Posted inAnalysis

Short-termist sovereign wealth funds miss return targets

Expert Investor

According to the report, sovereign wealth funds made average returns of 4.1% in 2016. This is the same number as in 2015 and two percentage points below their average long-term annual return targets.

Funds responding to Invesco’s survey expect to make little wholesale changes to their asset allocation this year, as the unexpected geopolitical developments of 2016 have made them wary of taking strong allocation bets.

Safe haven appeal

In response to political uncertainty, they plan to step up exposure to perceived safe havens such as the US and Germany, while reducing allocation to the UK. The US and Germany are regarded as the most attractive markets, receiving a score of 8 and 7.8 respectively on a 10-point scale. The UK’s score, however, decreased from 7.5 to 5.5. It’s now the least attractive market in Europe to sovereign wealth investors.

The preoccupation of sovereign wealth funds with (short-term) political risk is remarkable, since most of them have an extremely long-term investment horizon.

Surprising is also their preference for the US, which contradicts general market sentiment: recent fund flows as well as Expert Investor asset allocation sentiment data suggest US (equities) are currently deeply unpopular. Some four in 10 survey respondents expect to increase allocation to North America in 2017. This contrasts with more than a third of European fund buyers planning to reduce their exposure to US equities this year.

Higher interest rates in the US are one reason that the country is relatively popular with sovereign wealth investors, as US bonds look comparatively more attractive than equivalents in other developed markets. According to the survey, interest rates are indeed the most important macroeconomic factor driving both tactical and strategic asset allocation.  

Sovereigns without clothes

But survey respondents cite other, less convincing reasons for increasing their exposure to the US. The report cites “confidence of a ‘pro-business’ corporate tax regime following Trump taking office in January 2017”, as well as “growing optimism around the potential for new infrastructure deals in the US following political campaigning suggesting an investment opportunity of $1trn”. Good luck with that, sovereign wealth investors!

Some sovereigns also “deliberately target dollar exposure through their international investments,” says the report, as they were anticipating further dollar appreciation. While this dollar bullishness is understandable in the light of recent strong performance of the greenback, it is a questionable attitude for long-term investors which could easily backfire, especially if the Trump presidency is unable to implement the stimulatory policies described above.

And that’s exactly what happened: the dollar is down 6.4% against the euro year-to-date, making sovereign wealth investors’ dollar bet look rather poorly timed.

Finally, the report reveals an increasing home bias among sovereign wealth investors in response to increased political uncertainty. Sovereign wealth funds now have an average of 47% of their assets invested in their home market, up from 40% in 2015.

This seems at odds with the primary objective of most sovereign wealth funds, which is to provide diversification. As sovereign funding tends to be heavily dependent on the local market, having almost half of your assets invested in their home market suggests sovereign wealth funds are pre-occupied with reducing (short-term) risk, while neglecting their diversification objective. Perhaps it’s time they refocus on the long term.

Part of the Bonhill Group.