What Is A Sovereign Wealth Fund and How Do They Work?

Sovereign wealth funds (SWFs) are key players in today’s financial markets. These state-controlled entities are means through which nations make investments, by squirrelling away excess revenues.

They are mostly based in emerging markets and are meant to provide long term economic stimulus or bring stability to the finances of a government.

But despite sharing a moniker, each SWF is different from the others. There are many differences among sovereign wealth funds, including variations in their level of sophistication as well as goals and sizes.

Today, we are going to talk about sovereign wealth funds and why they are becoming increasingly powerful components in financial markets.

Meaning of a sovereign wealth fund

According to the International Monetary Fund (IMF), a sovereign wealth fund is a long term government controlled fund that is at least partially invested in overseas assets.

As mentioned before, most SWFs are based in emerging economies and often created using excess cash flow derived from a country’s trade and commerce activities.

As such, most of the wealth managed by these entities is based in oil-rich nations such as Saudi Arabia, Russia, Kuwait, Norway, among others.

However, SWFs can also be funded via other sources, e.g. bank reserves amassed from government transfer payments, foreign currency operations, budgeting surpluses, and privatization operations.

Examples of SWFs

There many sovereign wealth funds today, and those at the top have been around and stayed in the lead for decades. Some of the world’s biggest SWFs include;

Government Pension Fund Global (Norway)
China Investment Corporation (China)
Kuwait Investment Authority (Kuwait)
Abu Dhabi Investment Authority (Abu Dhabi, UAE)

In the U.S., some of the largest SWFs include Alaska Permanent Fund, Texas Permanent School Fund, Texas Permanent University Fund, Permanent Wyoming Mineral Trust Fund, and New Mexico State Investment Council Investment Funds.

How do SWFs work?

One of the biggest distinguishers about sovereign wealth funds is that they are investment vehicles formed by governments as a way of putting their surplus money to work.

SWFs act as a variant of private equity firms, jumping into the global financial markets to invest on behalf of their currencies.

Considering the massive amount of capital held by SWFs, finding the right investments is a challenging task.

For years, many SWFs in nations that had accumulated large chunks of dollars, often reinvested the money in U.S. Treasury bonds.

But in the last couple of years, these entities have become more sophisticated, increasingly diversifying their currency holdings and buying stakes in foreign companies.

For example, in 2016 Saudi Arabia’s sovereign Public Investment Fund (PFI) bought a $3.5 billion stake in Uber (NYSE: UBER), marking what was and still is the large single investment a foreign fund has ever made in a U.S. startup.

The deal resulted, which happened about 3 years before Uber went public, resulted in PFI owning 72.8 million shares in the ride-hailing giant.

PFI is also a huge backer of Japanese investment firm SoftBank Group, which also controls a 16% stake in Uber.

Sovereign wealth fund structure

The main structure of a sovereign wealth fund rests on the following basic elements:

They are state-controlled entities formed using money generated by the government, often scooped from a country’s surplus reserves.
They have a wide range of investments, including government bonds, foreign direct investment, stocks, valuable metals, or alternative investments such as hedge funds or private equity firms.
The risk posture and asset allocation policy of SWFs vary with the type of assets they manage.

A key thing worth noting, and particularly important when a SWF is investing outside its domestic market, is the foreign direct investment (FDI) restriction.

Like investors, SWFs that buy assets outside their home markets and have direct or indirect ties to governments, have to balance their investment with the underlying economic or political considerations.

Nations that apply FDI restrictions, to a lesser or greater extent, include the U.S., U.K., Canada, Australia, Japan, China, India, and European Union members.

FDI restrictions move beyond the national security concept, as this is sometimes considered to be too broad to provide guidance to participants and regulators, for its actual implementation in practice.

Types of sovereign wealth funds

As mentioned earlier, a sovereign wealth fund’s main goal is to maximize returns and minimize risk for the nation its tied to.

However, there are several different strategies or types of SWFs that do different things. The goals of the sovereign wealth fund will determine its investment holdings.

That said, some of the most common include stabilization funds, savings/future funds, reserve investment funds, pension reserve funds, and strategic development sovereign wealth funds.

The dark side of SWFs

According to U.S.-based Sovereign Wealth Fund Institute, some SWFs tend not to be open as others.

For example, one fund may periodically make their investment holdings public, while another fund may keep them completely out of the public eye.

1Malaysia Development Berhad (1MDB), for instance, was making headlines a few years ago following alleged financial fraud and money laundering in which U.S. and Malaysian authorities say billions of dollars were stolen from the fund.

1MDB was a sovereign wealth fund initiated by former Malaysian leader Najib Razak to help promote economic development in the country.

But between 2009 and 2014, top-ranking officials of the fund and their associates stole its funds and used the loot to buy luxury real estate and other assets.

While Malaysian authorities have managed to recover roughly $3.24 billion in assets tied to the 1MDB scandal, roughly $4 billion more is still unaccounted for.

Bottom Line

Today, we’ve learned that sovereign wealth funds are state-controlled entities that nations use as an investment vehicle, and where the initial capital is usually derived from the nation’s surplus reserves.

SWFs in turn in a variety of ﬁnancial assets such as bonds, stocks, private equity, real estate, commodities, and other things.

These entities invest increasingly on a global basis and also in their domestic markets, and are important investment and funding sources alongside traditional investors.

SWFs also have additional objectives and goals, and different characteristics, compared with other investing entities such as private equity firms and hedge funds.

These manifest themselves in the way sovereign wealth funds develop and adopt their risk policies, the type of their investment, the length of their investment timelines, their liquidity requirements, and how they organize other priorities.

Sometimes, these priorities can include corporate, environmental, and social goals. In particular, a fund may consider the societal beneﬁts of an investment and not just the ﬁnancial or economic beneﬁts.