Sovereign Wealth Funds Boost Alternatives

967563_flagsSovereign wealth funds have increased allocations to alternative investments in the past year and expect to continue doing so in 2014, according to a study.

The Invesco Global Sovereign Asset Management Study suggests this continued appetite for alternatives is a structural trend driven by the influence of allocating assets strategically, rather than a short-term shift due to tactical allocations to boost short-term returns.

First, many sovereign investors remain underweight in alternatives relative to their strategic asset allocation targets. These sovereign investors had increased their target allocations for alternatives in the last five years and had yet to reach these targets.

Second, many sovereign investors (46%) expect funding levels to increase in 2014 relative to 2013. A large increase in assets encourages more strategic allocation placements since allocating significant assets tactically could lead to breaching internal guidelines.

The third reason that increasing appetite for alternatives should be attributed to strategic rather than tactical asset allocation is the fact that alternatives underperformed during this period, with sovereign investors typically citing an average return of 7% for alternatives in 2013, compared with a target of 8%.

“Given alternatives underperformed during the period in which their allocations increased, it is clear that a strategic asset allocation strategy is driving sovereign investors to alternatives, rather than tactical allocation,” says Nick Tolchard, co-chair of Invesco’s global sovereign group and head of Invesco Middle East. “The expected net increase in new funding this year is another key factor that explains this preference for alternatives, driven by increasing country surpluses and strong support from governments for their sovereign funds.”

The report also notes there will be growth in new capital flow to emerging markets. Like alternatives, this trend appears to be largely driven by strategic allocation targets.

Feedback from sovereign investors indicates they are underweight in emerging markets relative to their strategic asset allocation targets, giving them more room to increase new exposure to the regions. This long-term structural trend to emerging markets does not appear to have been influenced by the fact that emerging market equities underperformed developed market equities during 2013.

There are some exceptions where tactical asset allocation strategies are at play, such as Central Eastern Europe and Russia. These are the only emerging markets to which weightings declined on a net respondent view basis in 2013 and to which respondents expect exposure to remain flat going forward into 2014, primarily due to political instability.

However, while the major trend in geographic allocation is a strategic shift to emerging markets, with allocations set to increase from current levels, this takes place within the context of a strong historical preference for developed markets, relative to the total portfolio.

“Despite allocations to emerging markets set to increase, a strong underlying preference for developed markets is still apparent, with sovereigns attracted by their depth, stability and diversification benefits, the latter of particular importance to sovereign investors based in emerging or frontier markets,” Tolchard adds. “Various factors determine sovereign geographic allocations—most notably political stability, openness of a country to sovereign investment, strength of shareholder rights, level of private ownership and government relationships.”

The report is based on interviews conducted with 52 different sovereign investors worldwide.