Sovereign wealth funds are taking more risks. The bigger appetite makes sense, but needs to be matched with stronger portfolio management.
State-owned entities that came to the rescue of capital-short Western financial institutions a few months ago have done badly. Despite being burnt the first time—losses near 40%—some are mulling a fresh round of injections. The Kuwait Investment Authority has indicated it might raise its holdings in Citigroup and Merrill Lynch & Co. Inc.Lehman Brothers Inc. and Barclays Group are also thought to be in talks with sovereign funds.
It’s a part of a trend. Sovereign funds are dedicating an increasing portion of their portfolios to higher-return asset classes. Risk-free bonds are no longer the predominant destination of choice. Of the estimated $2.5 trillion (Rs107.25 trillion) assets under management, they are now thought to invest 49% in equities and alternatives such as real estate and private equity.
Yet, sovereign funds will also be keen to minimize the increased risks and potential ridicule that come with investments such as China’s disastrous punt on Blackstone and Qatar’s loss on its stake in the London Stock Exchange. Sure, these occasional trip-ups won’t ruin anyone, yet there’s a danger such failures could multiply.
Unlike pension funds, the majority of sovereign funds do not have liabilities to inspire caution. Indeed, the chance of making a killing from the credit crunch has even tempted traditionally low-profile funds, such as the Government of Singapore Investment Corp. Pte Ltd, to make uncharacteristically big bets.
One way to avoid embarrassing errors is to start with a clear mandate. Existing goals tend to be vague, such as achieving long-term returns, diversifying away from oil revenues and making strategic investments.
If governments want to avoid squandering their wealth and repeating the mistakes made by cash-rich oil states in the 1970s, sovereign funds pursuing high-risk opportunistic investments need more disciplined safeguards.
Here is a simple suggestion. Governments should create separate funds for high- and low-risk investments, each with clear targeted rates of return and acceptable levels of volatility. That would, at least, make it easy to spot whether funds are managing their appetite.