Sovereign Wealth Funds – Investment Strategies

The role played by sovereign wealth funds (SWFs) in the global financial system has been become increasingly prominent in recent years. The resources controlled by these funds, estimated to be $5.5 trillion in 2010 have grown sharply during the past decade.

Projections, while inherently tentative due to the uncertainties about the future path of global economic growth and commodity prices, suggest that they will be increasingly important actors in world finance in future years.

Despite this significant and growing role, financial economists have curiously paid little attention to them in the past. While the investment behaviors of financial institutions with less capital under management, such as hedge and private equity funds, have attracted widespread scrutiny, sovereign funds have largely been ignored. This lack of scrutiny can largely be attributed to the deliberately low profile adopted by many SWFs, which makes systematic analysis challenging.

Several investment patterns are inherent within Sovereign Wealth Funds:

SWFs are more likely to invest at home when domestic equity prices are higher, and more likely to invest overseas when foreign prices are higher.
On average, funds invest at significantly lower price-earnings (P/E) ratios when investing at home and higher P/E levels outside. This result is mainly driven by Asian and Mid-Eastern funds, while the opposite holds for Western funds.
Asian groups and, to a somewhat lesser extent, Middle Eastern SWFs, see the industry P/E ratios of their home investments drop in the year after the investment, while they see a positive change in the year after their investments abroad.
SWFs where politicians are involved in governance have a much greater likelihood of investing at home, while those relying upon external managers display a reduced likelihood.
SWFs with external managers tend to invest in lower P/E industries, while those with politicians involved in the governance process invest in higher P/E industries.
Investments by SWFs with the involvement of external managers tend to be associated a more positive change in industry P/E in the year after the deal, while for funds where politicians are involved, the trend goes the other way around.

Taken as a whole, two competing interpretations are in play here. It may be that funds investing more heavily in their domestic markets, particularly those with the active involvement of political leaders, are more sensitive to the social needs of the nation.

As a result, they might be willing to accept investments which have high social returns but low private ones.

Since the social returns are not easily observable, it would appear that these funds are investing in industries with lower performance. The alternative interpretation would suggest that greater investment at home is a symptom of poor investment decisions, since the funds are prone to home bias.

It is hard to explain why social welfare concerns would lead politician-influenced funds to invest in the highest P/E industries, especially in light of the negative returns that usually characterize these sectors.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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