logical figure to reach.

Globally, this is a pattern: a recent report by Preqin concluded that 36% of sovereign wealth funds globally were investing in hedge funds, 61% in infrastructure and 59% in private equity. Perhaps related to this, there is growing interest in megatrends like sustainability, scarcity and security, all of which are of course highly relevant in the Middle East too. In Asia, these themes tend to be expressed in deals with big energy and resources companies, often as pre-IPO investments. Some also consider currency an interesting asset class in its own right, and in Asia the discussion is particularly keen around the RMB as it becomes an increasingly international, offshore-traded currency. GIC, for example, holds a QFII licence, allowing it to invest up to a quota amount in mainland Chinese assets.

In other respects, though, sovereign wealth funds in Asia are exceptionally diverse. This is nowhere more true than in mandates. Temasek and CIC have no defined liabilities: they are tasked with building up assets for some nebulous future good. GIC and KIC are entrusted with foreign exchange reserves, but even then there’s a difference, as KIC has an odd combination of central bank and finance ministry funds, each with a different risk tolerance. Some are hydrocarbon resource funds in the manner of the Middle East, like Timor L’Este’s Petroleum Fund, the Brunei Investment Agency fund, and the developing entities in Mongolia and PNG. Then there’s Khazanah, which exists to manage and improve state-held companies.

One other trend, not so good for fund managers, concerns outsourcing. Here, too, Singapore is illustrative. Temasek rarely outsources anything anymore; it doesn’t invest through portfolios but mainly through direct holdings in companies themselves, and doesn’t need external managers for that, apart from which it already has its own fund management arm, Fullerton. GIC is renowned for its internal smarts – it is believed to have a larger headcount than ADIA – and can do almost anything you can think of internally; generally the best way in to GIC now is probably to be a hedge fund and to encourage co-investment.

The pattern tends to be that funds start out outsourcing, master a particular asset class, then bring it in house again. This is true of the KIC, for example, where the proportion of outsourced assets has declined from 60% in 2008 to 35% in 2009 and 29.3% in 2010. In younger funds, the proportion outsourced is higher. CIC outsources 59% of its portfolios assets today, but is also expected to bring more assets in-house over time.

In this respect, it’s important to get in early. You might not think East Timor is the most lucrative place in the world but its fund is already approaching $9 billion, and there’s 20 years of gas there. So far it has outsourced only conservative and largely passive fixed income portfolios to the Bank of International Settlements and Schroders, but its finance minister, Emilia Pires, is trying to get parliament to approve a shift to a more traditional asset allocation with about 50% of the fund in equities. Similarly the PNG LNG project in Papua New Guinea will generate $30 billion of wealth to be managed, and there is every intention to outsource once the money starts flowing. Mongolia’s Stabilization Fund will at some point start to be invested as a sovereign fund; one only has to look at the economics around the Oyu Tolgoi and Tavan Tolgoi mines being developed in the country’s south, very much the tip of the iceberg in Mongolian resources, to see what the potential is.

It’s often said that sovereign funds will use passive approaches for the bulk of their money and take active bets around the edges, where the opportunities arise for foreign managers. Actually, it’s not always true that all passive work is done in-house; we believe ADIA, for example, outsources passive mandates. It’s probably closer to the truth to say that outsourcing opportunities are keen either for highly active or completely passive managers, but not for would-be-active benchmark-huggers. Several sovereign wealth funds won’t even countenance a meeting with an external manager without a clear illustration of where alpha will be added.

So the picture for external managers is mixed. On one hand there’s a bounty of assets coming into sovereign funds, from a greater range of institutions than ever before. On the other hand, they want more from their external managers. Those who thrive will be the ones who can be demonstrably successful and different from the herd.