Sovereign wealth funds have experienced a bit more volatility than they are used to over the past two years. Rising rates and inflation hit sovereign portfolios like they have all others and these funds have also felt the pullback in private equity activity as well as the fluctuations of U.S. equities.
According to Invesco’s recent sovereign asset management survey, sovereign funds underperformed broadly in 2022, but rebounded strongly in 2023. The data for 2024 is not in yet, but sources say that sovereign funds are refocusing on diversification and are willing to take on a bit more risk where they can get a premium for it.
Moving an aircraft carrier
Sovereign wealth funds are not known for being the most tactical asset allocators – they have large budgets and very long investment horizons, but when market regimes shift significantly – so do they.
“We’ve been pulling back from U.S. stocks for quite some time – we started in 2017,” explains Vince Smith, CIO at the New Mexico State Investment Council. “We’re at what I think is our lowest exposure at 17-18%. We’ve redeployed that capital as much as we can into private markets. We’ve increased our exposure to private credit and we like the value we’re finding in international equities.”
The shift into private markets is part of a larger effort within New Mexico SIC. More money has been coming into the fund than going out and they have a lot of cash on hand. According to the investment plan presented to the Council last week, the goal is to continue to increase exposure into private markets across asset classes over the next several years. So far, the private credit portfolio, for example, has 57 partnerships with a market value of approximately $4 billion. SIC has been active in private credit year to date, including in new real assets partnerships, and is continuing toward reaching its full target allocation.
These shifts echo those of other sovereign wealth funds. 62% of SWF respondents to the Invesco survey said that they were taking a closer look at international equities and increasing exposure. Fifty-six percent of respondents said their funds were invested in private credit instruments and a further 30% said they were involved in direct and/or co-investments.
Smith says SIC benchmarks itself against a group of approximately 36 funds across the U.S. that it considers to be peer funds including other sovereign wealth funds like the Alaska Permanent Fund. “On average those 36 funds have an expected volatility of about 12%,” he says. “Our expected volatility is about 14% so we take a little more investment risk and the primary place we take it is in private markets.”
SIC works on a time horizon of 7-10 years with its investment plans, which aligns it well with typical lockup periods for traditional private equity and more recently private credit. “When we look at the big sovereign wealth funds within the U.S. all of us are moving more toward private markets and taking on a bit more risk. I think that’s a trend that is likely to continue.”
These moves largely track with how Marcus Frampton, CIO at the Alaska Permanent Fund, thinks about diversification. He anticipates that institutional portfolios could see a fairly significant shift in drivers of performance. “The past ten years have been defined by outsized returns in U.S. equities and private equity and I don’t think we’re going to see that to the same extent over the next decade,” he says.
Frampton is more constructive on fixed income, which accounts for 20% of the portfolio as well as private markets more broadly. “I don’t know if our 20% allocation to fixed income is high or low relative to peers but we are seeing value from it. Our absolute return program – which is hedge funds – has been a positive for us as well. Everyone does hedge funds differently; our portfolio is largely macro managers and market-neutral equity. We also have some gold investments – we are big believers in gold,” he says.
Increasing partnerships
Frampton adds that he’s seeing more sovereign wealth funds show up together in deals and announce partnerships. “I started noticing it first in biotech venture. We’ve been active there over the past decade and 10 years ago no one was in it. But over the past few years the number of funds you see on the cap table in a series A or B has increased,” he says. “People have taken their lumps lately in biotech venture, but I think this is a trend we’re going to see continue.”
Rod Ringrow, head of official institutions at Invesco, agrees. He says more sovereign wealth funds are adopting partnership models. “We see it with the larger funds in particular, where they build a relationship with an asset manager or real estate firm, usually in relation to a specific asset class. Those partnerships provide opportunities for co-investment for both parties. We’ve also seen a number of sovereign funds working together on particular transactions. We think that is likely to continue.”
The economics of partnerships are typically more favorable than paying an external manager all of the fees associated with investing in a traditional commingled fund. Sovereign wealth funds may also be able to deploy more capital as a co- or anchor investor than they would in a commingled fund.
Sovereign wealth funds in the Middle East have recently emerged as key benefactors for AI companies. Saudi Arabia, the United Arab Emirates, Kuwait, and Qatar have all put more money into tech companies as a means of diversification, according to data from PitchBook. In March, sovereign wealth fund Mubadala launched a $100 billion artificial intelligence-focused investment vehicle called MGX. That fund got a stake in OpenAI’s September fundraising round. MGX is also working with BlackRock and Microsoft on a data center project.
Competing for talent
While the partnership model has a lot of benefits for sovereign wealth funds and helps them improve portfolio diversification it also means they are competing with asset managers for the internal talent that helps them participate in partnership transactions.
Claude Shaw, managing partner at consulting and advisory firm Egon Zehnder, advises sovereign wealth funds and says many of his clients are looking for professionals that have had direct experience with underwriting transactions to support their co- and direct investment teams. But it’s not easy. “Sovereign wealth funds have advantages because they aren’t going out and fundraising every year so they can just focus on investing, but they don’t pay carry. That’s a big source of value for private equity professionals,” he explains. “They have other compensation of course, but there are some tradeoffs.”
Frampton says Alaska’s willingness to offer things like remote work is helping them attract new talent but notes that it has been a struggle in the past. “We’re all looking for the same types of people,” he says.
Smith agrees. He says the SIC will likely have to double the size of its investment staff over the next several years. “We’re growing really quickly,” he says. “Our fund inflows have been very high so we have more cash to put to work and we will need more people for that. We are actively recruiting, and we do think it’s an advantage that people in the market can see us growing.”
Ringrow says that the willingness of sovereign wealth funds to develop their talent internally can often make them attractive places to work. “These are increasingly sophisticated investors. As new funds are created, we will see a bigger presence from sovereign wealth funds in the global capital markets, both in terms of economic activity but also playing a role in human capital development” he says.
The next decade may also prove to be a bit of a test for sovereign wealth funds and their teams. Frampton says he expects if not a recession, at least a significant economic slowdown at some point in the next five to ten years. If that happens, internal investment teams could find themselves under pressure.
“There is a fair bit of data that shows that in private equity, for example, you’re not really getting the premium you might expect unless you’re invested in top quartile managers and everyone thinks they are top quartile. If we have some type of reset or drawdown, it’s going to be fairly evident who was in the top quartile and who wasn’t,” he says.
Tags: Alaska Permanent Fund, Claude Shaw, Egon Zehnder, Invesco, Marcus Frampton, MGX, Mubadala, New Mexico State Investment Council, PitchBook, Robert Vince Smith, Rod Ringrow, Sovereign Wealth Fund