Sovereign wealth funds have attracted a lot of attention in recent years as more countries open funds and invest in big-name companies and assets. Some experts estimate that all sovereign wealth funds combined to hold more than $5 trillion in assets in 2012, a number that is expected to grow relatively quickly. This has given way to a wide concern over the influence these funds have on the global economy. As such, it is important to understand exactly what sovereign wealth funds are and how they first came about.

Sovereign Wealth Funds - Friend Or Foe?

What Is a Sovereign Wealth Fund?
A sovereign wealth fund is a state-owned pool of money that is invested in various financial assets. The money typically comes from a nation's budgetary surplus. When a nation has excess money, it uses a sovereign wealth fund as a way to funnel it into investments rather than simply keeping it in the central bank or channeling it back into the economy.

The motives for establishing a sovereign wealth fund vary by country. For example, the United Arab Emirates generates a large portion of its revenue from exporting oil and needs a way to protect the surplus reserves from oil-based risk, thus it places a portion of that money in a sovereign wealth fund. Many nations use sovereign wealth funds as a way to accrue profit for the benefit of the nation's economy and its citizens.

SEE: A Guide To Investing In Oil Markets

The primary functions of a sovereign wealth fund are to stabilize the country's economy through diversification and to generate wealth for future generations.

The first funds originated in the 1950s. Sovereign wealth funds came about as a solution for a country with a budgetary surplus. The first sovereign wealth fund was the Kuwait Investment Authority, established in 1953 to invest excess oil revenues. Only two years later, Kiribati created a fund to hold its revenue reserves. Little new activity occurred until three major funds were created:

  • Abu Dhabi's Investment Authority (1976)
  • Singapore's Government Investment Corporation (1981)
  • Norway's Government Pension Fund (1990)

Over the last few decades, the size and number of sovereign wealth funds have increased dramatically. In 2012, there are more than 50 sovereign wealth funds, and according to the SWF Institute, has exceeding north of $5 trillion.

Commodity vs. Non-Commodity Sovereign Wealth Funds
Sovereign wealth funds can fall into two categories, commodity or non-commodity. The difference between the two categories is how the fund is financed.

Commodity sovereign wealth funds are financed by exporting commodities. When the price of a commodity rises, nations that export that commodity will see greater surpluses. Conversely, when an export-driven economy experiences a fall in the price of that commodity, a deficit is created that could hurt the economy. A sovereign wealth fund acts as a stabilizer to diversify the country's money by investing in other areas.

Commodity sovereign wealth funds have seen huge growth as oil and gas prices increased between 2000 and 2012. In 2012, commodity financed funds totaled more than $2.5 trillion.

SEE: Oil And Gas Industry Primer

Non-commodity funds are typically financed by an excess of foreign currency reserves from current account surpluses. Non-commodity funds totaled $2 trillion in 2012, which is three times the total three years earlier.

Currently, the majority of funds are financed by commodities, but non-commodity funds may reach beyond 50% of the total by 2015.

What Do Sovereign Wealth Funds Invest in?
Sovereign wealth funds are traditionally passive, long-term investors. Few sovereign wealth funds reveal their full portfolios, but sovereign wealth funds invest in a wide range of asset classes including:

However, a growing number of funds are turning to alternative investments, such as hedge funds or private equity, which are not accessible to most retail investors. The International Monetary Fund reports that sovereign wealth funds have a higher degree of risk than traditional investment portfolios, holding large stakes in the often-volatile emerging markets.

SEE: Why Country Funds Are So Risky

Sovereign wealth funds use a variety of investment strategies:

  • Some funds invest exclusively in publicly listed financial assets.
  • Others invest in all of the major asset classes.

Funds also differ in the level of control they assume when investing in companies:

  • There are sovereign wealth funds that place a limit on the number of shares bought in a company and will enforce restrictions either to diversify their portfolios or to adhere to their own ethical standards.
  • Other sovereign wealth funds take on a more active approach by buying larger stakes in companies.

International Debate
Sovereign wealth funds represent a large and growing portion of the global economy. The size and potential impact that these funds could have on international trade has led to considerable opposition, and the criticism has mounted after controversial investments in the United States and Europe. Following the mortgage crisis of 2006-2008, sovereign wealth funds helped rescue struggling Western banks CitiGroup, Merrill Lynch, UBS and Morgan Stanley. This led critics to worry that foreign nations were gaining too much control over domestic financial institutions, and that these nations could use that control for political reasons. This fear could also lead to investment protectionism, potentially damaging the global economy by restricting valuable investment dollars.

In the United States and Europe, many financial and political leaders have stressed the importance of monitoring and possibly regulating sovereign wealth funds. Many political leaders assert that sovereign wealth funds pose a threat to national security and their lack of transparency has fueled this controversy. The United States addressed this concern by passing the Foreign Investment and National Security Act of 2007, which established greater scrutiny when a foreign government or government-owned entity attempts to purchase a U.S. asset.

Western powers have been guarded about allowing sovereign wealth funds to invest and have asked for improved transparency. However, as there is no substantive evidence that funds are operating under political or strategic motives, most countries have softened their position and even welcomed the investors.

The Bottom Line
The size and number of sovereign wealth funds continues to grow, assuring that these funds will remain a crucial part of the global economy in the future. One report projects that if sovereign wealth funds continue to grow at their current pace, they will exceed the annual economic output of the U.S. by 2015 and that of the European Union by 2016. The emergence of sovereign wealth funds is an important development for international investing, and as regulation and transparency issues are resolved in the coming years, these funds are likely to take on a major role in shaping the global economy.

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