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We published our first report on the sovereign asset management industry in 2013 following interviews with 43 sovereign investors. This year marks our fifth annual study with the evidence-based findings based predominantly on face-to-face interviews with 97 leading sovereign wealth funds, state pension funds and central banks with assets in excess of US$12 trillion.
Over the past five years we’ve noted a number of factors influencing sovereigns such as low interest rates, the falling oil price and reduced funding. This year however we note geopolitical shocks in developed markets are shaping decision making. When coupled with uncertainty over the end of quantitative easing, the commencement of quantitative tightening and ongoing volatility in currencies and commodities it’s clear sovereign investors are faced with a challenging macroeconomic and therefore investment environment.
The first theme in this year’s report addresses the aforementioned factors and notes a continuing return gap between target and actual returns with asset deployment challenges limiting the ability for sovereigns to match strategic asset allocation targets. We note sovereigns are increasingly looking to evolve their business models through internalisation or investment partnerships to reduce management costs and improve placement efficiency.
Geopolitical risks have led to an increased concentration on perceived ‘safe haven’ international markets such as the US, India and Germany as well as an increasing focus on home market allocations in an effort to reduce foreign currency exposure.
We focus on real estate in our third theme, highlighting accelerated growth in the asset class. We examine the drivers for these allocations as well as setting out how and where assets are being deployed.
Despite sovereigns being well placed to implement Environmental, social and governance (ESG) strategies due to their size and long-term orientation, the uptake of ESG practices by sovereigns appears to have varying success. We highlight sovereigns’ polarised perspectives on ESG investing across various regions.
We conclude with a theme focused on central banks. This year we have expanded and segmented our central bank sample to understand differences in strategy and pace of change with respect to investment tranches across developed and emerging markets.
We hope the unique, evidence-based findings in this year’s report provide a valuable insight into a fascinating and important group of investors.
Shift from investment strategy to business model The gap between target and actual portfolio returns along with declines in investment commitments are reshaping sovereigns’ strategic agendas.
Increasing appeal of perceived ‘safe haven’ markets Geopolitical uncertainty is leading to a focus on perceived ‘safe haven’ international markets and home markets.
Attraction to real estate for matching and flexible participation Sovereigns are increasing allocations to high-quality direct real estate given perceived return, matching and flexibility attributes.
Environmental, social and governance (ESG) growth dependent on performance data Perspectives on ESG are polarised with supporters moving to further embed and integrate ESG in investment processes while non-supporters wait for evidence of investment implications.
Central bank risk appetite driven by financial market exposure Central bank investment priorities and risk appetite vary according to the size of the country’s reserves and to the level of exposure to financial market shocks.
Sovereign segmentation is crucial to understanding attitudes and responses to external themes Economic challenges affect sovereigns differently, according to their liabilities, risk appetites, funding dynamics and other factors. We use the framework in figure 1 to categorise sovereign investors. We will explore the unique implications of the themes in this report for each of these segments.
Investment sovereigns Investment sovereigns do not have any liabilities, allowing for long time horizons and high exposure to illiquid asset classes. Due to this investment freedom, return targets are high – investment sovereigns have responded to falling returns by targeting greater illiquid asset exposure (to generate higher returns) and developing internal management capability (to capture more of the value chain), however many funds are reaching limits on these allocations.
Liability sovereigns Liability sovereigns are split into funds with existing outflows (current liability sovereigns) and funds with future liabilities (partial liability sovereigns). While partial liability sovereigns have similar strategies to investment sovereigns (due to their long time horizons), matching outflows is a key concern for funds with current liabilities. The return gap is therefore of particular significance to liability sovereigns and many funds expect their target rates to eventually increase as they update models to lower ‘risk free’ rates and increasing life expectancy. To manage these concerns, many current liability sovereigns are seeking greater exposure to high-yielding asset classes.
1Central banks have secondary liquidity objectives as well as primary capital preservation objectives. They are distinct from sovereigns through their role in local market money supply and their regulatory function.
Liquidity sovereigns manage assets to stimulate economies that are highly dependent on commodity prices during a market shock. Due to the unpredictable and sudden nature of outflows, liquidity sovereigns have extremely short time horizons and prioritise portfolio liquidity above investment returns. Despite low yields of government bonds, liquidity sovereigns are unable to seek higher returns from alternative asset classes due to the inherent liquidity risk.
The asset and geographic allocation of development sovereigns is driven by the requirement to encourage local economic growth (rather than investment return). Development sovereigns take large (often controlling) stakes in companies of economic significance in order to grow their presence in the local market. While other sovereigns adjust allocations to maximise their asset growth and yield, development sovereigns consider their success in economic metrics such as GDP growth and job creation, working closely with their investments to grow long-term strategic assets. This means that development funds are relatively unreactive to return shortfalls and asset allocation trends.
Central banks are ‘lenders of last resort’ – managers of a large foreign reserves portfolio to bail out financial institutions of public importance. Due to the importance of maintaining reserves to sufficiently cover such requirements, preservation of capital is of greatest importance. Central banks also have high levels of public accountability and disclosure, encouraging risk aversion through short time horizons and highly liquid investments. While other sovereigns invest in home market assets, central bank reserve managers hold the majority of their assets in foreign securities, increasing the importance of currency exposure relative to other sovereigns.
Unlike sovereign investors, central banks have objectives outside of reserves management, including local market liquidity management and maintenance of currency pegs. Since these external factors have influence over the foreign reserves, in this study we consider central banks separately from sovereign investors. However, as many government bonds have negative yields, certain central banks have looked to invest in non-traditional asset classes (e.g. equities) to preserve their capital, closer aligning their foreign reserves investment strategy to that of sovereign wealth funds.