The spectre of Sovereign Wealth Funds

Sovereign wealth funds stand at a massive $3.2 trillion, which is larger than the entire hedge fund industry, and they're growing at an astonishing rate. Morgan Stanley reckons that if energy prices remain high, they could balloon to $12 trillion by 2015, dwarfing even the GDP of the US.

Many of the 40-plus sovereign funds have invested in the banking sector, propping up big players such as Citigroup (C), Merrill Lynch (MER), UBS (UBS), and Morgan Stanley (MS) - all listed in New York - to the tune of over $70 billion. This is part of an established pattern of looking for value in burned out sectors. Like other investors, sovereign are mindful of diversification, seeking out assets that are inversely correlated

with their existing holdings, such as hedge funds that specialise in asset-backed lending.
 
With global equity markets becoming so coupled, it is difficult to find markets that are not highly correlated to other assets. Last week, BP (BP-) announced that the State Administration of Foreign Exchange, a unit of China's Central Bank that manages $1.6 trillion in foreign exchange reserves, has quietly built up a £1 billion stake, prompting the oil major's shares to jump 2%. Last month, the same unit spent £1 billion on a stake in French oil firm Total. Neither stake is large enough to exert any control, but could prove useful in terms of connections. Total's stance, according to a company spokeswoman, is that the investment could prove useful as a way to "diversify our shareholding and open up to China".

The French Government is not so sanguine, however, and is understood to be producing a report on how to deal with the political threat posed by sovereign funds to the country's 'industrial jewels'. The US has in recent years scuppered the takeover of Unocal by the Chinese state-owned oil company Cnooc and the US operations of P&O by Dubai Ports World. In contrast, the UK Government has so far adopted a relaxed approach, and has consequently made itself a prime target.

Whether the funds are worth following closely is debatable, because most can afford to take a very long view and their scale presents capacity constraints that are unknown to the private investor. Neither are they a homogenous group, with various levels of transparency and different agendas. Norway's fund is quite open for instance, but the Gulf funds are notoriously secretive.

Challenging return benchmarks

There are however one or two funds which are known to have challenging short-term return benchmarks. For instance, China Investment Corp, the $200 billion fund that spent more than £4 billion on a shareholding in private equity firm Blackstone, is funded by swaps arranged by the Ministry of Finance and central bank. These involve demanding interest payments, especially as the RMB is strong against the dollar, prompting CIC in its search for external managers to demand quite aggressive targets of around 150-200bps (1.5-2%) above benchmarks such as MSCI All Country, EM, EAFE and related bond indices.

Apart from its $5 billion stake in Morgan Stanley, CIC has steered clear of Western financial institutions, save for shares in the New York-listed credit card company Visa Inc (V). Among non-financial companies, a $100 million investment in China Railway Group when it went public in Hong Kong is CIC's only known deal so far.

The older sovereign wealth funds have armies of experienced analysts, and may be better at spotting interesting opportunities.  Two with a large staff are Singapore's $330 billion Government Investment Corporation  and Abu Dhabi's $900 billion fund, the largest in the world. They don't always get it right, however. GIC made its investment in  $11 billion in UBS last December, for example, but since then the Swiss bank has gone ever more pear-shaped.

GIC has been keen to get its mitts on UK property, taking 3% of British Land (BLND) in January, after the shares halved in a year. The fund also owns a 40% share in MetroCentre in Gateshead, a 17.5 % stake in Kent's Bluewater shopping centre and 50% of the Westquay shopping centre in Southampton.

Abu Dhabi Investment Authority's banking bail-out was a $7.5 billion bond investment in Citigroup. Publicly, the fund has said it "will focus on utility, transport, social and energy-related projects in the Middle East and North Africa". However, last November it also bought an 8.1% stake in New York-listed microchip-maker Advanced Micro Devices (AMD). The electronics industry has also proved attractive to state-owned Dubai International Capital, which has acquired an undisclosed stake in Japan's electronics and entertainment giant Sony Corp (SNE) - listed in New York.

Government worry

Such apparent bids for high-tech expertise are a worry to governments around the world who have upped talks with their fellow states about the growing influence of these funds, alleging they do not always behave according to traditional market logic. Japan is particularly concerned that its high-tech industrial base is the target of emerging economy governments.

The EU has examined the issue but so far failed to come up with a solution. The establishment of a vetting body would be difficult with 27 member-states needing to agree the mandate, and the debate could easily be hijacked by the protectionist nations. One potentially workable solution might be to restrict sovereign funds with low levels of disclosure to buying non-voting shares in European companies.

The hardest questions will arise when the funds seek to buy companies in more sensitive sectors such as energy or defence. For instance, EADS, the European aerospace consortium, could soon be 25%-owned by Vneshtorgbank, a Russian state-owned bank looking to boost its stake, and  this has helped foster its relationship with Russian business partner Irkut, now part of state airline United Aircraft, to the potential detriment of US firms like New York-listed Lockheed Martin (LMT), General Electric (GE) and United Tech (UTX).

While home governments may not approve, as far as the corporations are concerned, these alignments can confer real commercial muscle, particularly in the most sensitive commercial environments.

Sovereign funds are also bolstering the developing markets by supplying billions of dollars to build infrastructure, which keeps local economies afloat by boosting jobs. Many have developed joint ventures with big banks to invest in infrastructure projects in Asia, the Middle East and North Africa, such as UBS with Abu Dhabi Investment, Deutsche with Abraaj Capital and HSBC with Dubai International Capital.

The purchasing appetite of these new consumer economies are a prime reason the so-called recession has yet to bite deeply into western economies.